Greg Maffei says he doesn’t lose any sleep over Microsoft Corp.’s antitrust battle with the Justice Department, simply because the software giant’s 39-year-old senior vice president and CFO plays no role in the case. Yet Maffei claims that he worries about the company’s future nonetheless.
What dark fate, apart from what the government’s lawyers might convince the courts to dish out, could possibly await the world’s most valuable company? After all, Microsoft boasts 90 percent-plus gross margins on a 90 percent-plus share of a growing market for its core product–the operating systems of personal computers–along with no debt and a cash hoard of $22 billion. It’s a company that, after its initial public offering in 1986, zoomed from less than $350 million in revenue to $8.7 billion in less than 10 years, without having to raise an additional penny in capital. In Maffei’s previous position at the company, he recalls, this enviable state of financial affairs prompted people “to come up and tell me that being the treasurer of Microsoft was a joke.”
But since taking over the CFO spot in July 1997, following former finance chief Mike Brown’s retirement, Maffei’s main task has been to make sure Microsoft doesn’t fall victim to its own extraordinary success. To hear him tell it, that’s a tougher job than is immediately apparent. And it’s a job that will require all of his reputed prowess as a tough, shrewd dealmaker.
The basic problem is that Microsoft’s revenue growth is slowing. From fiscal 1995 to fiscal 1996, for example, the revenues that the company reported on its income statement soared by 46 percent, but the two fiscal years since have seen annual revenue growth slow to 31 percent and 28 percent, respectively. And Maffei says he expects revenue growth to decline both this year and next, unless Windows 2000 (Microsoft’s new operating system) and Office 2000 (its updated office productivity suite) are as successful as he hopes.
A substantial part of the slowdown may be due to Microsoft’s deferred recognition of revenue–a practice that has exposed the company to charges that it manages earnings. And the Securities and Exchange Commission has launched an investigation into its accounting practices with that issue in mind. However it’s resolved, future growth will be harder to come by than it once was, says Maffei, and analysts agree.
“The days of consistent, 30 percent plus, year-over-year growth are over,” notes Mary Meeker, an analyst for Morgan Stanley Dean Witter. This, of course, seems only natural. The larger a company gets, the harder it is to sustain its historical growth rates. And in Microsoft’s case, analysts contend that further growth in its software business is constrained by the already considerable size of its installed base. “Microsoft is in a tough position,” says Thomas Hensel, formerly an equity analyst at Everen Securities Inc., in Chicago. “They’ve saturated a lot of the market.”
Given Microsoft’s market share and profitability, one might think a slowing top line would merely require Maffei to lower investors’ expectations so that Microsoft can continue to meet or exceed them. After all, Microsoft’s track record on that front is almost as impressive as in marketing software. Maffei “always talks down the quarter,” says Aaron Scott, an analyst for Advest Inc. in Hartford.
Microsoft, however, is not exactly known for reducing other people’s expectations, or for being satisfied with anything less than head- turning growth. Its ambitions remain outsize. It wants to outfit giant corporations and home offices alike with its software. It wants to have a commanding presence in computing platforms and Web portals. It wants to offer new development tools to programmers and new Internet services to consumers. And it’s developing a new business model that will depend on steady streams of revenue from software sales.
But though the Justice Department has done an admirable job of painting the Redmond, Washington-based behemoth as a crass monopolist, Microsoft is by no means assured of extending its dominance to the Internet. Or to the explosion of new devices and “information appliances” that require operating software, from handheld computers to cell phones to cable-TV set-top boxes. Meanwhile, the core franchise, Windows, is under attack from an unexpected new competitor, Linux, while bitter rivals Oracle Corp. and Sun Microsystems Inc. regularly proclaim the irrelevance of the operating system.
Even Microsoft needs friends in this competitive free-for-all. Better, it wants partners–made through investments, acquisitions, joint ventures–and it wants them fast.
Already, Maffei has embarked on a flurry of dealmaking. The most notable recent deal at press time was last May’s $5 billion investment in AT&T. In exchange, Microsoft won the right to supply a simplified version of Windows for as many as 10 million of the set- top boxes that AT&T plans to install, plus an equity stake of as much as 2.9 percent.
Maffei played a critical role in the deal, as he has in most of the more than 120 investments and acquisitions Microsoft has made since he joined the company in 1993 as director of business development and investments. Maffei came to Microsoft from the CFO job at Pay ‘N Pak, a troubled home- improvement chain that had been taken over by Citicorp Venture Capital. Previously, he had been a vice president at the venture capital outfit.
Microsoft has given Maffei, who holds an MBA from Harvard Business School, ample opportunity to wheel and deal. He has “incredible street smarts,” says his counterpart at WebTV Networks, Albert “Rocky” Pimentel, and is “a masterful poker player” when it comes to negotiating deals.
But Maffei’s persona is as far removed as a CFO’s can get from the nasty caricatures that Justice Department prosecutors and competitors have drawn of Microsoft executives. Both in public and in private, Maffei comes across as anything but an arm-twisting, bad-ass dealmeister. In fact, he pokes fun at the image. When, for example, we suggested at the start of our interview in his small, spartan office that we intended to stray from the list of questions that we’d submitted in advance, Maffei, dressed for the occasion in golf shirt and khakis, joked that he was sorry, but that was just not possible.
“He’s funny, honest, and easy to be around,” says Leo Hindery, who as president and CEO of AT&T Broadband & Internet Services, in Englewood, Colorado, spent days negotiating the AT&T deal with Maffei. On the other hand (and with apologies to Hindery), Maffei admits that he uses humor as a means of disarming his negotiating partners.
Maffei also seems to have disarmed critics of Microsoft’s accounting practices. Twelve days after telling CFO that the SEC had signed off on its deferral of revenue, but a month before this issue went to press, Maffei held a conference call with analysts and the press and announced that the company had learned “sometime during the past few months” that the SEC had launched an inquiry into Microsoft’s accounting. If the SEC challenges Microsoft’s deferral of revenue, the company could find it more difficult to smooth out earnings volatility. But in the conference call, Maffei said the inquiry would not have a material effect on the company’s results, and the stock barely budged on the news. Smooth indeed.
Maffei, however, does have his detractors. Some analysts contend that Microsoft overpaid for WebTV, for example, when it spent $425 million in 1997 for technology designed to provide TV sets with Internet capability. Reportedly, Microsoft initially expected to have somewhere between 2 million and 3 million WebTV subscribers by now, but so far the company has managed to sign up less than 1 million.
But on closer examination, the WebTV deal may be less expensive than it seems. Microsoft wrote off nearly 70 percent of the purchase price as in-process research and development. Although the SEC has been cracking down on such write-offs, Maffei says Microsoft’s accounting for the acquisition passed SEC muster.
Other analysts complain that Maffei didn’t get as much as he should have in the AT&T deal. They note in particular that Microsoft’s contract to supply software for the set-top boxes is nonexclusive. But both Maffei and AT&T’s negotiator point out that Microsoft did not seek exclusionary terms, and that it wasn’t all that critical to have done so. “[The deal is] de facto important, if not exclusive,” says AT&T’s Hindery.
Also, it might have been unwise for Microsoft to demand exclusionary terms when such arrangements rank high among the business practices being challenged by the Justice Department. Maffei agrees: “If Microsoft and AT&T were to do an exclusive deal, you’d have to be deaf, dumb, and blind not to notice.” But he adds that Microsoft would have sought the same terms for the deal even if it weren’t an antitrust target.
To Be Remodeled
More broadly, Maffei says the focus of Microsoft’s dealmaking isn’t on short-term financial returns but on strategic benefits down the road. An extra million dollars here or there is beside the point: “People don’t pay us a multiple of our capital gains,” he remarks. Hindery, for one, supports this view. Referring to the AT&T deal as well as other investments and acquisitions that Maffei has overseen, Hindery contends that “these companies aren’t just good deals, they’re good businesses.”
Indeed, Microsoft hopes they will eventually produce an entirely new business model for the company–one no longer dependent on one-time sales of licenses, but instead on rental contracts that produce an ongoing stream of revenue. Likening such a model to that of companies that offer cell phones or cable TV service, analyst Hensel says that Microsoft would eventually like “to get a cut every time” its software is used. And he says the company’s E-commerce business in particular lends itself to such a model.
“Our business model is clearly changing,” confirms Maffei. And as the CFO sees it, more and more of Microsoft’s business will eventually produce “an annuity-like revenue stream.”
How would that happen? Maffei explains that commercial software is starting to become “embedded in services” and “highly aligned” with communications capabilities–so much so that the business and the technology are inseparable. “Is AOL [America Online] a software company?” he asks. “Sure. Is Amazon.com a software company? Is Ebay? Software is a very important element of what they do. So I think you’ll see us continue to be looking for all sorts of partnerships.”
These deals will help produce a fee-based business model in both direct and indirect ways. Deals such as the one with AT&T will help develop the infrastructure for Internet services, thereby supporting other deals in which Microsoft either offers such services itself or provides the software for other service providers. In either type of arrangement, the company expects to get a cut of whatever advertising or transaction revenue the services generate. As for the software itself, “It’s a loss leader,” says Hensel.
And to the extent that such a model would produce a steadier revenue stream and less volatile earnings, Maffei says Microsoft’s stock multiple and price might begin rising again. (For the most part, the stock has been going sideways since last April.) What’s more, the new model might allay analysts’ and SEC concerns about Microsoft’s accounting. To create such a model, “Greg’s challenge is to put into place the right assets,” says WebTV’s Pimentel, who has no doubts Maffei is capable of doing that.
Long before the deal with AT&T, Microsoft began investing in a host of content-oriented Internet properties, including the MSNBC news site, Hotmail E-mail service, Expedia (travel services), and CarPoint (car shopping). Its more-recent forays have stressed the underlying technology that helps distribute such services, including stakes in several European cable TV companies as well as in AT&T and Nextel Communications Inc. All told, Thomas Hensel projects Microsoft’s Internet business to account for 10 to 15 percent of Microsoft’s revenue next year, and the Wall Street firm of Warburg Dillon Read estimates the business is currently worth about $50 billion.
Granted, “Microsoft has more money than time” to get all the necessary assets into place, according to Esther Schreiber, a former analyst for CS First Boston. But Maffei isn’t prepared to overpay for them. His poker- playing skills may have been reflected in the AT&T deal, observes another analyst, since it preceded a flurry of subsequent transactions, including a $600 million investment in Nextel and the $127.5 million acquisition of Swedish Internet software maker Sendit A B. (Talks are also reportedly under way for stakes in the cable TV operations of Cable & Wireless and Deutsche Telekom AG.) This analyst, who asked not to be identified, suggests that Maffei may have held off on some of these subsequent transactions until he had closed the AT&T deal, for fear of “showing his hand” to AT&T–which thus would have been able to negotiate a higher price.
Maffei dismisses such speculation. “I wish I were that smart,” he says. Hindery declines to comment on it, noting only that both AT&T and Microsoft benefited from the deal.
The fact that Maffei’s dealmaking efforts are so nuanced leads Hindery to suggest that Maffei is “eminently capable of being a CEO of a lot of things.” Indeed, press reports a few months ago suggested that Maffei was interested in running Road Runner, a high-speed cable-modem joint venture in which Microsoft invested a reported $425 million in June 1998. But when the company asked Microsoft founder, chairman, and CEO Bill Gates for permission to hire Maffei as its chief executive, it was turned down. Maffei reportedly then lobbied to be named head of Microsoft’s new consumer and commerce group, which encompasses the Internet business, and was disappointed that the job went to vice presidents Brad Chase and Jon DeVaan instead.
A company spokeswoman is quick to point out that Microsoft has since promoted him from vice president to senior vice president, named him to a new “business leadership” team, and given him the additional titles of head of procurement and real estate. But this may not be enough to keep him in the CFO spot for long. “There’s some truth to the Road Runner rumors,” says Hindery.
For his part, Maffei maintains he’s happy in his current job. “Most CFOs look to the idea of being a CEO or to run something at some point. That said, I’d be hard-pressed to think of a [better] job in finance or as a CFO. This is a great job, with tons of intellectual challenge.”
The transition to the new business model is weighty enough. Ideally, says Hensel, such a rental scheme would apply to consumers as well as to corporate customers. To win contracts at present, Microsoft often tailors terms to individual customers–another reason its revenue isn’t as predictable as Maffei would like. To reduce the volatility of Microsoft’s revenue, the new pricing structure “needs to be consistent,” says Hensel, but he contends it will be difficult to establish one that’s acceptable to all. Maffei says the company has begun testing standardized rental arrangements with small companies, but adds that it’s too early to judge their success.
The company’s recent reorganization may help, though it will be difficult for outsiders to tell. Microsoft president Steven A. Ballmer has realigned operating divisions to reflect groups of customers rather than products, a change Microsoft says is designed to stimulate innovation and streamline development. But the company will not alter its internal reporting system to reflect the new setup, according to Maffei.
He won’t say why, but it may be because he doesn’t want to run afoul of the SEC’s new disclosure requirements for business segments. Basically, these require companies to disclose in their financial statements the same information about their business segments that they report internally. And many CFOs don’t want to report their company’s results this way for competitive reasons (see “Sliced, Diced, and Still Obscure,” CFO, February 1998).
Of course, the results of Microsoft’s business segments would become abundantly clear if its biggest antitrust fear came true. In the widely anticipated worst-case scenario, the company would be broken up along the lines of its various product segments. Yet analysts say that might not be so awful, simply because they could add back the pieces for purposes of valuation. And the sum of the disparate parts may even be greater than the whole if separation unlocks any value now hidden.
Few observers expect Judge Thomas Penfield Jackson to go so far as to break up the company. Some expect the court instead to require Microsoft to make the source code for its operating system available to outside software developers. The spokeswoman would not comment on that observation but did say that Microsoft was open to a settlement if it could continue to add new features into its operating system. But so far, she says, the government has refused to accept that possibility.
At any rate, a decision in the antitrust case isn’t expected to be made until year’s end, at the earliest. Any judgment that imposes stiff penalties on Microsoft will no doubt be appealed to the highest courts–a process that could take an additional two years or more.
One thing seems clear: Greg Maffei may well be a CEO somewhere by the time the antitrust battle is over.
The Dark Side of Deferral
Does Microsoft Understate Its Growth?
Microsoft’s argument that it isn’t a monopoly would only be helped by the impression that its revenue growth is slowing. But a big part of the slowdown may simply reflect a change in the way the company recognizes revenue.
A growing portion of Microsoft’s revenue isn’t recognized when payment is received, but is deferred instead. As of last March 31, the company had almost $4.2 billion in “unearned” revenue as a liability on its balance sheet, compared with $2.9 billion on June 30, 1998. Without such deferrals, Microsoft’s revenue growth would have remained above 30 percent in fiscal 1998.
Granted, the practice of deferring revenue in this fashion is required under generally accepted accounting principles to the extent that software contracts call for the manufacturer to supply product support and unspecified upgrades at no additional charge. And Microsoft insists that it hasn’t changed its revenue-recognition practices. Instead, it says the growing amount of its deferred revenue reflects the fact that its sales are increasingly contingent on product support and upgrades.
The company explains that it defers approximately 10 percent to 25 percent of its revenue from selling Windows to PC makers and other original equipment manufacturers, its main sales channel; that it expects to recognize this revenue over roughly three years; and that it will defer the same amount of Office 97 revenue, recognizing it over an 18-month period.
With the total amount of deferred revenue on its balance sheet now equal to roughly 80 cents a share (on an undiluted basis), or almost two quarters’ worth of current earnings, analysts now pay as much attention to this liability as to earnings. And they draw comfort from seeing the amount of the liability grow. “We believe the company’s core earnings power is higher than printed and is held back, in part, by the company’s aggressive revenue-deferral efforts,” noted Mary Meeker, an analyst for Morgan Stanley Dean Witter, in a recent report.
To the extent that Microsoft recognizes a portion of the up-front cash payment over subsequent periods, the practice converts a one-time payment into a stream of revenue, just as its forays into E-commerce, cable television, and wireless communications are intended eventually to produce.
A Whistle-Blower’s Tune
But some analysts also suggest that Microsoft may use the deferred amounts to manage earnings, which violates both GAAP and federal securities law. In a little-reported whistleblower’s lawsuit settled last year, Microsoft’s former chief of internal audit, Charles Pancerzewski, charged that the company had set up a cookie-jar reserve that it used to eliminate fluctuations in its earnings prior to his resignation in 1996, and that he had been forced to resign after calling attention to the practice.
In his lawsuit, Pancerzewski cited Microsoft’s use of deferred revenue as a potential means of creating such a reserve, and brought in William Simpson, a former SEC accountant in its Los Angeles office and now a consultant, to testify that Microsoft did indeed manage its earnings through such means, according to court documents. Microsoft convinced the court to seal Simpson’s testimony from public view, and both he and Pancerzewski declined to be interviewed for this article.
Nor would CFO Greg Maffei comment on the lawsuit. (Repeated attempts to reach former CFO Mike Brown were unsuccessful.) But Maffei strongly defends the company’s use of deferred revenue, and says it doesn’t use the amounts or any other item as a means of managing earnings. “We manage the expectations about earnings,” he says. They are “two different things.”
As for how Microsoft determines the amount of revenue it defers, Maffei insists “we follow GAAP. That unearned revenue is not managed earnings in any way, shape, or form. It’s quite the opposite. When people talk about managing earnings, they think you’ve got some hidden pocket here or there that you’re pulling [money out of].” But he adds, Microsoft’s deferred revenue is “entirely visible. It goes in under a set of rules that we proclaim to analysts. We reviewed that with the SEC, and they agreed.”
Despite the recently announced SEC inquiry into Microsoft’s accounting practices, Maffei says analysts can still draw comfort from the amounts of revenue it defers. He notes that the inquiry “to our knowledge” has nothing to do with the deferred revenue, though a spokesman for the commission declined to confirm that.