Notes: this is part of a series on major tech companies’ Q4 2014 earnings. All past earnings posts can be seen here, and all earnings posts for Q4 2014 can be seen here. For the sake of easy comparisons and transparency, I always use calendar quarters in my analysis. Hence, Q4 2014 in this and every post on this blog means the quarter ending December 2014, even though some companies (Microsoft included) have fiscal years that end at other times of the year. 

As usual, I’m going to run through a handful of charts and provide some analysis in this post. Subscribers to my quarterly company decks service will have received a slide deck with a much larger set of charts – this subscription is $10 per month for individual subscribers, and corporate subscriptions are also available.

The hardware business – some progress, some slippage

One of the themes last quarter was how the hardware business at Microsoft had progressed, and that’s a theme again this quarter. Surface revenues were the highest they’ve ever been in a quarter, crossing the $1 billion mark for the first time, and in addition the gross margins were not only positive for the second time, but significantly so if my calculations are correct:

I suspect that, on an operating basis, the Surface line still loses money because of all the marketing spend involved, but I would guess it’s not a million miles away from producing a positive contribution margin at this point, which is enormous progress from the early quarters. I suspect, with almost all the revenue this quarter coming from Surface Pro 3 sales, that ASPs were around $1,000, and that this represents around a million unit shipments, with some accessory spending rounding out the rest. Chances are that’s not much higher than previous quarters.

Lumia sales also hit a milestone this quarter, crossing 10 million for the first time:

Microsoft also reports non-Lumia phone sales, which dipped below 40 million for the first time in almost 10 years (including the former Nokia devices business). That business is now dropping fast. It’s hard to tell because Microsoft doesn’t provide ASPs for these two product lines, but based on my calculations, I suspect Lumia ASPs dropped from about $140 to closer to $120, reflecting the company’s focus on the low-end market. I continue to question the rationale for pursuing this end of the market, however. Microsoft’s thinking is that if it can capture these users, it can slowly migrate them up to more expensive devices along with Microsoft services, but I suspect that only a very small proportion of the users it’s capturing here will do so. They’re largely attracted by the low price and are also overwhelmingly in low-income demographics, making future revenue prospects poor.

Insight into Windows Phone financials

The “Windows Phone” reporting line has always been a fascinating one at Microsoft, and one I’ve dug into quite a bit in the past in search of nuggets of data. Two new nuggets came this time around, highlighting a couple of interesting points. Here’s my best estimate of the Windows Phone revenue line for the past two years or so, based on various statements in Microsoft’s SEC filings:

What’s interesting here is the extent to which this revenue dropped when Microsoft folded Nokia’s devices unit into the company. Q4 last year saw over $1 billion in revenue reported in this line, but this quarter it was under $400 million. The vast majority of that drop – around 60% – was said to be related to the Nokia acquisition. That, in turn, suggests that Android licensing revenue was less than half of total revenues in this reporting line, contrary to many people’s belief that Microsoft derived more revenue from Android licensing than Windows Phone licensing.

The other interesting tidbit was that Microsoft reported a fall in cost of revenue for the Devices & Consumer Licensing business related to the Nokia acquisition as follows:

D&C Licensing cost of revenue decreased, mainly due to a $224 million decline in traffic acquisition costs, primarily driven by prior year costs associated with our joint strategic initiatives with Nokia.

The only thing I can think of here is that this relates to some combination of Windows Phone and online advertising, since TAC is a metric usually associated with online advertising businesses, and D&C Licensing houses those Windows Phone revenues we just looked at. It seems as though Microsoft may have paid Nokia a fee for the traffic it sent to Bing and other Microsoft online properties, and this was somehow reported in D&C Licensing as a cost related to the Windows Phone revenues. The scale of that fee is pretty significant – $224 million in a single quarter, or almost $1 billion per year, which should improve the margins for the online advertising business significantly.

Online advertising continues to diverge

Speaking of online advertising, the trends there continue to diverge, as they do at other major online advertising companies, between search and display revenues. I’m presenting below the percentage of online advertising revenues that comes from each of these sources, according to my calculations:

As you can see, search advertising is now well over 75%, while display advertising is rapidly approaching 15%. I’ve talked before about these businesses, and my conviction that at this point Microsoft should simply pull out of the display advertising business, sacrificing a small amount of revenue but in the process bolstering its claim to be more sensitive to users’ data privacy concerns than Google, and this just reinforces the case. Bing is, at any rate, far more strategically important to Microsoft, especially given the integration with Cortana that’s critical to Windows Phone today and Windows 10 going forward.

Office Consumer transition continues

Another data point I’ve picked up on in the past is the performance of Consumer Office, which comes in two parts: the legacy Office model, and Office 365 Home and Personal. The two continue to move in opposite directions, but with the overall impact of falling revenues from this business:

The red line shows total revenues from these two, which continues to fall year on year as Microsoft goes through this transition. As Microsoft gives away more and more of the core functionality of Office for free in the consumer market, however, this trend will accelerate. One bright point in this area, however, was the bump in Office 365 users this past quarter. I’m not yet sure what to attribute that too, but it’s likely that a combination of Office on the iPad and the new, slightly cheaper, Personal option (launched in Q3 but available for the whole of Q4) both had an impact:

As the previous chart shows, the revenue stream associated with these subscribers is still small, but this is the future of Office in the Consumer market, so it’ll be well worth watching what happens to both the subscriber numbers and the revenue associated with them as Microsoft’s changing business model for Office kicks in (especially with the launch of Windows 10 later this year).

Lots more slides in the deck

Again, this is just a sampling of the data I collect and analyze on Microsoft on an ongoing basis. The deck that’s part of the subscription service has the full set, and is available now to subscribers. Sign up here if you’re interested (Paypal and credit card payment options available). A screenshot of the slides in the deck is below:

Note to new readers: I use calendar rather than fiscal quarters for easier comparability between companies’ results. As such, I use Q3 2014 universally to refer to the period ending September 2014, even though some companies (in this case Microsoft) use a different reporting calendar). All the charts and analysis below use calendar rather than Microsoft fiscal quarters. This is part of a series on major tech companies’ Q3 2014 earnings. Prior analysis on Microsoft can be seen here. 

There are four sections in this post – click below to jump to each of them:

• Consumer hardware performing surprisingly well
• Cloud run-rates and actuals
• Office in transition
• Online advertising divergence continues

Consumer hardware performing surprisingly well

One of the most surprising things about today’s earnings was that the consumer hardware businesses, which are important to Microsoft’s strategy but have performed poorly, all got a bit of a boost this quarter. Xbox, Surface and Lumia devices all had strong year on year growth:

All three device categories saw record results, in fact – Lumia sales and Surface revenue were both the highest they’ve ever been, while Xbox unit sales were the highest they’ve ever been outside the seasonally much higher fourth calendar quarter. Now, we have to put all this in context: both Lumia and Surface sales are dwarfed by the respective markets in which they compete. But on a relative basis, the company continues to see growth in both categories, and the Xbox year on year growth was solid too.

Now, much has been made of the fact that Microsoft reported a positive gross margin for the first time for the Surface as well. Long-time readers will now that I have teased estimated gross margin numbers out of Microsoft’s SEC filings for the past few quarters, so I thought I’d provide an update on the same basis. Here’s the chart including this quarter’s numbers:

As you can see, the number does indeed seem to be positive this quarter on the basis of my analysis, at a little under $100 million. That’s a gross margin of around 9%, which is not earth-shattering and in fact about half the gross margin of the phone business at Microsoft. But it’s progress, as with the growth numbers above. There’s a long way to go to get to the kind of gross margins that would lead to true profitability once marketing and other costs are factored in. How many Surface devices did Microsoft sell in the quarter? Well, they won’t say, but given the new version starts at $800, it’s entirely possible that the company sold a million or fewer Surface tablets in total, and likely well under a million Surface Pro 3s in their first full quarter on sale. It sold about ten times as many Lumia devices, and about 40-50 times as many mobile phones, just for comparison’s sake. Continue reading →

Note: this is a follow-up to my first post on Microsoft’s recent quarterly earnings, and is part of a series on major tech companies’ earnings for Q2 2014.

Microsoft filed its 10-K for the year ending June 2014 with the SEC on Thursday, and as usual there are lots of extra little bits of information lurking in the document to be teased apart and analyzed. The 10-Q filings are useful too, but the 10-K gives us a really good picture of where Microsoft’s revenues come from in quite some detail beyond its high-level segments. The first part of the analysis below covers this breakdown of Microsoft’s segments by line of business in additional detail, and below that you’ll find some thoughts on other items illuminated by the 10-K. Throughout the analysis, I’ll refer to Microsoft’s fiscal years 2013 (ending June 2013) and 2014 (ending June 2014) as FY 2013 and FY 2014 respectively.

Where does Microsoft’s revenue come from?

The chart below shows where Microsoft’s revenue comes from. You will notice that the individual percentages don’t necessarily add up due to some rounding. Where I have been able to find or derive exact numbers, I’ve left percentages accurate to one decimal place, but where there are estimates involved I’ve rounded to the nearest half-point to avoid giving a sense of false precision. Note that in much of what follows I’m providing estimates rather than reported figures. I’m very confident that my figures are broadly in line, since they’re all based on percentage growth rates and such found in Microsoft’s various filings. But they may be off by a percentage point or two here or there because they are estimates and not directly reported figures.

The bolded numbers are Microsoft’s reported segments, so those are actual numbers. I’ve left out the Corporate and Other line because it doesn’t relate directly to actual products and services, but it makes up part of the total of 100%. I’ve left out entirely the new Phone Hardware unit (the former Nokia phone business) because Microsoft only reported results for a single partial quarter in its 10-K so there’s no real run rate to go on here. I’ll come back to that later, though. Continue reading →

In contrast to other quarters, in the fourth quarter Microsoft doesn’t release its in-depth SEC filing immediately. Since that’s where many of the juiciest bits of data land, we have limited information to go on so far. But I wanted to do a quick first-take on Microsoft’s earnings based on what we do know. Once the 10-K is out I will likely do a follow-up post on the additional detail. This is part of a series on Q2 2014 earnings – you can see the full set here.

Margins – Microsoft’s past versus its present

I wanted to start out with a quick look at Microsoft’s margins. These days it only gives us gross margins at the detailed segment level, so we’ll have to be satisfied with those. The chart below shows gross margins for the new set of segments, including the former Nokia devices business:

The data point for the former Nokia business is the brown circle hiding behind the last dark gray D&C C&G hardware circle, and it’s fitting in some ways that the margins for the two consumer hardware businesses should be so close to each other, at under 5%. By contrast, the two licensing businesses also have very similar gross margins, at over 90%. In the middle we have the nascent businesses: D&C Other and Commercial Other, which include all manner of products from enterprise cloud services to Bing. The contrast between hardware and licensing couldn’t be more stark: one makes enormous gross margins, and the other barely scrapes a profit. And yet that traditional licensing business is the past for Microsoft, while its other segments represent the future. It’s no wonder Nadella isn’t keen on first-party hardware for its own sake: it barely makes any money. But by the standards of the legacy Windows and Office businesses which make up the bulk of the licensing segments, Microsoft’s fastest-growing businesses are much less profitable too. They are becoming more profitable over time, with the help of scale, but they will never generate the same kind of margins as licensed software, which has almost zero incremental cost. Continue reading →

The next company in my series of “thoughts on earnings” pieces (see Google here, Apple here and Facebook here) is Microsoft. I’ll be doing something on Amazon next, most likely. Microsoft is a complicated business, with many parts to it, so I’ll focus mostly on the things I think most people overlook, because they’re rather buried in the earnings release or even the 10-Q. This involves making some estimates, calculations and assumptions, as well as interpolation, so please understand that many of the numbers are my best guesses rather than those reported by Microsoft (I try to be clear on which is which in each case).

Long story short: for all Microsoft’s talk about Mobile and Cloud, those two categories likely generate under 10% of Microsoft’s revenue today – something I’ll return to in the conclusion at the end of this post.

Windows Phone

First, Windows Phone. I’ve written at length before about the methodology used here, but we got another couple of quarters’ worth of solid data so I’m providing some quick numbers off the back of that.

The key thing to note here is that, other than in the fourth quarter, this number stays a little under $400 million a quarter. And it’s worth reminding everyone that this number is not just Windows Phone licensing itself but also the rest of Microsoft’s mobile licensing activity (think patents licensed to Android OEMs). As such, as Microsoft executes on its new policy of not charging OEMs for Windows for devices under 9 inches, there’s only a very small amount of revenue at risk – likely $100-200 million per quarter. And of course Nokia was paying about 90% of that anyway, so it would have become an internal transfer starting today. Continue reading →