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As Microsoft's growth slows down, CFO John Connors tries to keep its profits up.
Kris Frieswick, CFO Magazine
May 1, 2002
When John Connors became chief financial officer of Microsoft Corp. in January 2000, the job was still a pretty sweet gig: sweep up the mountains of revenue generated by Windows and Office software, report fabulous earnings growth every quarter, do deals with the ever-more-humongous cash hoard, and laugh all the way to the bank if you felt like it. An exaggeration? Maybe, but at the turn of the millennium, the CFO spot must have felt like a nice reward for a 40-year-old CPA from Montana who had paid his dues for 11 years at eight different jobs in just about every department in the company.
John Connors has bad timing.
That's because he became CFO just as it started to turn into one of the most challenging jobs in the company: keeping returns high in a depressed technology market while Microsoft completes the transition from headstrong adolescent to Fortune 100 adult. It's Connors who now has the task of persuading investors that shares of the Redmond, Washington-based software giant are still worth the heady multiples of a growth stock, despite evidence to the contrary.
Start, for example, with Microsoft's revenue growth rate in fiscal 2001--a paltry 10 percent, down from 16 percent a year earlier. Over the same period, earnings declined 23 percent, thanks largely to a $4.8 billion impairment charge on investments. Cost of revenue increased to 17.5 percent for the first six months of fiscal 2002, up from 13.7 percent during the year-earlier period. (Microsoft's fiscal year ends June 30.) Even with last fall's successful launches of Windows XP and Xbox, revenues were up only 12 percent for the first half of fiscal 2002, compared with the first half of the previous fiscal year.
The market for its primary revenue driver, the Windows operating systems for personal computers, is saturated, and PC market growth has slowed dramatically--down 5.2 percent worldwide in 2001, and predicted to grow only 3 percent in 2002. And although the company says that the introduction of Windows XP in October 2001 was the most successful launch of any of its operating systems, a big part of XP sales was attributable to existing Windows customers rushing to upgrade to the latest OS in time to qualify for a new software maintenance program.
Then there's that pesky antitrust case, whose settlement is still pending. Microsoft faces potential penalties that may change the way it sells its flagship Windows product, and could alter the way it is allowed to pursue new markets going forward. All in all, since late 2000 declining growth and increasing uncertainty have pushed Microsoft's stock down to around $60, a level not seen since 1998 and half its December 1999 peak.
That's not to say the company is in trouble--far from it. Its cash hoard now tops $40 billion, and it has nary a penny of debt. Although slowing, Microsoft's revenues are still at record levels. And the stock currently sells at 55 times earnings, a 100 percent premium over the Dow Jones Technology/Software Index. But the go-go growth of the mid-1990s is a thing of the past, and chairman Bill Gates and CEO Steve Ballmer know it. They also know that if the company wants to retain anything near that level of growth, it is going to have to find new markets.
"When you have $27 billion in revenue," says Robert Herbold, a retired Microsoft COO who held the spot from 1994 until last year, "your ability to grow by whopping percentages is less than when you're a $5 billion company. Every business has to assess its challenges and think, where do we go from here? When you're a $27 billion company, those challenges look a lot different."
By and large, the investment community agrees. "In the past," says Joseph Beaulieu, senior analyst with Morningstar, "the company had the luxury of milking the cash-cow PC business. They had the luxury of doing things that were far-forward-looking. Now they have to focus on the here and now--basically making their numbers from quarter to quarter."
Right Man, Right Time
Microsoft hopes that Connors, its fourth CFO, is the right man at the right time. He shrugs off the notion that his challenges are any harder than his predecessors' were: "Any job you go into, you've got to deal with the hand you're dealt."
Microsoft's previous CFOs played with very different hands. Its first CFO was Frank Gaudette, the self-described "grandfather" of Microsoft from 1984 to 1993, when the company needed his experience to guide it through its initial growth spurt and IPO. Gaudette's successor, Michael Brown, took over just as revenue growth started to slow, from an average of 45 percent between 1988 and 1993 to 33 percent between 1993 and 1997, when Brown retired. Among his accomplishments, Brown imposed more discipline on the company's internal processes.
After Brown came Greg Maffei. An ex-investment banker and consummate deal-maker, Maffei was a logical choice during a red-hot stock market. In 1994, as Microsoft's treasurer, he came up with the idea of selling puts against the company's stock to offset the costs of its aggressive employee stock-option program. The bull market kept the puts out of the money, and Microsoft reaped more than $2 billion in premiums between 1994 and 1999. During his tenure as CFO, Maffei spent more than $20 billion on private and public investments. Some of these deals--the acquisition of WebTV, a $5 billion investment in AT&T, a $1 billion equity investment in Comcast--were clearly strategic, designed to open the door to new markets. Other investments looked like venture-capital plays. By the end of fiscal 2000, the company's stock and warrant portfolio was valued at 68 percent more than Microsoft paid for it.
But Maffei was unable to secure the bigger operational role in Microsoft that he reportedly wanted, and he left in December 1999 to become CEO of 360networks. Connors, then head of Microsoft's Worldwide Enterprise Group, became CFO. A few months later, the stock market and the economy headed south, and in fiscal 2001 Connors had the unhappy task of writing off $4.8 billion in impaired investments. That kicked income into negative-growth territory for the first time in company history. (He wrote down another $1.95 billion in the first six months of fiscal 2002.) Connors was also forced to dismantle the put program, at a cost of $1.4 billion.
In short, Connors's first two years on the job have largely involved cleaning up somebody else's messes, an observation he characteristically dismisses. "It's just part of the job that some things that you get are good, some things that you get ain't so good," he says. "And you just have to work through them."
This low-key, intensely practical approach is Connors's stock-in-trade. Those around him say he has a flair for boiling a problem down to its lowest common denominator, getting everyone to understand its scope, then setting out to methodically correct it.
As corporate controller between 1994 and 1996, Connors helped modernize the company's antiquated financial reporting system--at the time the subject of some internal embarrassment. "When I came to Microsoft [in 1994], I was shocked how far behind we were as a company using our own technology," recalls Scott Boggs, who was assistant corporate controller under Connors and is now vice president and corporate controller. Working with Connors, Boggs spearheaded the creation of a state-of-the-art Web-based financial system that provided near-real-time access to a variety of financial metrics.
Connors continued his efficiency campaign when he took over as CIO in 1996. "We were in the embarrassing situation of not having a good set of applications to run the company, and some [applications] weren't running on Microsoft software," says Herbold. "We wanted to make Microsoft a showcase relative to its systems, and John was a good guy to lead that charge. And that was what we achieved."
In mid-1999, to prepare for the future, Microsoft unveiled a new organizational structure built along customer segments instead of product lines--thus taking the focus off of individual products, like the slower-growth Windows. Considering the slowing PC market, the company began seeking entry into new markets, such as computer games and game hardware, software for personal digital assistants (PDAs) and cell phones, and, most important, a new Internet application platform--.NET. To fund these investments while keeping operating profits up, Microsoft had to become leaner and more efficient.
"The business was turning right about 2000," says Herbold. "It's clear that we needed a back-to-fundamentals approach. [Connors] was the perfect candidate to tackle that."
Indeed, managing costs has always been a personal crusade for Connors. Microsoft has avoided layoffs and has been able to continue to increase salaries, he says, thanks in part to "the extreme focus we've had on gaining cost efficiencies." He claims that to date in fiscal 2002, this focus has saved more than $600 million against budget amounts.
Saving the Margins
As a result of his cost-cutting evangelism, Connors routinely receives unsolicited ideas from employees via E-mail. He takes pride in recounting one initiative that came after he delivered a rousing talk at the administrative group's annual conference. "One [administrative assistant] went back to her group, which was an R&D group, and convinced the execs to cut their lab spending by $13 million," he says.
Procurement is another critical focus for Connors, who as corporate controller helped replace a paper-based invoice and accounts-payable system with online procurement software. In one of his first major initiatives as CFO, Connors threw his weight behind an aggressive procurement program that seeks to standardize purchases across the organization and find incremental savings everywhere it can. He has set fiscal 2002's savings target at $250 million--a "very high bar," notes Mike Huber, head of corporate services.
That sum may still seem small for a company with $40 billion in cash and a dominant software franchise. But analysts say Microsoft's move into computer games, via its Xbox game console and gaming software, makes Connors's cost-cutting focus a crucial part of the company's long-term vision.
"They've never before been a hardware maker of any real scale, and now they are," says Mark Specker, a managing director of research at SoundView Technology Group. And while the hardware business may drive top-line growth, its margins are much lower than software's. "John's goal has to be to take a piece of the body blow that [hardware] inflicts on net margins and to do his part to add as many basis points as he can," says Specker. "The only line on the income statement he has to play with is general and administrative, because they don't want to mess with sales and research."
So far, Connors has played well. General and administrative costs for the first half of fiscal 2002 were $1.02 billion, including $660 million set aside to settle consumer class-action suits. Less that holdback, G&A spending was 2.6 percent of sales, compared with 3.1 percent of sales for the first half of FY2001.
Unlike Maffei, Connors isn't a deal guy, nor does he wish to be. In November 2000, Connors recruited investment banker Richard Emerson of Lazard Freres & Co. to take over investment and acquisition deal-making. And as the stock market has fallen from its late 1990s peak, so has the pace of Microsoft's deal-making, from $20.7 billion in calendar years 1998 and 1999 to $8.6 billion in 2000 and 2001. Most investments today are made to gain entry into established markets where Microsoft isn't a serious player.
One such deal was the April 2001 purchase of Great Plains Software, an ERP vendor for small and midsize businesses. Analysts lauded that acquisition as a key play in Microsoft's diversification strategy.
Just about the only thing that Connors catches any flak for is the company's efforts to free revenues from dependency on the PC market, by changing from a perpetual to a recurring software licensing model.
Under the old model, enterprise software customers bought Microsoft software (usually Windows and Office) with a perpetual-use license when they bought PCs or upgraded. When new versions came out, the customer could either buy the upgraded version for 50 to 70 percent of the full purchase price or just keep using the older version. Under a new program, Microsoft will allow all enterprise software customers to join an ongoing software maintenance program, called Software Assurance. The program gives participants ongoing upgrades as they become available, but the annual program fee is 25 to 29 percent of the cost of a full license.
Designed to produce a stable revenue stream, the recurring model is "very similar to the software licensing model that other large enterprise providers have always had, whether it's Oracle, SAP, et cetera," points out Connors. "The difference is that we had a broad range of other ways you could buy our software, many of which proved to be quite popular. So for our move to a larger percentage of subscription-oriented licensing [to succeed], the first thing is: you have to have value. If subscribers don't think there's value they won't upgrade, and the programs will be a disaster."
Microsoft had originally given customers until October 1, 2001, to upgrade to the latest versions of Windows and Office in order to be eligible for the new program, or face paying full price for the newest versions after that date. But D-day was rolled forward to this summer after considerable customer outcry. Customers complained that Microsoft wasn't giving them enough time to prepare for the new plan, and some, especially those customers who don't upgrade frequently, continue to grumble that the program will increase their software costs. (Some analysts say that companies that upgrade less than every 3.5 years will end up paying more under the new program.)
The company is also unveiling a licensing model in which customers "rent" enterprise software licenses for three years, but then must renew licenses when they end. Analysts are still debating whether or not Microsoft's new "subscribers" will choose to participate in either new program, and whether the programs will have the hoped-for effect on revenue flow.
A possible hitch with Software Assurance and rental models is that they will increase the company's unearned revenues, which stood at $6.6 billion as of December 31, 2001. Those revenues are already under scrutiny by the Securities and Exchange Commission. Connors insists that Microsoft recognizes the unearned revenue in later periods in full accordance with GAAP, but the SEC is investigating whether the revenues served as a "cookie jar" that the company used to smooth earnings in the mid-1990s. In 1999, the company's former head of internal audit alleged in a wrongful-termination lawsuit that such smoothing occurred, but the suit was settled out of court, and the SEC has yet to rule on the allegations. (A recent $1 billion restatement of first- and second-quarter FY2002 unearned revenue--necessitated because of a "clerical error"--would seem to undercut Connors's claim that Microsoft's accounting practices in this area are scrupulous.)
[Microsoft's] policies regarding revenue recognition are thoroughly documented and remain consistent as much as they can remain consistent," says SoundView Technology's Specker. "It's hard to accuse them of cookie-jar accounting in that context. But like George Costanza used to say on Seinfeld, 'It's not a lie if you believe it.' If you document it and stick to it, then you can't be accused of changing the rules because you needed the extra revenue.
"But the goal of a P&L is to provide a current view of changes in business conditions," adds Specker, and even if Microsoft consistently applies its policy for recognizing unearned revenues, he says, the effect is to distort the view afforded by the income statement.
Connors scoffs at such criticism. "I think the most important thing about this place is that a long-term view is taken," he says. "Bill [Gates] and Steve [Ballmer] pay virtually no attention to quarterly financial results. We set an annual plan for the company; we then set the expectations of the annual plan with the investment community."
The $40 Billion Question
Microsoft has also come under fire from the likes of Ralph Nader for amassing $40 billion in cash instead of paying a dividend. Connors says the board of directors periodically reviews the question of paying a dividend, and "when the board, and our executive team, feel like the best way to maximize shareholder value is a payout, we will do that. But if you look at where we are today, we face big risks, big bets. And while $40 billion is a substantial amount of money, given the current environment I think it's kind of an odd thing for your company to get beat up for having a healthy balance sheet."
Healthy, indeed. Analysts expect Microsoft will hold on to the cash until the antitrust penalty phase is complete, then go on a spending spree to buy into more markets, create more partnerships, and push shared technology platforms with other technology providers.
But the old days when Microsoft could conquer markets without much help are gone, so the company has a lot of fence-mending to do. Last March, CEO Ballmer said that Microsoft knows that it has to be "a respectful, open, and appropriate competitor." For the first time, the company has started opening up parts of its software source code to competitors. And a recent companywide memo from Gates refocused Microsoft's efforts on improving the security of its products--crucial to acceptance of its new .Net platform for Internet-based applications.
Who better to represent a more open Microsoft than John Connors? The respect he's earned inside the company is matched by praise from the analyst community. He's "the Eagle Scout of CFOs," declares David Readerman, an analyst at Thomas Weisel Partners. Adds SoundView's Specker, "I think he's done a spectacular job."
Connors says his role model, both professionally and personally, is his father. Dan Connors coached high school basketball and football back in John's hometown, but quit when John became a freshman so he wouldn't be John's coach. "He could have stayed another year or two [and broken some records]," recalls the son. "But he left the new coach with a great hand--and that's what I would like to do."
He may well succeed. But given the profound changes facing a maturing Microsoft, it could be a very different hand from the one Connors is playing now.
Kris Frieswick (email@example.com) is a staff writer at CFO.