Microsoft's quandary: Big profits from software or shrinking margins with devices

Company's Q4 financials illustrate the hit Ballmer's strategy takes on gross margins

For all his talk of "devices and services," when Steve Ballmer hands over the reins to a new CEO, he will leave an economic powerhouse that prints money by making software, but not one that makes much on anything else.

The next chief executive will have to figure out a way to turn Ballmer's words into reality, or, much less likely, pivot the company back toward its very lucrative roots.

"Their devices strategy is more aspirational, and the 'devices and services' strategy is in some ways a misnomer. They are still a software company," asserted David Mitchell Smith, an analyst at Gartner.

Perusing Microsoft's most detailed financial report, the one it filed with the U.S. Securities and Exchange Commission (SEC) last Thursday, makes it clear why Smith spoke of software, not of Microsoft's professed turn to a strategy that emphasizes devices and services.

Two of the company's five business units -- Devices & Consumer (D&C) Licensing and Commercial Licensing -- generated 66% of the company's total revenue for the fourth quarter of 2013 and 93% of its gross margin. Those units, as their names imply, primarily sell software licenses: Windows to OEMs in D&C's case, Office and a slew of other products to enterprises in Commercial's.

And their margins were stratospheric, above 92% in each case. In other words, for each $100 brought in by those two units, from software sales, Microsoft retained at least $92. That's close to printing money.

The other units -- D&C Hardware, D&C Other and Commercial Other -- had gross margins of 9%, 24% and 23%, respectively, but contributed less than 3% each to the total gross margin for the quarter, showing that they were not only less profitable than the software units, but were nearly invisible on the bottom line.

Microsoft, of course, knows full well the profit-making disparity between what it has historically done -- sell software -- and what it wants to do in the future, particularly with its own home-grown devices, of which it made much last week when it reported record revenue, improved Surface sales and the launch of Xbox One.

"But [Xbox] is never going to be an 83% gross margin," said CFO Amy Hood last week, when asked what Microsoft's margins would look like as a devices- and services-centric firm. "It's just a different business, even for the market leader, and even successfully generating cash and returns."

Indeed.

While sales of Microsoft's Xbox game console and Surface tablet were in large part responsible for the company beating Wall Street expectations, a closer look at the numbers reveals high costs and declining margins for devices, a fact of life that the Redmond, Wash. company must learn to live with as it continues to push its strategic revamp.

"In a general way, they're using hardware as a loss leader," said Patrick Moorhead, principal analyst at Moor Insights & Strategy, after studying Microsoft's financial statements and spreadsheets. "The Surface, for example, is more of a PC than a tablet, and PCs have smaller gross margins [than tablets]."

Rajani Singh, of research firm IDC, concurred.

"Cost of revenue is high in any device manufacturing segment because fixed costs, works-in-progress and overhead are very high," she said in an email reply to questions. "But the Surface looks like a loss-making venture, unless there are accrual revenue associated with the Surface business, which Microsoft has not mentioned anywhere."

For the fourth quarter of 2013, Microsoft booked record revenue of $24.5 billion, representing a year-over-year increase of 14.3%. But the company's profit rose just 2.8%, to $6.6 billion.

The vast bulk of Microsoft's gross margin -- an indicator of profitability -- came from its software sales, while other businesses, including its hardware efforts, generated next to nothing. (Data: Microsoft, SEC filings.)

Much of the gap between those gains was attributed to the Devices & Consumer Hardware unit, which under Microsoft's new corporate structure is responsible for the Xbox and Surface, some video game royalties, Xbox Live subscription revenue, and PC and Xbox accessories like Microsoft's keyboards and controllers.

Unlike software, which historically generates very high margins -- with costs that approach zero for each additional unit once development has been amortized -- component and distribution costs for hardware not only never vanish but result in much smaller profits, especially at the beginning of a product's lifecycle when a vendor cannot capitalize on large-scale component orders or leverage high sales volume to squeeze distributors and retailers.

The trick is to reap the large revenue that hardware can generate, but also produce significant profits. Among device manufacturers, only Apple has been able to consistently do both, though more recently Samsung has proven capable of the same with its consumer-driven smartphones and tablets.

Last quarter, Microsoft showed in spades how tough it is to mimic those rivals.

The Devices & Consumer Hardware group posted sales of $4.7 billion, up a whopping 68% from the same quarter a year earlier. Microsoft credited the Xbox for nearly two-thirds of that revenue jump, particularly the launch of the Xbox One, which sold 3.9 million consoles in less than half the quarter. Microsoft also sold 3.5 million of the older Xbox 360 in the three-month stretch.

For the Surface, revenue rose even sharper, climbing to $893 million, or up 123% when compared to the third quarter, not the usual year-before period. Although Microsoft did not disclose unit sales -- it has never revealed them for its tablet line -- it said they also more than doubled over the previous quarter.

But while device revenue was up -- Microsoft's Hood gave a nod to "a successful holiday" -- so were costs.

The Hardware group's gross margin was just $411 million, down 46% from the same quarter in 2012 because of a 111% increase in the cost of revenue, which Microsoft said takes into account cost of goods, assembly, distribution and marketing. Again, the Xbox accounted for most of the additional costs -- and thus the decline in the margin -- because of the larger console sales volume and, of course, the new Xbox One's launch.

The Surface actually earned less in revenue than the cost of that revenue, Microsoft admitted, pegging the gap between the two at $39 million.

Overall, the Hardware division's margin as expressed as a percentage was about 9%. For every $100 Microsoft collected on hardware, it retained $9. That's low for premium-priced goods like the Xbox and Surface, low compared to Apple's gross margin, which has hovered in the mid-30s, and strikingly low -- just a tenth as much -- compared to the company's software margins.

"You can't run a super-successful hardware business with gross margins at 10% or lower," said Moorhead, who before he became an analyst worked at both Compaq and chip-maker AMD.

Also troubling for Microsoft's device strategy was that the 9% gross margin for Q4 was only a third that of the same period in 2012, when Microsoft launched the first-generation Surface tablets and retained 27% of each dollar of revenue. The trend has been downward since the Surface debut, with gross margin for the Hardware unit falling to 22% by June 2013, then slumping again to 14% in September before sliding to 9% for the year's fourth quarter.

Moorhead, however, urged patience, saying that one should think of Surface specifically, and Microsoft's Hardware group in general, as a start-up, even though its biggest money maker, the Xbox, has been around 12 years.

"I wouldn't expect them to be profitable for a few years in hardware," said Moorhead, speaking specifically of the Surface line. "You just cannot make money without scale. And to get that, Microsoft would have to selling tens of millions of Surface tablets."

The gross margin for Microsoft's Devices & Consumer Hardware unit, which produces most of its revenue from sales of Xbox and Surface devices, has steadily fallen over the last six quarters. (Data: Microsoft, SEC filings.)

Microsoft's Hood wasn't as explicit as Moorhead -- no surprise -- but she said something similar last week. "I do think it's more to think about it as a goal we absolutely have," Hood said of future Surface profitability.

Hood dodged a question from Brad Reback, an analyst with Stifel Nicolaus, who wanted to know what Surface sales volume would put the business in the black.

"Our goal was really to create a product that showcased what can happen when you innovate in hardware, in the service, and in the software," Hood said, repeating a mantra Microsoft has used to portray Surface as a model for others to follow, not necessarily a business meant to turn a profit. "We've learned a lot over the course of this journey. And we have to make more meaningful progress."

IDC's Singh would have agreed wholeheartedly with Hood on that last bit. Singh blasted the decision to stray outside software.

"Microsoft is selling software, adding a little bit of services," said Singh in an interview Friday. "But devices are not something that Microsoft can benefit from in either the short or the long run. Devices are altogether a different animal, and a highly, highly competitive business."

She dove into the financial statements to make her case. "Hardware had a GM [gross margin] of 9%, but software had a GM above 90%. And you're trying to move out of a business with a GM of over 90% and locating your resources in something that has a GM of just 9%? That's not very prudent."

Her take was reminiscent of opinions expressed by Wall Street analysts who have been down on the company's foray into devices, and have said Microsoft should spin off its less profitable businesses -- Xbox and Bing are those most often mentioned -- to improve the bottom line and boost the stock price.

Those analysts have a point: Delete D&C Hardware from the spreadsheets, and Microsoft's gross margin jumps from the actual 66% to a stunning 80% company-wide.

Nor did Singh see much chance of improving Microsoft's financial situation by adding another big piece to the device group, which is what will happen when Microsoft wraps up the $7.4 billion acquisition of Nokia's handset business this quarter.

"Nokia may benefit the revenue of Devices & Consumer Hardware, but not Microsoft as a whole," Singh contended. "Smartphones are not a high-profit product, and in developed markets, smartphone sales may go down or at least growth rates may go down."

Her argument was that it's foolish for Microsoft to divert energies and resources into new markets -- like devices -- unless those moves made the whole company more profitable. "When venturing into new segments, the pieces should build synergy, and the whole should be worth more than the pieces," Singh said.

She saw no evidence of that in Microsoft's numbers. "Microsoft's gross and net profit margins are falling," Singh said, pointing to last quarter's company-wide gross margin of 66%, down 7 percentage points from the 73% the year before.

But perhaps Moorhead put it best.

"Financially, Microsoft is doing just fine," he said Friday. "They're doing pretty well in a down market for both PC and enterprise spending, they out-performed the market in both consumer and commercial.

"But strategically, I can't make a case that they are doing well at all," Moorhead continued. "In mobility, smartphones and tablets, but even in the cloud, I'm not impressed."

Gregg Keizer covers Microsoft, security issues, Apple, Web browsers and general technology breaking news for Computerworld. Follow Gregg on Twitter at @gkeizer, on Google+ or subscribe to Gregg's RSS feed. His email address is gkeizer@computerworld.com.

See more by Gregg Keizer on Computerworld.com.

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