MS exec lists joys of high prices, vast margins to top investor

Aiming for monopoly monopoly, apparently...

Smoking emails return to haunt Microsoft this week with the Minnesota overcharging lawsuit, which commenced on Monday. The court's exhibit vault was at time of writing disappointingly empty, but its mere existence shows willing, so check it early and often. And we have a taster of things to come in the shape of senior MS exec Jeff Raikes in full-on robber baron mode, describing a business with profit margins of 90 per cent plus that can only get better.

This particular email is one of the trial exhibits, and escaped along with some choice quotes from a few others in yesterday's Wall Street Journal. (If you've a sub to the WSJ, you can get the email here and the story here.)

The 1997 email was sent to Berkshire Hathaway boss Warren Buffett, and is an attempt to persuade Buffett - who famously declined to invest in Microsoft - to back a certainty. Raikes says that this effort is meant as a "fun discussion or intellectual exercise," but Buffett's influence was and is such that a change of mind on his part surely would have had a substantial impact on Microsoft's share price. And if Raikes really is only doing it as an intellectual exercise, for fun, then there's many a CFO who'd view his going on the record with this sort of stuff as cretinously irresponsible.

So it's 1997, and Raikes is describing the numbers for 96. There were about 50 million PCs sold worldwide, and 80 per cent of these shipped with Microsoft operating systems. "Although I would never write down the analogy of a 'toll bridge' [er, you just did you imbecile - CFO], people outside our company might describe this business in that way. Those 40 million licenses averaged about $45 per, for a total of about $1.8BN in revenue." Raikes claims the remaining 20 per cent largely used Microsoft operating systems as well, but they were mainly pirate and so Microsoft didn't get any revenue. It's interesting that as far back as 97 Microsoft took the view that anything you didn't buy from Redmond is probably stolen, but it's not the main thrust of his argument.

For FY2000, Raikes sees Microsoft as having a 90 per cent share of a 200 million PC market, with "piracy" being squeezed down to 10 per cent. The 96 sales yielded "about $45 per, for a total of about $1.8BN in revenue." But for 2000 Microsoft "will be transitioning the world to a new version of our operating system, Windows NT." By this of course he means Windows 2000, aka NT 5.0. "Today, we get more than $100 per system for NT, but only on a small percentage of the PC's. But NT will be on closer to 70 per cent of the PC's sold in FY2000. We can achieve average license revenue of $80. So 90M licenses at $80 per license totals about $7.2B, up from just under $2B in 3 to 4 years. And since there are effectively no COGs and a WW sales force of only 100-150 people this is a 90%+ margin business."

The DoJ antitrust trial threw up some interesting emails from around this time showing that Microsoft was maintaining its price to OEMs at a time when PC prices were falling drastically, thus increasing its percentage take per PC sold, but not its revenue per PC. Here, however, we have Raikes confirming the company's intention to put the per PC price up as it moves everybody onto the one operating system. Because it has what "pricing discretion", by which we think he means it can charge whatever the hell it likes, and that it will.

But that's just the baseline. In addition to the hugely profitable OS business, there's the rest. "The majority of the rest of the business is called the 'finished goods' business. It consists of businesses or individuals buying office productivity software, educational or entertainment software, etc. Again the structure is very simple. A PC is just a razor that needs blades, and we measure our revenue on the basis of $ per PC. In FY96, nearly 50M PC's were purchased and Microsoft averaged about $140 in software revenue per PC or $7B. This amount is in addition to the OEM royalty business I described above."

In the intervening period Microsoft has become an even more dominant force in the razor market, and has successfully been able to charge more. At the same time, it has won a similar lock on the desktop productivity market, to the extent that just shooting all the MS Office licences and installing StarOffice has become a tempting quick fix for IT managers looking for cost reductions. Their discovery that MS Office is a mere razor blade that needs frequent replacing may accelerate this process.

Having detailed the financial joys of owning the franchises, Raikes moves on to the benefits of monopoly - these would seem to be things monopolists can never have enough of. If you are a sufficiently dominant force in a given area for you not to have serious competition, then you can charge what you like, while if you become similarly dominant in related areas, you gain the additional benefit of protecting the first franchise. "If we own the key 'franchises' built on top of the operating system, we dramatically widen the 'moat' that protects the operating system business," he explains.

And you can never have enough moats. Of Microsoft's TV investments he writes: ""The real goal is to figure out a way to get an 'operating system' royalty per TV. 10's of millions of TV's per year at $10-$20 per TV is a nice little 'operating system' business." Microsoft has in fact contrived to throw away quite a lot of money on this quest in the intervening years, but you'll have noted that it's still trying, and Raikes is telling us why, just in case we couldn't guess. You get the base franchise, pricing discretion, the price goes up, and you develop new franchises on top of that.

Aside from the Raikes email, there seems to be plenty of other good stuff on the horizon. Gates seems to have been involved in a 'kill Lotus' (one of Raikes' first jobs at MS) thread, and complained of Linux: "Maybe we could define the APIs so that they work well with [Windows] and not the others, even if they are open." Sounds like we might have some pissy emails from billg coming, yum. ®

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