July 30, 2002 8:30 AM PDT

Cold shoulder for Microsoft plan

The majority of Microsoft's customers won't be signing up for a controversial licensing plan set to go into effect on Thursday, according to analysts' estimates.

Signing onto the plan, which would commit business customers to a two- or three-year annually paid contract guaranteeing the right to upgrade, will be the only way to continue buying Microsoft software at deep discounts.

The holdouts have until the end of their business day on Wednesday to sign up for the plan or risk paying full price the next time they buy software from Microsoft. They won't get a reprieve, either. Microsoft has twice extended the deadline for the new program, but a representative said Monday that there would be no more extensions.

The reason for stiff customer resistance is simple: cost. The plan, called Licensing 6, effectively raises volume-licensing fees from 33 percent to 107 percent, according to market researcher Gartner. Microsoft also eliminated the most popular means of buying upgrades, which allowed companies to pay when they wanted new software, rather than spend money in advance for software upgrades.

Financially, the low number of customers signing up for the plan shouldn't hurt Microsoft. Through a combination of other licensing plans, the company recorded a huge revenue windfall in its most recent quarter. Licensing could contribute some $6 billion in revenue for the company's fiscal 2003.

But dissatisfaction with Microsoft's licensing terms could lead customers to consider options such as Linux and rivals to Microsoft's Office business software.

"This is the sort of thing that has lost Microsoft a lot of friends," said Directions on Microsoft analyst Paul DeGroot. "A lot of corporate customers feel this thing has one winner: Microsoft. What we've heard from a lot of corporate customers is that they've looked at Licensing 6 and frequently felt that all the advantage falls to Microsoft's side."

One technology manager at a large company based in the southwest United States said that the cost of the new licensing plan has created havoc at his company.

"Our IT budget has been savaged by this," said the manager, who requested anonymity. "We have lost any hope of (buying) a (new) helpdesk system, a new SQL Server (license) and the hiring of an additional technician. All (are) out the window now."

Sunbelt Software, a Windows consulting company, conducted surveys of technology managers, in October and again in March, that assessed the impact of Licensing 6. The surveys, the first of which was done in cooperation with market researcher Giga Information Group, contacted about 4,500 technology managers.

"About two-thirds aren't going to sign anything, because it's too expensive for them," said Stu Sjouwerman, president of Sunbelt. "If you look at our current survey, from March, those numbers haven't changed much."

Yankee Group analyst Laura DiDio agreed with Sunbelt's estimate of companies staying away from the new licensing plan. But she noted that of the huge number resisting Licensing 6, a good portion chose to renew under the cheaper Licensing 5 contract or had contracts under the old plan that don't expire until 2003 or 2004. So technically, at least some of that two-thirds signed up for an annuity licensing plan, if not the full Licensing 6 plan.

"But at the end of that time, they are going to have to decide what to do about Licensing 6," DiDio said. "They delayed their decisions until later."

Gartner analyst Alvin Park said it's too early to tell how many customers eligible for Licensing 6 actually signed up for the program. However, "there's no question (that) many customers won't jump on board," he said.


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Microsoft offers three licensing plans: Open, Select and Enterprise Agreements. The first two are the ones affected by the Licensing 6 changes and by the introduction of the subscription-like "Software Assurance" program. An Enterprise Agreement is already an annuity program, and one that has grown in popularity in part because of the higher cost of Software Assurance under Open and Select licensing plans.

"The number of Enterprise Agreement customers has increased from about 15 percent to 35 percent," Park said.

Microsoft would not say how many customers signed on to an annuity-licensing plan, although a representative said the company had achieved its internal targets.

The company's Chief Executive Officer, Steve Ballmer, acknowledged customer resistance to the new licensing plan during a speech at last week's annual meeting with financial analysts.

"I think the fact that our customers probably didn't understand our licensing as well as they might have earlier, makes the transition and makes the perceived pain actually higher than perhaps the real pain," he said.

Overwhelming customer resistance
The most controversial piece of Licensing 6 is Software Assurance, through which businesses pay 29 percent annually of the full price for two or three years. This entitles them to upgrade to new software versions released during the contract period.

For the majority of businesses, which upgrade software every three to six years, Software Assurance works out to a hefty price increase, as there is no certainty that Microsoft will deliver a product during the contract period. Many businesses in this group have good reason not to sign up for the new licensing program, say analysts.

"If you're on a three-year, four-year or five-year upgrade cycle, you're better off without Software Assurance," DiDio said. "The break-even point Microsoft has identified is about 42 months. After that, it costs you just as much as or less to buy a whole new license."

About 80 percent of technology managers in the second Sunbelt survey said they had a negative view of the new licensing plan. Thirty-seven percent of respondents said they would not sign up for the new licensing plan at all.

Analysts note that in a competitive market, Microsoft would find it difficult to push customers into adopting a plan with uncertain benefits and a huge price increase. But Microsoft owns a huge share of the operating-system market.

"It's not possible to quantify the benefits of Software Assurance, because you don't really know what you're buying," DeGroot said. "You don't know when the product is going to come out, so you can't say that, in early 2005, Longhorn--the next version of Windows--will be on our desktops. With Software Assurance, you simply cannot predict what you are going to get for that money."

In that sense, Licensing 6 could backfire on Microsoft, because companies have more incentive to make sure the company's software ships on time. So far, Microsoft's record for on-time releases isn't good, DeGroot said.

You're in trouble "if Microsoft doesn't meet the ship date, and as a consequence your Software Assurance expires," he continued. "The next time you buy this software, do you believe these guys? Are they credible? They've just taken a bunch of money, and they're not giving it back. But you got nothing for it. I think that's a terrible risk for Microsoft," said DeGroot.

So if customer resistance is stiff now, it could be much worse in two or three years if products such as .Net Server--already delayed by a year--or Longhorn, ship late. In the past, customers accepted delays in expectation of getting a more stable product, but that, too, could change, DeGroot said.

"Ironically, customers' attitude may change: Ship, ship, ship that sucker on time, and I don't care whether it works or not," he said. "I paid for you to hit that date."

But some Microsoft customers said they'd survive the price increases because they retooled their budgets to absorb higher licensing fees.

"I can understand how Microsoft's recent actions could have a heavy impact on business or government agencies that have not been as proactive as our CIO and agency leadership have been," said Elena Gellepis, a technology manager with the Florida Department of Transportation.

Gellepis noted that her agency is the exception rather than the rule among Microsoft's customers.

Other companies caught flatfooted by Licensing 6 should plan for future price increases. Gartner is recommending that its customers add 40 percent to their annual software budget with Microsoft to cushion against continued licensing changes.

Microsoft's windfall
Even with the majority of customers refusing to sign on to Licensing 6, the company has seen an enormous windfall from the new program. Unearned revenue, the majority of which comes from software licensing agreements, rose more than $2 billion during fiscal 2002 over the previous year, Microsoft reported.

Analysts describe the increase in unearned revenue from the company's third quarter to fourth quarter as "staggering."

"Growth in unearned revenue on the balance sheet was very strong, up 38 percent year over year, and $830 million sequentially, reflecting the large number of annuity agreements signed during the quarter," Scott Boggs, Microsoft's corporate controller, told financial analysts during the company's fiscal-fourth-quarter conference call, about two weeks ago.

In the fourth quarter, unearned revenue for desktop applications rose 59 percent year over year, and for server software, 102 percent. Also in that quarter, previously deferred licensing income accounted for 20 percent of revenue. Microsoft ended the fiscal year with $7.74 billion in unearned revenue, the majority from licensing. Of that amount, the company expects to record $6 billion as revenue during fiscal 2003, or about 20 percent of the projected $32 billion in revenue.

"The success we had in fiscal year '02 with our licensing business does give us an earned revenue in '03 that is a little bit unusual compared to years past," John Connors, Microsoft's chief financial officer, told financial analysts last week.

Before introducing Licensing 6 in May 2001, Microsoft saw declines in its software revenue for key products, such as its Office application, as more customers extended their upgrade cycles to three years or more. By instituting an annuity program, which would be the precursor to a full subscription program, Microsoft could smooth out the hills and valleys in revenue.

Even though only a third of its customers have agreed to the new program, "Microsoft should get a nice revenue bump as a result of people upgrading to Licensing 6.0," Yankee's DiDio said. "They needed to feed the revenue monster and feed the recurring revenue stream to make up for the shortfall for the upgrades they were getting from people buying new products. Without that 20 percent bump, where would Microsoft have been?"

But Microsoft's enormous windfall could come with uncertain long-term cost.

Sunbelt's March survey found 38 percent of respondents were considering switching to other products, a slight increase from the 36 percent in the October survey.

"Lots of people say they are interested in Linux, but there are few actually doing it," said Sjouwerman. "Microsoft understands that Linux is a viable alternative, and there are people actually moving. But there aren't that many. Most people say, 'Listen, in two or three years if I really need an upgrade, I will think about it at the time.' So a lot of people simply have not taken any action."

Another problem is lost revenue on existing software licenses for the many companies that decided not to sign up for the new program.

"That means that all those old licenses are frozen in time and can never be upgraded, but must die a natural death," Gartner's Park said. "So for those people that don't sign for those licenses, Microsoft can never recover that revenue again."

Companies would not be prohibited from continuing to use those licenses, just from purchasing upgrades for them.

Still, unless a huge number of Microsoft customers switch to competitive products, the software titan is the ultimate winner, not customers, DeGroot said. For example, those people paying full price will be looking at a minimum of $700 for Office XP versus $440 under volume licensing.

"Microsoft wins either way, whether you buy Software Assurance or not," DeGroot said. "Their revenues go up. You can pay more for your upgrade, but less than full price--or you can pay full price later on. The fact that two-thirds of their customers are not purchasing Software Assurance is not necessarily bad news for Microsoft."

 

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