Microsoft filing shows losses in four divisions

In a regulatory filing last Thursday with the U.S. Securities and Exchange Commission (SEC), Microsoft for the first time provided financial results for each of seven recently formed business units, revealing operating losses in four segments, including the unit that produces its Xbox video game console.

The disclosures appear to support the idea that in order to tap new and potentially lucrative markets for products such as enterprise software applications and video games, Microsoft is prepared to incur significant near-term losses to build up those new businesses, financial analysts said.

The analysts cautioned against reading too much into losses reported by some of the divisions, and they said that at first glance the filing appeared to offer no great surprises.

In its 10-Q regulatory filing made Thursday with the SEC, Microsoft said its Home and Entertainment division, which includes its Xbox video game products, incurred operating losses of US$177 million in its first fiscal quarter, ended Sept. 30, on $505 million in revenue. Microsoft launched its Xbox in November 2001. It competes machines from with Sony Computer Entertainment Inc. and Nintendo Co. Ltd.

For its Business Solutions segment, which includes software from its acquisitions of Great Plains and Navision A/S as well as its bCentral offerings, Microsoft reported an operating loss of $68 million for the quarter, on revenue of $107 million, the filing states.

For its recently formed CE/Mobility division, Microsoft reported a loss from operations of $33 million on revenue of $17 million, while the MSN unit, which offers Internet access services, incurred a loss of $97 million from operations on revenue of $531 million.

The Client division, which includes Windows operating systems products for desktop and notebook PCs, generated operating income of $2.48 billion on revenue of $2.89 billion, making it the most profitable segment. Its Server Platforms unit, including Windows server software sold to businesses, produced operating income of $519 million on revenue of $1.52 billion.

Microsoft's recently formed Knowledge Worker division, which makes desktop productivity software including Microsoft Office, produced operating income of $1.88 billion, on revenue of $2.39 billion.

"I'm not surprised at these results," said Kim Caughey, an equity research analyst at Parker/Hunter Inc., in Pittsburgh. "We all had a gut feeling that the Windows businesses, and specifically the client OS and the Office products, were funding a lot of these new businesses."

"It just confirms our belief of where the money is coming from and, quite honestly, where we expect it to come from in the next couple of years," she said.

"Most reasonable people" support the idea that Microsoft draws on profits from franchises such as Microsoft Office and Windows to support new ventures where it sees the potential for financial rewards in the long term, said Brent Williams, a software analyst at McDonald Investments Inc., in Cleveland, Ohio.

He cautioned against reading too much into the losses disclosed Thursday. Microsoft's Xbox business is new and the company has been building up inventory and cutting prices to get the business off the ground, he noted. In addition, the company may have incurred one-time costs related to research and development and other areas as it worked to get the Navision business up and running, he said.

"We have to understand the effect of all the charges and the R&D investments," agreed Eric Upin, a software analyst with Wells Fargo Securities LLC.

Like other game makers, Microsoft expects to generate its biggest profits in gaming from the sale of gaming software, rather than from the consoles, Williams said. The strategy is to sell as many Xboxes as possible even if profit margins are thin, then sit back and wait for customers to buy the games, he said.

"The fact that they're losing money in a market where they're new isn't surprising, and they've been telling people that for a while," he said.

By investing in areas like video games and enterprise applications, the company is effectively placing calculated bets on new businesses with the expectation that it will win big where the bets pay off, Caughey said.

"It's kind of like being an oil wildcatter," she said. "You believe you have the applications or the solutions that people want, you decide you're going to fund this, and then you see what happens."

Microsoft is "really driving to diversify itself into new segments," including software used to run large servers in corporate data centers and, on the consumer side, into the video game business, Upin said.

The company is making "substantial investments" in its enterprise software business and showing "solid early signs of progress," Upin said. Its investments in consumer areas such as video games are at an earlier stage, he said, and "we're still waiting to see how that turns out."

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