Slowing PC market, another online reinvestment ahead for Microsoft

With half of 2008 having already gone by, Microsoft's online services situation today is pretty much the same: Without a Yahoo partnership, the division is still bleeding. It's a good thing Microsoft's also a software company.

If the recent economic downturn can be characterized as a "storm" for those industries in which America has a major stake, the PC industry is certainly weathering this storm very well. Analysts had expected shipment growth to rise to only 12% annually; but from Microsoft's perspective, the number is more like 15%.

That rising tide may not stay risen for very long, however, and as Microsoft Chief Financial Officer Chris Liddell warned analysts yesterday afternoon during the company's fiscal fourth-quarter earnings call, there will probably be a leveling off of PC industry growth. That could be reflected in its earnings numbers for fiscal 2009, but even that tapering won't be catastrophic, paring growth to somewhere between 7% and 9% annually.

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When PC shipments grow, the need for newly installed operating systems grow in turn; and that's what butters Microsoft's proverbial bread. The Client division of the company saw 14.6% higher revenue for the quarter ending in June, than for its fiscal fourth quarter of 2007, to about $4.37 billion. That's a direct reflection of brisk hardware sales.

In previous years, when demand for PCs had been dampened, the OEMs -- those resellers in the channel who package their hardware with Windows pre-installed -- felt the pain most directly. This last quarter, they're feeling the benefit of the sales surge. Shipments of Microsoft software to OEMs skyrocketed 22% over this time last year, the company's investor relations manager, Colleen Healy, reported yesterday.

"When taken together with reported revenue, total bookings for the company grew 23%, driven by over 20% bookings growth for our core businesses of server and tools, client, and the Microsoft business division," stated Healy (with our thanks as always, on these busy weeks, to Seeking Alpha for its transcript of yesterday's call).

There are two company divisions not covered in that list. One is Entertainment and Devices, which saw a loss for the quarter of $188 million. Lower sales? Not at all; as Healy reported, the company sold 88% more Xbox 360 consoles than during the same quarter last year: 1.8 million, by her estimate. But the company absorbed a $1.1 billion charge in this quarter, as a result of having extended its warranty program for Xbox 360 to three years.

The other division Healy didn't mention in that list is the one that's the subject of so much attention these days: online services. Revenue from that division actually rose $161 million over the prior quarter. But that's a pretty marginal amount, and after you account for all the money Microsoft's been pouring into the division to shore it up, it still lost $488 million.

Yesterday, one of CFO Chris Liddell's unhappy duties was to warn analysts that this problem won't get better soon, especially with regard to the company's guidance for the four quarters to come. Operating margins for all the other company divisions should remain flat next year, which isn't so bad since they're at healthy points right now.

It helps to separate the good from the bad rather than mix it all together. "Taken together, our businesses representing over 90% of our revenue will grow double-digits next year with the margin structure intact," Liddell told analysts. "Clearly the online services business has a totally different dynamic and is in a period of significant investment. We do not make these investments lightly, as the loss in this division will be a drag on an otherwise exceptionally good performance."

It only makes sense to continue investing in online services, Liddell went on, as the industry as a whole is expected to be evaluated at $80 by 2012. And with Yahoo having answered Microsoft's offers by partnering with Google instead, Liddell is making plans to combat both players without any acquisitions taking place.

"Given that [online advertising] environment, we made some decisions to accelerate our online services' organic growth strategy," the CFO said. "Mainly we decided to increase our investment in the high-margin scalable areas of search and ad platforms. So about two-thirds of the incremental spend that we are planning is related to investments to drive usage of our search offering."

This "drag," as Liddell puts it, will offset what he forecast as continuing gains in the company's core business segments, though not at the same levels as Microsoft has been seeing. With PC unit growth believed to go back down to as low as 12% annually for fiscal year 2009, and 10% for the first quarter of that year, growth in client software revenues could taper down to 7% for Q1 and 10% for the full year.

While Liddell declined to comment much about the attempt at a Yahoo deal, what he did not say -- and the volume he chose to use in not saying it -- spoke volumes. His expenditure plans and his guidance for the year also omitted Yahoo, an indicator that his company is making preparations for a "no-go."

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