NEW YORK (CNN/Money) -
The problem, of course, is that no matter how impressive 4.5 percent or 9.42 percent is on short-term investments, Microsoft was not built on single-digit returns. Indeed, the whole reason Connors has all that cash to manage in the first place is because Microsoft's core software business is such a money gusher.
Software requires tremendous up-front research and development costs, but once a program begins shipping, additional copies can be produced for nickels (a blank CD, some cardboard and shrink wrap) or even less (pre-installed on a computer or delivered via the Web).
As a result, Microsoft's gross margins (revenue minus the cost of goods sold) top 90 percent most years -- an astounding figure. Add in the facts that Windows ships pre-installed on 92 percent of all desktop computers today and that its Office applications (Word, Excel, PowerPoint, Outlook and the like) account for 96 percent of all business productivity suite software sold, and it's clear why Microsoft has been a darling of investors.
But now Microsoft faces a new challenge. Its core business -- uniquely profitable, uniquely dominant -- has become so large and pervasive that outsize growth is no longer possible. "That's simply the law of large numbers," says CEO Ballmer. Rogers Weed, Microsoft's newly installed vice president of the Windows division, puts it this way: "We're not going to grow at 50 percent with 120 million machines shipping a year. That's just a fact."
And that fact puts us back on the trail of all that cash. If the first purpose of the cash is to generate income, another, Connors explains, is to enable Microsoft "to spend a significant amount on R&D and to take long-term equity positions if the opportunity arises."
To compensate for the inevitable slowdown in its most successful units, Connors notes, the company is seeding new ventures in a wide variety of product categories, hoping to create a collection of promising new businesses.
While Microsoft has made some large acquisitions over the years (including flow-charting-software maker Visio for $1.3 billion in 1999 and Great Plains small business applications for $1.1 billion in 2001) and invested just under $10 billion in various cable operators, the company prefers to build from within. In its last fiscal year alone, Microsoft spent a colossal $4.4 billion -- almost 17.3 percent of revenue -- on R&D.
All over the Redmond campus are research labs looking to make a better mousetrap or to out-think a less aggressive competitor. The range and ambition of the projects is impressive. In Building 113, researcher Ross Cutler is cobbling together state-of-the-art video-conferencing tools designed to sell at bargain-basement prices to try going after market leaders like Polycom.
In Building 117, Brian Shafer, group product manager of mobile devices, demonstrates a smart phone prototype Microsoft has built (code name: Stinger) that also acts as a PDA, links up wirelessly with a desktop PC, and runs pocket Office applications and note functions.
Shafer's business model is not for Microsoft to produce the phones, but to persuade wireless phone carriers and equipment manufacturers to embrace the phone's technology as a standard while Microsoft provides the software that makes it go. In other words, Shafer is hoping to replicate the high-margin PC software business model on phones.
The Xbox game console, which Microsoft launched in the U.S. last November after three years in development, is another product of this R&D effort. A direct competitor to the Sony PlayStation 2 and the Nintendo GameCube, the Xbox was an instant success, selling 1.5 million units in the first two months. Although Microsoft is losing money on every box sold, that's all part of the plan: build an installed user base now, then rake in the profits with higher-margin game software later.
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"The analogy I like to use with regard to our investment strategy," says Ballmer, "is this: We plant a select number of seeds that we nurture...in anticipation of strong growth down the road." Then came the "saplings," he continues, "businesses that have taken root....Today that would include enterprise servers, MSN and Pocket PC....Trees are our core businesses -- Windows and Office -- that help us plant more seeds and nurture more saplings. We have a very long time horizon."
Still, even successful efforts will have trouble matching the financial characteristics of Microsoft's core software business. Merrill Lynch analyst Christopher Shilakes calls the new businesses "outboard motors on the Queen Mary."
Take the Xbox. "Interactive entertainment is a $20 billion business. That's bigger than movie box office receipts," says chief Xbox officer Robbie Bach, who estimates that PlayStation 1 at its peak contributed 30 to 35 percent of Sony's annual corporate profits. "If the industry grows 15 to 30 percent a year and I can grab a significant share of that, do I think that's a good business? Yeah, I think that's a good business."
But not as good a business for Microsoft as it is for Sony. At Sony, the core business is producing hardware -- a much lower-margin enterprise that was lifted by the mid-range margins of the PlayStation.
Bach acknowledges that whatever profits the Xbox might ultimately produce will be less efficient than the company's pure-software core, driving Microsoft's margins lower. "The business is different, no doubt about it," says Bach. "But we wouldn't do it if we didn't think it made financial sense."
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