While Microsoft's upcoming Windows XP operating system and Xbox game console may grab the headlines, nothing beats the company's Office applications for sheer money-making power. That's why Office XP, set to debut Thursday, is financially the most important product Microsoft will ship this fiscal year, analysts say.
Office and other desktop applications accounted for 37 percent of Microsoft's $6.46 billion in revenue in the most recent quarter. As the Redmond, Wash.-based company prepares for the Windows XP launch Oct. 25 and Xbox's debut Nov. 8, cash flow is important.
Microsoft will spend a total of nearly $700 million on marketing alone for the Windows XP and Xbox launches, according to estimates from the company and Merrill Lynch.
Office XP could deliver a welcome cash infusion of nearly $3 billion in additional desktop application revenue the first year the new licensing plan is in place, analysts say.
But first, Microsoft may have to strong-arm its customers into adopting Office XP. By Microsoft's own estimate, about 60 percent of Office customers still use the two oldest versions of the product: Office 95 and Office 97. Interest in Office XP appears lukewarm, at best.
To ensure repeat business from its huge customer base--more than 120 million licensees--Microsoft recently revamped its licensing program to potentially force the bulk of businesses to upgrade to Office XP before Oct. 1.
"If Microsoft didn't do the licensing change, I wouldn't think Office XP sales would be all that dramatic," said Gartner analyst Michael Silver. With the program in place, "companies will be forced to buy upgrades in the next six months, if they plan to upgrade at all."
Aging cash cow
Microsoft's Office sales dilemma is twofold, said Banc of America Securities analyst Greg Vogel. "It's been a particularly rough year for Microsoft," he said. "Revenue growth has slowed, in part because PC unit growth has slowed. Many companies have slowed their purchases of new technology."
The market for new Office sales is nearly saturated, Vogel said. Signs of an impending sales slowdown arose shortly after Office 2000's launch.
"Office is a great cash cow for the company; it delivers terrific margins and terrific cash flow, but at this point it doesn't have any significant growth," Vogel said. "You can't win any more market share when you have more than 90 percent, so they have run out of steam."
Office revenue growth has stayed fairly flat for most of fiscal 2001. Although desktop application revenue grew 7 percent year over year during the third fiscal quarter, sales declined from the previous quarter. Revenue reached $2.4 billion during the period, down from $2.49 billion the previous quarter, when revenue dipped 2 percent compared with $2.53 billion in the second fiscal quarter of 2000.
During Microsoft's third-quarter earnings conference call with financial analysts, Chief Financial Officer John Connors credited the desktop applications sales spike to unexpected sales of "organizational licenses." But analysts warn that it is not sustainable.
Many of those sales are tied to a spike in Windows 2000 upgrades, Silver said. In a survey conducted at Gartner's recent Windows 2000 conference, about 70 percent of companies upgrading to the operating system also were changing versions of Office, he explained. Many companies are in the midst of Windows 2000 upgrades now.
While that would appear good for Microsoft, many of the companies moving to Office 2000 use the Enterprise Agreement licensing program, which means they don't need to pay extra for the upgrade. "So there isn't a long-term revenue benefit for Microsoft," Silver said. Gartner estimates that 10 percent to 15 percent of Microsoft's largest customers subscribe to the Enterprise Agreement program, which essentially allows them to upgrade at will.
To make matters worse for Microsoft, many of these companies are not interested in Office XP.
"I have spoken with a lot of folks that are planning to upgrade to Office 2000, not to Office XP," Silver said. "A lot of the people are...not even considering (Office) XP."
Ray Bailey, information services manager at the Bergquist Company, a manufacturer of electronic components and other goods, said he has "no plans to go to (Office) XP. We are doing a transition from Office 97 to Office 2000."
About 60 percent of the more than 300 computers at Bergquist's Prescott Operations' division have Office 97, which is being phased out for Office 2000. Like many other corporations curtailing technology spending because of the economy, Prescott has scrapped its "plan to have all (Office 97 desktops) upgraded by the end of this fiscal year," Bailey said.
Analysts said customers like Bailey don't see a compelling reason to upgrade to Office XP.
"Office is a mature product," Vogel said. "There's some new functionality, but it's kind of like another mature industry--the auto industry--and adding cup holders to the back of the minivan. The changes are incremental, and there isn't a whole lot there that will make a lot of people go out and upgrade."
Driving the herd
Office 2000 loyalists also make Microsoft's new licensing program all the more important. The new program forces a large portion of the company's customers to upgrade to Office XP, whether they want to or not. On Oct. 1, subscribers to Microsoft's two most popular licensing options, Open and Select, will have to enter a new upgrade program called Software Assurance. The program also requires companies to be on the most current version of a product.
"Office XP is going to be considered the current program," said IDC analyst Al Gillen. "If you want to get into any of these licensing programs, you have to get current between now and Oct. 1."
With more than half of Office users on Office 95 or 97, Microsoft has been struggling to drive upgrades, Gillen added. "So Microsoft essentially is penalizing people who buy a particular product for a number of years," he said. "If you're one of the people who buys a product and uses it for three, four, five or six years, then comes back and buys an upgrade, it's going to have a lot of impact on you."
For investors, the potential for a sudden surge in desktop application revenue is tantalizing. For customers, like Prescott Operations, which either won't or can't get to Office XP before the Oct. 1 deadline, the prospect of a large expense to upgrade software in the near future is frustrating.
"We will just have to bite the bullet and spend the cash later," Prescott's Bailey said.