Microsoft again writes off Surface inventory, renews profitability doubts

Omits cost of revenue for Surface in latest SEC filing, but acknowledges a write-off to cover the Surface Mini that didn't launch

Microsoft again took a hit on its Surface business, the company has acknowledged, although the extent of the damage was unclear.

For the June quarter, Microsoft said Surface had booked $US409 million in revenue, a 16 per centdecline from the previous quarter. Microsoft has never said what revenue it recorded in the 2013 June quarter - instead it lumped that quarter with two others, Q4 2012 and Q1 2013, tallied the trio and came up with $US853 million - so a year-over-year comparison was impossible.

But unlike the past two quarters, Microsoft has not revealed the cost of revenue associated with the Surface for the June period, at least in the 8-K document filed with the US Securities and Exchange Commission yesterday.

Even so, Microsoft did admit to losses in the prepared remarks read by chief financial officer Amy Hood during the call with Wall Street analysts yesterday, as well as in the 8-K.

"During the quarter, we reassessed our product roadmap and decided not to ship a new form factor that was under development," Hood said, referring obliquely to the Surface Mini, which Microsoft was going to launch alongside the Surface Pro 3 in May, but then changed its mind at the last moment. "Combined with the transition of production towards our latest Surface offering, we made inventory adjustments which impacted our gross margins."

In the SEC filing, Microsoft said much the same, but didn't add any additional detail. "Current year cost of revenue included Surface inventory adjustments resulting from our transition to newer generation devices and a decision to not ship a new form factor," the company stated.

The company did not reveal the extent of the "inventory adjustments" that "impacted gross margins."

To make Microsoft's financials even more difficult to decipher, it has essentially masked the profit, if any, of the tablet/notebook hydrid by grouping the line with the Xbox video game console in the "Computing and Gaming Hardware" (C&G Hardware) group.

The company did spell out the gross margin of the group, however. "Gross margin" is the difference between revenue and cost of goods and production, but does not take into account other expenses, such as marketing or research and development.

The gross margin of C&G Hardware was just $US18 million on revenue of $US1.44 billion. The latter figure was up $US274 million or 23 per cent, compared to the same quarter of 2013, when the group, called "Devices and Consumer Hardware" until now, booked $US1.17 billion in sales.

Nor was Tuesday's earnings call any help: None of the analysts who asked questions of Hood or CEO Satya Nadella, who was on the conference call for the second straight quarter, brought up the Surface.

Bottom line, however, was the fact that, after accounting for the adjustments Microsoft needed to make for the switch to the Surface Pro 3 and for the abandonment of the Surface Mini, the C&G Hardware group -- again, including the Xbox console line -- managed a gross margin of just $US18 million.

In Microsoft money, $US18 million is a drop in the proverbial bucket: The company had revenue of $US23.4 billion, and net income - profit in other words - of $US4.6 billion. The $US18 million in gross margin for C&G Hardware was just 0.4 per cent, or four one-thousandths, of the firm's total net income.

Microsoft's tablet may have been profitable in the second quarter, but another write-down strongly suggests it was not. (Data: Microsoft, SEC filings.)

The Surface Mini adjustment, of course, was reminiscent of the massive $900 million write-off the company took a year ago after over-producing and under-selling the original Surface RT tablet. It suggested that Microsoft has made a second costly mistake on the Surface by taking the Mini almost to the release line, then balking at pushing it across.

So, did the Surface line lose money again? Without more information -- which may appear in a follow-up document Microsoft is required to file with the SEC -- it's impossible to positively, absolutely answer affirmatively.

"I think there's a good chance that it did lose money again, especially as they will have spent on marketing Surface Pro 3 in June without seeing a lot of sales yet," said Jan Dawson, chief analyst at Jackdaw Research, in an email reply to questions Wednesday. "That's not necessarily covered in cost of sales, but would affect contribution margin. At low volumes, it's also likely that gross margins would have been low or negative."

If the Surface ran into the red in the June quarter, as the available data strongly suggested, it would not be a shock: Microsoft has yet to turn a profit on its first stab at computing hardware. Prior to the June quarter, Microsoft had acknowledged a total loss of $1.2 billion on the Surface in other filings with the SEC.

The company has been making progress, though, at least for the three quarters of Q3 and Q4 2013, and Q1 2014, as the losses in the last two of the threesome were significantly less ($39 million and $45 million, respectively) than the first ($216 million).

But the undisclosed amount of the adjustment Microsoft called out for the Surface Mini could easily throttle that progress.

By virtue of the adjustment, it seems very unlikely that Microsoft will ever release the Surface Mini, at least the version that it designed and probably manufactured in some volume before deciding not to sell it. If it planned to simply warehouse those devices until, say, a more favorable moment, it would not have had to announce the adjustment.

That moment, some have speculated, would be when Microsoft has readied a touch-first version of Office on Windows 8.1. Microsoft has been clear -- never more so than lately -- that its device strategy is tightly tied to productivity, and Office is the productivity software giant. A smaller-screen Surface would be worthless with the current edition of Office, which is designed for mouse-and-keyboard control.

Long-time Microsoft watchers such as ZDNet's Mary Jo Foley have asserted that a touch-centric Office -- which Microsoft has promised it will deliver -- will ship next year, perhaps alongside the next iteration of Windows, which most have dubbed "Threshold" and may end up being called "Windows 9" for lack of a better name.

Microsoft may reveal more information about the Surface's profitability in the forthcoming 10-K, but that may not appear for two weeks or so.

Because the June quarter was the end of Microsoft's 2014 fiscal year, the company has more time to complete and file the 10-K. Officially, it has 90 days after the close of the fiscal year to do so. But most companies, Microsoft included, file long before that. Last year, for instance, Microsoft filed its end-of-year 10-K just 12 days after it did the June quarter's 8-K.

Computerworld will revisit the Surface's financials if that 10-K includes more data.

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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