Xbox 360 loses money for Microsoft, but SQL Server makes it up

Posted by Scott M. Fulton, III

Redmond (WA) - The cost of producing Xbox 360s in the quantities necessary to sustain demand rose by $1.64 billion over the past 12 months, and $682 million during Microsoft's fiscal fourth quarter alone, the company reported yesterday afternoon. As a result, the company's Home and Entertainment division posted an operating loss of $414 million for Q4 2006.

The loss reflected a wipeout of the stunning gains by that division, with revenues rising 94% annually to $1.14 billion. In its fiscal Q4 2005 quarter, Microsoft also posted a loss - about half as much - but at that time, the company promised a big payoff the following year to make up for what the company then characterized as investments in its future. Those gains have not yet materialized.

If there's a lesson to be learned by this, it's that if you plan to sustain yourself for any length of time as a video game producer based in the US, you had better have a brand of relational database manager to serve as a backup source of revenue. SQL Server - of all things - has become the company's star, garnering more attention than even Windows itself, and certainly more than Office. Coupled with Windows Server, SQL Server triggered an 18% revenue gain year-over-year in the company's Server and Tools division, to $3.18 billion. And operating income from that division rose 53% on an annual basis, to $1.25 billion. Losses due to a product many of us perceive to be a critical element of the economy at large, and not just the company, were more than made up for by a product many of us use in some form every day, but don't even see.

So the news was not all that bad for Microsoft yesterday, which should make it feel better after a succession of difficult weeks. Public scrutiny of Microsoft has increased, especially since the company faces new fines in the European Union, perhaps another delay in Windows Vista's consumer release, embarrassment over a software release gone sour, charges of self-favoritism in its choice of default search engines, and consumer anticipation that the company is planning a device to rival the iPod. So it got some yesterday, releasing a fiscal fourth quarter earnings report that highlighted nicely higher revenue: up 16% over the year-ago quarter, to $11.8 billion.

But in light of all this scrutiny, Microsoft is having a much harder time burying the bad news than ever before, especially with its own chief counsel stating just days earlier that his company will, from now on, abide by twelve tenets of ethics, several of which deal with transparency and truthfulness. So there it was, plain as day for all to see: operating expenses rising nearly 10.5% over Q4 last year to $7.9 billion, driving net income down to $2.8 billion - nearly 31% lower than the year-ago quarter - and earnings per share dropping from 34¢ to 28¢.

Knowing that news would go over badly, Microsoft unveiled a strategy to soften the blow: First, it will buy back up to $40 billion worth of its own stock over five years' time, $20 billion of which through a tender offer between now and mid-August. In such an agreement, the company agrees to a certain price range it's willing to pay shareholders for its own stock; the shareholders then state how many allotments of stock it's willing to sell within the given price range. If such a deal is handled properly, shareholders can walk away with a nice cash infusion. $20 billion more of MSFT stock will be repurchased through an ongoing share program between now and June 2011; the company just completed a $30 billion repurchase program this past quarter.

Second, the company issued a fairly rosy forecast during its fourth-quarter conference call yesterday afternoon, depending in large part on consumer demand for Vista. With Xbox 360 demand still high, and SQL Server proving to be the company's sleeper hit of the season, the news succeeded in softening the blow, triggering a nice rally. Shares of Microsoft stock traded up 4.5% by noon today.

Legal costs for Microsoft's fiscal fourth quarter totaled what might be a staggering amount for any other company: $787 million. The largest chunk of that amount, believe it or not, was attributed to the company's settlement payment to IBM; the second European Commission fine took second place on that tally.