Microsoft Death Watch – Second Quarter Numbers

Death courtesy Incry
Death courtesy Incry

I’ve been going over Microsoft’s Second Quarter numbers for close to a month now. My apologies for the delay, but some of it didn’t make sense.

I made a prediction 18 months ago that Microsoft would file for Chapter 11 Bankruptcy Protection by the Fall of 2014. Many people have found this prediction incredible. And quite frankly, from one point of view, they are right. Microsoft has historically been one of, if not the most profitable companies ever to exist.

What they don’t understand is that Microsoft, while profitable, also has huge costs. Also Microsoft’s profits come from a narrow range of products. Damage to margins of one particular product, Microsoft Office, would have tremendous effects on the company. Other products have never been overly profitable.

January 27, 2011 10Q Filing

First, download and look at this file. You will need to use an ODF compatible spreadsheet, such as Libre Office or Open Office. Note that all figures are in Millions – in other words add six zeros after the number.

You also need to consider several important points.

1) The amounts listed for divisional sales don’t always match with the 10Q, but total sales are always correct. This is a function of accounting. It’s easy to determine your total sales. It’s not always easy to be sure of exactly which division made the sales. Let’s take Ralph – Ralph works for Server & Tools, and he makes a huge sale to an OEM. But what Ralph actually sold was copies of Microsoft Office, which come under Business Division, not Server and Tools. So the total sales are right, but the initial numbers are in the wrong place. Another problem occurs when a new SKU is setup with the wrong details, so that the wrong division is credited when it is sold. This sort of issue doesn’t concern me, it happens everywhere. What would concern me is if there were NO adjustments. Perfect reports only happen when someone is lying.

2) I’m not giving you all of the numbers, I’m giving you the numbers that I feel are of importance. In other words, read the filings yourself, and if you don’t understand what you are reading, get professional help, especially if you intend to make an investment.

3) I’ve made a prediction that I think is right. I’ve not seen anything since then to make me change my mind. But that doesn’t mean that I’m right. I’ve used logic to make my evaluations, and as Joseph Wood Krutch said ‘Logic is the art of going wrong with confidence’.

4) Only an idiot trusts something they read on the internet 🙂

5) I’m making the assumption that Microsoft won’t see the problems and take action to avoid them. This assumption has already been proven wrong. Microsoft has taken several actions which indicate that they know that they have problems, including moving out several managers, and making the huge Nokia deal

Let’s look at the spreadsheet. The first thing you need to consider is that all of the amounts are listed by quarter, which means that I had to take the 10K (Yearly report) and subtract the three 10Q filings to get the fourth quarter results. While I’ve checked the numbers, it’s always possible that I’ve made a mathematical error. I’ve left column B empty for the Third Quarter results, which should be released in late April.

First, look at revenue,  row 2. Like most companies Microsoft’s sales are seasonal, with Quarter 2 (ending December 31) always being the best quarter for sales. I’ve made the background color red for Quarter 2 revenue.

Second, look at cost of revenue, row 3. Like revenue, cost of revenue is also seasonal. This is to be expected, as expenses involved with sales will be highest in the months when sales are highest.

Third, look at row 4, Research and Development, which is colored in blue. You’ll notice that R&D spending is relatively even, without seasonal variation.

Row 5, Sales and Marketing, is of course seasonal. You advertise your products most during the heaviest sales times.

Skip row 6, and go to row 7, Total Operating Expenses. Again note that this is seasonal, with the greatest expenses being in the same quarter as the greatest revenue. Again, this is natural, and the quarters with the highest number have a read back ground.

Rows 8 and 9 are the most important to any company. Operating Income is income before taxes, Net Income is income after taxes. Row 10 is the calculated difference between row 8 and row 9, the taxes. Preferably this amount would be zero, in other words the company wouldn’t pay any taxes. In theory taxes should be highest in the quarters were revenue is highest, however you’ll notice that this isn’t always true. There are a variety of reasons that tax levels can change, and Microsoft isn’t required go into details of why their tax payments have changed, however it’s possible that the increased costs pushed them into a different tax bracket.

So What Do The Numbers Mean?

This is where it gets fun. There’s a lot I don’t know about Microsoft, and I’m not a professional accountant. Also it’s dangerous to make assumptions based on basic numbers.

However there are things that we do know, which are having an effect on the numbers:

1) Microsoft’s sales of Windows Phone 7 haven’t been all that good. It appears that WP7 is costing Microsoft more than it’s making in sales. Charlie over at Semi-Accurate has reported that Microsoft is giving WP7 away. If what Charlie says is true, it’s also likely to put downward pressure on the price of Windows for personal computers.

2) Check row 15. Microsoft Business, which includes Office, is Microsoft’s best profit center. The problem is that Microsoft Office only works on the personal computer version of Windows. Anything which impacts on the number of personal computer Windows licenses that are sold will hurt Office sales. There aren’t versions of Office for tablets or phones, which are the fastest growing segments of the personal computer market.

3) HP is planning to use WebOS in phones, tablets, and personal computers. WebOS is a Linux based operating system, somewhat similar to Android, another Linux based operating system, and Apple’s IOS, a BSD based operating system. Windows Mobile, the predecessor of WP7, which was supposed to take this market never did sell well.

4) Apple has always been a thorn in the side of Microsoft. While Apple had really bad trouble at one point, it’s refusal to adopt Windows has given Microsoft considerable problems, as Apple has been an example of how to be successful in face of a monopoly.

5) Windows for Arm – which will probably be Windows 8. Microsoft’s decision to port Windows from X86/X86-64 to ARM is driven by Intel’s failures with the Atom processor range. Microsoft was counting on Atom, which is a low power X86 chip designed for use in phones, tablets, and other low power applications. But while Intel is a great CPU designer, Atom has never been competitive in anything other than netbooks, and even there ARM designs have beat it for power.

6) App Stores like what Linux has had for years. App stores, which allow fast and inexpensive software shopping and delivery, as long as you have an internet connection. App stores that deliver lower prices (Apple’s own personal computer App Store offers far lower prices than you’d pay in store), and a far wider selection, since the software isn’t taking up limited shelf space.

7) ARM in personal computers. Since Windows doesn’t currently run on ARM, ARM computers usually run BSD (Apple’s IOS) and Linux operating systems. Since ARM processors are so power efficient, an ARM based laptop would require a far smaller battery. ARM chips are also less expensive. This would make ARM based computers less expensive to purchase. ARM already owns the phone and tablet markets, locking out Windows, until Windows 8 is delivered.

8) ARM computers with the App store. Apple designed a Universal Binary for use when it was moving from Power PC processors to Intel processors. There’s nothing to stop Apple from extending the Universal Binary concept to include ARM processors. Say you are a long time Mac user, who has a lot invested in Mac software, and when you buy an ARM device, Apple delivers to you copies of all of the software you own licenses for in ARM format, making your switch over painless and simple. Since Qualcom has shown it’s Quad Core 2.5 ghz Snapdragon ARM chip, this is a distinct possibility.

9) The media situation. If you watch Star Trek, Babylon 5, or most other Science Fiction television shows, you’ll notice that it is assumed that the source code for the devices is available, and modifications can be made. The cultural impact of such assumptions has mostly been on computer geeks such as myself, but many average computer users are also aware of the assumptions.

So generally we should expect to see the percentage of expenses vs revenues rising over time as competitive pressures effect margins. At present we aren’t see that. In Q2-2011 the percentage is 59.0788, which is lower than it has been for most quarters over the last several years. However during part of this time Microsoft was dealing with the XBox360 hardware problems, which means that the percentages were higher during that period. So Microsoft should have shown a drop, which it did. During 7 out of the 10 quarters in the spreadsheet the percentage was over 60%. Q2-2010 was exceptionally low at 55.2466%. Q1-2011 was at 56.0605%. So why is Q2-2011 at 59.0788%

My conclusion is that we are starting to see the pressure on pricing effecting Microsoft, but to confirm this we need to see another two quarters. If I’m right, the next quarter will be in the 61.0000% to 62.5000% range, and that the quarter after that will be in the 62.0000% to 63.5000% range.

It should be interesting to see if I am right.

Regards

Wayne Borean

Wednesday February 16, 2011

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3 thoughts on “Microsoft Death Watch – Second Quarter Numbers

    1. Sam,

      Logic is going wrong with confidence.

      I’m pretty certain I’m right. I’m pretty good with numbers, and I found out over a year after I made my original prediction, and had written a bunch of these articles, that Business Insider had come to a similar conclusion.

      They hadn’t gone as far as I had, and I don’t think that they thought it would happen as quickly. But they were not recommending Microsoft stock as an investment.

      That said, Microsoft could put off their demise indefinitely if they do the right things. Don’t ask me what those things are, because I don’t know. I just know that if you are smart enough, and willing to work hard enough, there’s a way out of almost any situation.

      Wayne

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