The greatest surprise in Microsoft's third quarter results was the fourfold increase in its investment in other software developers over the past year.
This asset is now valued at $4.1 billion, and is firm evidence that a key part of Microsoft's development strategy and evolving business model is to take a minority stake in small software developers.
The advantages to Microsoft include gaining access to experienced personnel, some extremely innovative, without the overhead of having them on staff. It would be difficult to recruit such developers, since they are often motivated by the freedom to run their own small businesses.
From Microsoft's viewpoint, it acquires expertise that it does not have inhouse without the need for share options or increased payroll. Microsoft's investment usually gives it a seat on the board, but by keeping to a minority stake, it avoids any legal and antitrust problems. This tactic also gives Microsoft some degree of control over innovative technology and what is made available to competitors.
Greg Maffei, Microsoft's chief financial officer, admitted in his introduction to the quarterly results that the company has entered a period of slower growth. "Our growth has slowed for each of the last four quarters, and we are likely to experience slower growth for the balance of calendar year 1998," he said.
Previously, Microsoft had very carefully played down the quarter-on- quarter slowing of sales, pointing instead to its remarkable achievements in increasing profits when comparing with year-earlier quarters.
This quarter, on turnover of $3.77 billion (up five per cent on the previous quarter, and 18 per cent on the year earlier), the net profit was $1.34 billion (up 28 per cent from 1996-97). There was a very comfortable $12 billion - a year's income - in the bank and short term investments. At present, there appears to be very little on which Microsoft could spend such a large sum.
It did not escape the Senate Judiciary Committee (which recently 'invited' Bill Gates to give evidence) that Microsoft's operating profit is more than 50 per cent. Garth Saloner, professor of economics at Stanford University in California, said recently that "these are not the kinds of margins that are consistent with competition".
Maffei argues that Microsoft's profits are in line with many other major companies, and that the income statement did not take into account the enormous liability of the stock options held by Microsoft's employees.
The apparent paradox of slowing sales and increasing profits has been achieved by decreasing costs with a little belt tightening, hiking prices, and some accountancy measures that help to defer the effect of declining revenue increases.
The main cost saving has come from retail distribution of software on CD-Roms rather than diskettes, and increasingly going out-of-house for software development, content development and management services.
Corporate licensees of MS Office have found their costs increase as a result of new licensing arrangements that do not allow concurrent licensing. Previously, the licensing cost was based on the maximum number of Office users at any time, but the new enterprise agreements are more expensive, since there must now be a copy for each PC.
Microsoft's dominant position with Windows and MS Office has made it possible for it to increase prices to PC manufacturers at a time when the price trend for software has been strongly downwards. It is only in the consumer market, and a few niche markets, that Microsoft finds itself in competition with Corel and Lotus for office suites.
In good times, Microsoft is able to hold back on the recognition of some of its income - called deferred revenue - in order to claim it as income later, when sales are lower. It also reserves around 20 per cent of its income as 'unearned revenue', because, it says, it has committed to integrating products with the Internet Explorer browser, as well as giving telephone and Web site support, unspecified product enhancements, and servicing various maintenance and subscription contracts. The revenue is therefore not earned all at once, Microsoft claims, but a portion should be held back for a time in order to meet its commitments.
Microsoft accordingly marked its accounts with $425 million during the quarter, making the cumulated unearned revenue $2.5 billion at the end of the quarter, which was made up principally of $1 billion from Windows, $700 million from Office 97, and $660 million from content.
The liability to Microsoft for stock options would be in excess of $40 billion if all the existing share options were exercisable. This is ameliorated by the fact that it takes 4.5 years (and since 1995, 7.5 years in some cases) before option holders may buy the shares granted at the price when the option was granted. Microsoft always need to have enough shares to meet its employee stock option plans - at present, it has around seven billion.
Share options work very well as an incentive - providing the share price keeps rising - and there can be no complaints at present. However, there is concern that the shares are grossly overvalued. Indeed, Microsoft itself judged the price to be too high for it to purchase any of its own shares during the recent quarter, which suggests Microsoft is expecting lower prices in the future. Should there be a fall in the share price, this would cause many vested option holders to exercise all their options, and to sell the shares before the price dropped further. The consequences could be near-catastrophic, especially as a significant part of employee compensation is the incentive of the share option scheme.
Like a bellwether, Microsoft leads the technology share market by virtue of its market capitalisation, which is now only seven per cent lower than that of leader General Electric's $284 billion. Few doubt that Microsoft will achieve the greatest capitalization in the US this year, providing there is no sharp correction. There is an increasing feeling - expressed recently by Rick Berry of Argent Securities, for example - that the increase in share price does not reflect fundamentals, and that stocks like Microsoft represent a refuge for cash.
Maffei made the usual pessimistic noises about the future, noting that it is Microsoft's policy to be very conservative about growth forecasts. This message is largely blunted because Microsoft has played so well the game of beating the analysts' expectations.
This time, Maffei's comment was that "Asia, saturation, a maturing product cycle and the law of large numbers [by this he means the difficulty of finding significant sources of new income] have all taken their toll. This slowing trend will continue into the fourth quarter of 1998."
Maffei sees income being flat at least until the arrival of NT5. Windows 98 will not generate significant income, it seems.
Cotton seedling freezes to death as Chang'e-4 shuts down for the Moon's 14-day lunar night
Fortnite easily out-earns PUBG, Assassin's Creed Odyssey and Red Dead Redemption 2 in 2018
Meteor showers as a service will be visible for about 100 kilometres in all directions
Saturn's rings only formed in the past 100 million years, suggests analysis of Cassini space probe data
New findings contradict conventional belief that Saturn's rings were formed along with the planet about 4.5 billion years ago