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Weekly Column

Bah Humbug!: There Might Be a PC Recession, But That's Not What's Behind Microsoft's Recent Earnings Dip

Status: [CLOSED]
By Robert X. Cringely
bob@cringely.com

Last week, when the rest of us were checking our credit card balances and wondering if we'd have enough money for Christmas, Oracle CEO Larry Ellison became the richest man in the world. The dynamics of the moment were that Larry's wealth took a positive jump, spurred by an increase in the price of Oracle shares based on a good profit report. And at the same time, Bill Gates of Microsoft saw his net worth go in reverse when Microsoft issued its first profit warning to analysts in more than a decade and Microsoft stock nose-dived. Larry passed Bill on the turn, so to speak.

Both men have more money than they can ever spend, so this wealth competition is really meaningless. And just because Larry was up last week doesn't mean that Bill won't retake the crown next week. But I think there is a very interesting story underlying this whole event. The good news here appears to be from Oracle, but close examination suggests that the real interesting maneuvers are taking place at Microsoft, which announced an earnings drop that might not even exist.

Wall Street is obsessed with corporate earnings. Even great companies sometimes have bad quarters and the stocks of those great companies are crucified on Wall Street as a result. But good earnings, increasing profits, drive stock prices higher. Higher stock prices make it easier to acquire new companies for stock, and make it cheap to reward employees with stock options. Improved earnings are the fuel burned in the engine of corporate success. Sometimes it is so important to have good earnings that companies fake it. Oracle did that years ago when they counted as revenue orders that weren't yet filled — even orders that were eventually cancelled. Back then, Oracle had a controller who was 23 years old — a telltale sign. Of course, the company was caught cooking the books and was punished for it, but I can't help but think that a lot of Oracle's early growth was helped by those bogus reports. Last week's good news from Oracle was perfectly legit. The more questionable news came from Microsoft.

I have written several times over the years about Microsoft's financial practices as explained to me by Frank Gaudette, the company's first Chief Financial Officer. Back then Frank was Microsoft's oldest employee, as well as being its chief financial officer, head of human resources, head of manufacturing, head of distribution, head of facilities, and head of a department to be named later. All this from a guy who learned his trade working for Frito-Lay, and who couldn't have cared less about computers. Frank is dead now, and nothing he ever told me about Microsoft and its money specifically applies to the current situation except to try and see the situation from Microsoft's perspective. That is, from the perspective of the most successful company in the history of companies.

What happened last week was that Microsoft 's current CFO, John Connors, announced that earnings for the company's 2001 fiscal second quarter would be five to six percent lower than expected — in the $2.4 billion to $2.5 billion range. The company said earnings per share would fall in the range of 46 cents to 47 cents for the quarter, which ends Dec. 31. A consensus of analysts expected 49 cents per share, according to First Call/Thomson Financial.

Let's think about this news for a moment. Microsoft said its profit would ONLY be around $2.5 billion, which is to say more than all the rest of the personal computer software industry combined. That $2.5 billion figure means the company will earn a PROFIT of $203,000 per employee FOR JUST THIS ONE QUARTER. We're not talking about sales here but profits. Microsoft is MINTING money.

So what's the bad news? Well, profits will be a little lower than people expected. This is of course because of the general slowing of PC sales as already reported by companies like Dell and Gateway. All of this makes sense, but what I can't understand is why Microsoft reported it.

When a CFO makes that fateful conference call to analysts it is to report some bit of news so horrible that the U.S. Securities and Exchange Commission requires its public disclosure. Companies do conference calls to report their sales are down 30 percent or their profits look like they might be cut by half. But a CFO who makes a conference call to report that earnings might be 46 cents instead of 49 cents per share risks being laughed out of the CFO fraternity. This isn't really bad news, its just a little bad. And most importantly, it's not so bad that it couldn't all have been covered up by just shifting the money around a bit. There was no need for Connors to make that call, no need for the story to break, and certainly no need for the stock dip that followed.

Microsoft is so profitable that the company piles on extra expenses with the specific idea that it can easily cut those expenses later to boost profits if needed. Let me makes this even more clear — Microsoft makes so much money that even it is embarrassed. Wall Street rewards steady earnings growth. So one way to avoid embarrassment and assure earnings growth is to front-load expenses. Microsoft pays for things up-front when it doesn't have to, pushing down near-term earnings specifically so later term earnings will look better. They also buy stuff they don't really want or need in the understanding that if times get tough, they can just stop buying all that crap and earnings will instantly look better.

Any other company, faced with a little earnings shortfall, would pay some bills slower, stop construction on a building, delay hiring a few more employees, and by doing this save enough money to put earnings right where they are supposed to be. But Microsoft did none of that. CFOs at other companies only make those dire conference calls if their heroic efforts with the books still aren't enough to cover the difference. They only do it when not doing so would require breaking the law.

So why did Microsoft announce its shortfall when it could have avoided doing so? Even more to the point, why did they do something that they knew would hurt their stock price when they didn't have to? I can think of a couple good reasons.

First, there is the anti-trust case that Microsoft is appealing. It might help the company stay in one piece if it can be perceived as an underdog or at least weakened. Yeah, right. But this is the way they think. Poor Microsoft is hurting so badly they'll only make a profit of $2.5 billion this quarter. We'd better give those kids a break!

And who knows, maybe it will work.

The second reason for announcing bad news that you really don't have to announce was made clear in a more recent statement by Microsoft CEO Steve Ballmer. This week Ballmer wrote in a memo sent through the company, "We all have a big incentive as shareholders to re-ignite the kind of cost-conscious culture that marked Microsoft's earlier years."

Ballmer said Microsoft would be withholding extra features from products to save money. Heads will roll, names will be taken.

Microsoft is not stupid. It has some of the best financial people in the world and they had to notice the dip in hardware sales that would eventually lead to a slide in software revenue. They could have made any number of changes to adjust for this lower revenue, but they just decided to let it happen, both to help the anti-trust case and to help Ballmer's reengineering of Microsoft.

And that's the key to this. Ballmer was willing to accept a drop in the share price — even one that for a short time made Larry Ellison the richest man in the world — if it helped him bend Microsoft to his will. Tip O'Neill said, "All politics is local," and what this means at Microsoft is that there is a new leader, and anyone who doesn't want to do things his way should probably leave.

And they will leave, in droves, which of course will drive down Microsoft's costs and improve earnings. Funny how that works.

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