New Microsoft same as the old Microsoft

No matter what strategy the CEO touts, company's financials show entrenched revenue drivers and money losers

For all the talk by its CEO about a new and different Microsoft, the company's revenue and profit engines remain untouched, with money-making software groups tied to hardware-intensive divisions that increasingly drag down the firm's overall margin.

Perusing Microsoft's latest financial report, the one filed with the U.S. Securities and Exchange Commission (SEC) in July, makes it clear that little has changed in either the last year or since Satya Nadella took over the reins in February 2014.

Two of the company's six business units -- Devices & Consumer (D&C) Licensing and Commercial Licensing -- generated 68% of the company's total revenue for the second quarter of 2014 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, including Windows Server, to enterprises in Commercial's.

Those numbers were not substantially different from a year ago, much less six months ago when Nadella took over the company. In the second quarter of 2013, D&C and Commercial Licensing accounted for 75% of the revenue and 95% of the gross margin. Half a year ago, the figures were in the same ballpark: 66% and 93%.

And the D&C and Commercial Licensing margins were still stratospheric last quarter, 92% for D&C, 94% for Commercial. In other words, for each $100 brought in by those two units -- from software sales, in other words -- Microsoft retained $93.10. That's "printing money" by any business definition.

The other units -- Computing and Gaming (C&G) Hardware, Phone Hardware, D&C Other and Commercial Other -- had gross margins of 1%, 3%, 24% and 31%, respectively, but contributed even smaller portions to the total gross margin for the quarter. C&G Hardware, for instance, accounted for just 0.1% of the company's gross margin, while Phone -- the new line item in Microsoft's financials that represented the Nokia business acquired in April -- contributed only 0.3% of the gross margin.

As six months ago, when Computerworld last analyzed Microsoft's financials to try to figure out whether its strategy matched its numbers, the four units were not only less profitable than the software groups, but were nearly invisible on the bottom line. Collectively they accounted for 8% of the total gross margin. It's not a rounding error, certainly, but just as obviously not a core part of Microsoft's profitability.

And Nadella has talked "core" so often he could be an apple -- not Apple -- enthusiast.

"We made bold and disciplined decisions to define our core as the productivity and a platform company for the mobile-first, cloud-first world," Nadella said in the July 22 earnings call with Wall Street (emphasis added). "We will get crystal clear on the core businesses that drive long-term differentiation and the businesses that support them."

Nadella used the word "core" 10 times in his prepared statement at the top of that call.

Microsoft, of course, knows full well the profit-making disparity between what it has historically done -- sell software -- and what ex-CEO Steve Ballmer decided it must do, sell devices, too.

While revenue from C&G Hardware, which primarily came from sales of the Xbox game console and Surface tablet, and Phone added $3.4 billion to sales, a closer look at the numbers revealed still-higher costs and continued declining margins for devices.

After an increase in 2014's first quarter, the margin for C&G Hardware took a dive in the second, dropping to just 1%. In the last eight quarters, the group's margins have fallen in four when measured against the previous period.

And the 1% for the second quarter, a record low -- except for the second quarter of 2013, which included a $900 million write-off -- put new meaning to "razor thin."

Microsoft attributed the decline in gross margin for C&G Hardware to higher expenses for both the Xbox and the Surface, but the latter was what dragged down the number: Microsoft took an estimated $363 million loss on the tablet in the June quarter to push the total red ink to $1.7 billion since its October 2012 debut.

Nor did the addition of Nokia help much. With Phone added to C&G Hardware, the two groups returned just 50 cents for each $100 in revenue. When one charts the gross margins of Microsoft's divisions, those for C&G Hardware and Phone are so tiny they simply don't register.

Nadella wasn't unaware of the crummy margins for his company's devices, whether video game machine, tablet or phone. He killed the Surface Mini shortly before it was to launch, reportedly to eat crow immediately rather than to lose even more money down the road; rejected Ballmer's "devices and services" strategy; and talked instead about the company's mission as a "productivity and platforms" seller.

The vast bulk of Microsoft's gross margin -- an indicator of profitability -- still comes from its software sales, while other businesses, including its hardware and phone efforts, generated so little that they're impossible to see in the chart's scale. (Data: Microsoft, SEC filings.)

"At times, we will develop new categories like we did with Surface. And we will responsibly make the market for Windows Phone," Nadella said during the July 22 earning call. "However, we are not in hardware for hardware sake, and the first-party device portfolio will be aligned to our strategic direction as the productivity and platform company."

Other company executives, including former Nokia CEO Stephen Elop, have also deployed the phrase "responsibly make the market." which some analysts have interpreted to mean that losses will not be tolerated in Nadella's regime as they were in Ballmer's.

The mantra of "productivity and platforms" certainly matches Microsoft's revenues better then Ballmer's "devices and services," which was never really defined. The Office productivity family, represented by Commercial Licensing, and the Windows platform, more or less encapsulated in D&C Licensing, accounted for 93% of the firm's second-quarter gross margin.

That was actually down from a year ago, when the two lines combined for 95% of Microsoft's gross margin.

But another group, Commercial Other, which generates most of its revenue from what Microsoft calls "Commercial Cloud" -- Office 365 for commercial accounts; Azure, the company's cloud business; and Dynamics CRM Online -- more than made up the difference. The service-oriented group booked $2.3 billion in revenue during the June quarter, up 44%, and boosted its gross margin to $691 million, a 106% increase.

Commercial Other's gross margin in percentage format was 30.5%: For every $100 in revenue, Microsoft kept $30.50. That was not only a jump from 21.3% a year before, but the highest since the group's creation on the books.

"Commercial Other margins expanded again in this quarter, benefiting from both improved business scale and datacenter efficiency in our cloud services," said CFO Amy Hood last month.

Although Commercial Other was a creation of Ballmer, who regularly cited its offerings as the prime example of the "services" side of his strategy, the group also fits well with Nadella's updated message of productivity (Office 365) and platforms (Azure, as a cloud-based OS).

Add Commercial Other to the two licensing-centric groups, and the cumulative margin drops to 84.7% -- Microsoft keeps $84.70 of each $100 in revenue -- which, while a smaller number than licensing-only, is still a fantastic margin that demonstrates the financial power of software, whether delivered traditionally or as a service.

Nadella knows that, and has even acknowledged as much, although he uses the word "software" sparingly -- just twice, for instance, in the July 22 earnings call. In a May interview at Re/code's technology conference, Nadella said, "We are a software company at the end of the day."

No kidding.

Which makes the hardware divisions and their very low margins stand out even more.

If the Xbox, Surface and Nokia businesses, along with the rest of the peripheral units bundled with them, were purged from Microsoft's balance sheet last quarter, it would have raised the gross margin ten points, from 69% (with hardware) to 79% (without). In other words, Microsoft would be a smaller company -- just under $20 billion in revenue versus the actual $23.3 billion -- but a more profitable one.

That's not gone unnoticed by Wall Street, which has regularly pressed Microsoft to abandon hardware, sell the units or spin them off into independent companies. Industry analysts have also questioned the devotion to hardware.

"The contrast between hardware and licensing couldn't be more stark: one makes enormous gross margins, and the other barely scrapes a profit," said Jan Dawson, chief analyst at Jackdaw Research, in a July 22 analysis of Microsoft's financials. In a follow-up, he wondered how long Microsoft would put up with the losses of the Surface.

"Continued losses will make it harder and harder for Microsoft to keep the Surface project going, so a good performance in the next quarter or two will be critical to justifying its continued existence," he wrote on July 31.

A few days later, in an interview, Dawson elaborated. "My sense is that Nadella is less willing to accept losses than was [Steve] Ballmer," he said.

With a financial disparity like the one shown in the June quarter, who could blame Nadella if he did?

And he has hinted that pressure would be applied to the low-low-margin hardware divisions. "For those supporting efforts such as MSN, retail stores and hardware, we will also ensure disciplined financial execution," Nadella said on July 22 (emphasis added).

While margins for Microsoft's hardware group -- which sells the Surface and the Xbox -- continued to fall in the June quarter, margins have improved for 'Commercial Other,' the group that handles Office 365 for businesses and the Azure cloud. (Data: Microsoft, SEC filings.)

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