Microsoft News Tracker

Shareholders were justifiably nervous after the first good news called out in the 3Q08 Microsoft earnings report was that the nearly profitless sinkhole of Entertainment and Devices grew revenues by 68%. That such a diversion was necessary was because the milk yields of Microsoft’s leading cash cows, Windows and Office, dropped in a still mostly unexplained manner.

Below are the segment breakouts with some brief commentary based on the 10-Q.

Client:

The big hit here is the $1.14 billion of deferred revenue that got tacked on in 3Q07, but even removing that, revenues were down over last year despite OEM sales (which account for 80% of unit sales) being up 5% and the "premium mix" being up as well. Estimated PC sales growth was 8-9% and theories ranging from piracy to Apple/Linux competition to Microsoft shifting revenue to next quarter have been offered for the shortfall.

Business (mostly Office):

Subtracting the $500M deferred revenue booked in 3Q07 makes this look much better apparently due to strong Office revenue growth from businesses, but consumer revenue was actually down. R&D expenses were up 19% driven by headcount expenses and headcount itself was up 7%, presumably not to add bells and whistles to the traditional Office product.

Server and Tools:

Another sterling quarter for Server and Tools who launched major new products.

Entertainment and Devices (mostly Xbox):

The good news is that E&D made money in 3Q. The bad news is that it didn’t make much, but then it never does. R&D expense was up 26% and sales and marketing expenses were up 29%.

Online Services:

Online advertising revenue grew 39% ($175M) to $619 million including aQuantive’s $47 million. aQuantive also added $97 million in agency revenue. So where did it all go? There was a large write-off from the acquisition of aQuantive plus increases in general expenses for infrastructure, "online content expenses," and headcount. One item that caught my eye was "a $24 million in-process research and development write-off." The Online Services Business (OSB) doesn’t seem to be going anywhere fast. The question, of course, is whether it would go any faster with the addition of Yahoo.

Corporate Level Activity (overhead and legal): 

The big ticket item here was an increase of $1.2 billion in legal expenses including the EU fine.

Bottom Line:

Out of Microsoft’s three cash cows (Windows Client, Office, and Servers) only Servers delivered in accustomed fashion. Entertainment and Devices is all sound and fury signifying nothing, while Online Services is treading water waiting for a Yahoo life preserver

Back in November, 2006 Microsoft shut the doors on the failed MSN Music download service but kept the DRM servers going to support existing customers. Last week, the end of that service on August 31, 2008 was announced as well.

Like iTunes, PlaysForSure authorizations are bound not only to a user’s individual computer, but to that particular instance of their operating system as well. If a user has to rebuild, upgrade, or otherwise reinstall his or her operating system, authorizations for MSN Music subscriptions will be reset.

MSN Music customers have little recourse, unfortunately. Aside from permanently deciding which computers will keep their account’s authorization – once August 31 passes, authorizations cannot be changed – users have the option of burning purchased MSN Music to CD and then re-ripping the music to another compressed format, such as MP3. However, the process of “transcoding” (converting) lossy-compressed files (as WMA files are) to another lossy format (such as MP3) significantly degrades the quality of the resulting MP3 file. Users can also burn their music to CD and convert to a lossless format, such as FLAC, but lossless formats consume significantly more space in order to make a perfect copy of already-degraded WMA files.

If you aren’t an audiophile, that probably isn’t a bad solution, but the fact that it’s the only solution grated on many. Microsoft’s Rob Bennett defended the decision for the obvious reasons:

In an interview with CNET News.com, Bennett said that continuing to support the DRM keys was impractical, that the issue only affects a "small number" of people and that focusing exclusively on Zune was the best way to go. He also noted that it wasn’t Microsoft’s decision to wrap music into digital rights management.

The reason for shutting down the DRM-licensing servers was "every time there is an OS upgrade, the DRM equation gets complex very quickly," said Bennett, general manager of entertainment, video, and sports for MSN. "Every time, you saw support issues. People would call in because they couldn’t download licenses. We had to write new code, new configurations each time…We really believe that, going forward, the best thing to do is focus exclusively on Zune."

The main takeaway is that DRM schemes for failed download services are like any other failed audio/video format such as 8-track audio tapes or Beta videotapes or HD high-def DVDs - the purchaser is at the mercy of the technology providers and if the business goes south, so does your media collection. Of course, the other takeaway is that if you don’t buy DRM protected digital content, you won’t have a problem and that is getting easier in the audio realm every day.