Category Archives: Microsoft

Apple, Microsoft, and the Future of Touch

Note: this blog is published by Jan Dawson, Founder and Chief Analyst at Jackdaw Research. Jackdaw Research provides research, analysis, and consulting on the consumer technology market, and works with some of the largest consumer technology companies in the world. We offer data sets on the US wireless and pay TV markets, analysis of major players in the industry, and custom consulting work ranging from hour-long phone calls to weeks-long projects. For more on Jackdaw Research and its services, please visit our website. If you want to contact me directly, you’ll find various ways to do so here.

This is one of those rare weeks when two of the tech industry’s major players have back to back events and in the process illustrate their different takes on an important product category, in this case the PC. I’ve already written quite a bit about all this this week:

Now that it’s all done, though, I wanted to pull some of these themes and threads together. I attended today’s Apple event in person and so I’ve spent time with the new MacBooks, though not with Microsoft’s new hardware or software.

Differentiation: from hardware advantages to philosophical approaches

The biggest thing to come out of this week, which I previewed in my Techpinions piece on Monday, was a shift from hardware advantages to philosophical differences as the nexus of competition between Microsoft and Apple in PCs. MacBooks once enjoyed significant hardware advantages over all competing laptops in terms of battery life, portability, and features such as trackpads, but in recent years those advantages have all but disappeared. Instead, what we’re left with is increasingly stark philosophical differences in how these companies approach the market, and this week the focus was on touch.

Microsoft’s computing devices all run some flavor of Windows 10 and feature touch. Apple, on the other hand, continues to draw a distinction between two sets of products by both operating system and interactivity. On the one hand, you have iOS devices with touch interfaces, and on the other macOS devices with more indirect forms of interactivity. Today’s event saw Apple introduce an interesting new wrinkle to touch on the MacBook with the Touch Bar, but it’s clearer than ever that Apple refuses to put touch screens on the Mac and that won’t change soon.

Microsoft’s approach makes touch available everywhere, even when in many cases it doesn’t make sense. It’s optional, though, and Microsoft has pulled back from some of the earlier erroneous over-reliance on touch that characterized Windows 8. Apple, on the other hand, wants to largely preserve existing workflows based on mouse and keyboard interactivity while adding subtle new forms of interaction. It keeps all the interaction on the horizontal plane, while Microsoft has users switching back and forth between the tabletop and display planes. There isn’t necessarily a right and wrong here – both approaches are interesting and reflect each company’s different starting points and perspectives. But it’s differences like this that will characterize the next phase of competition between them.

In some ways, this new phase of competition is analogous to the competition between Apple and Google in the smartphone market. In both cases, there are now devices made by companies other than Apple which match Apple’s core hardware performance. That’s not to say that all devices now come up to Apple’s standards – it continues to compete only at the high end, while both Google and Microsoft’s ecosystems serve the full gamut of needs from cheap and cheerful to high-priced premium. But in smartphones as in PCs, the focus of competition at the high end is now moving to different approaches rather than hardware performance. It’s intriguing, then, that it’s during this era that both Google and Microsoft are finally getting serious about making their own hardware.


The Touch Bar itself is very clever. Apple made the decision to spend a lot of time in today’s event on demos, and I think that was a good use of the time (especially in an event with less ground to cover than most). The demos really showed the utility that the Touch Bar can provide in a variety of Apple and third party apps. What Apple has done here is in essence to take a slice of the screen and put it down within reach to allow you to interact with it. There will definitely be a learning curve involved here – I can see users forgetting that it’s there unless they make an effort to use it, but I can also see it prompting users to try to touch the screen (this happened to me in the demo area). “Touch here but not there” will be an interesting mental model to adapt to, but once users get the hang of it (and developers support it in their apps) I believe it will add real value.

Apple’s price coverage

Of course, MacBooks aren’t the only portable computers Apple makes, and it’s been increasingly making the case that the iPad Pro lineup should be considered computers too. These are Apple’s touch-screen computers, but in most consumers minds they don’t yet belong in the same category as Windows laptops. However, when you put the new MacBooks, older MacBooks, and iPad Pros together, you get an interesting picture in terms of price and performance coverage. The chart below shows base pricing for each of these products:

Apple Computer Portfolio

As you can see, there’s pretty good coverage from $599 all the way through $2399 with just the base prices. If you were to add storage and spec options (and Smart Keyboards in the case of the iPad Pros) the in between price points would be covered pretty well too. But Apple now offers a portable computer at almost any price point in this range, and that’s interesting. The newest MacBooks alone do a nice job of covering the spread from $1199 to $2399 with increasing power and capability, while the older MacBooks fill in some gaps. There’s no denying that these products are premium, but they extend down into price points that many people will be able to reach, while providing really top notch products for those that can afford or justify them. If you focus on those newer devices, I think this is the most coherent and logical MacBook portfolio Apple has had for years.

The next big question is what happens with desktops, because those are now from one to three years old, with no sign of an update. The one that’s had the most focus from Apple in recent years is the iMac, which is both the most mass market and the flashiest – it’s the only one that is highly visible, while both the Mac Pro and Mini could feasibly sit hidden under a desk. I don’t think Apple’s going to discontinue these anytime soon, but the timing of its lack of focus on these devices is providing an interesting window for Microsoft.

A few words on creativity

I won’t repeat everything I said in my earlier stuff on Microsoft’s event here, but suffice it to say that this creativity push is certainly interesting given that timing I just mentioned. However, it’s totally overblown to be talking about Microsoft somehow stealing away Apple’s creative customer base, for several reasons:

  • First, Apple has long since expanded beyond that base, especially if you look at the full set of devices including iPhones. Apple clearly isn’t selling hundreds of millions of iPhones solely to people that use Photoshop for a living. Even if you look at Mac buyers, they’re much broader than the cliche of ad agency creatives and video editors.
  • Secondly, all Microsoft has done so far is put a stake in the ground. The Surface Studio is a beautiful device and a well thought out machine for a subset of creative professionals. But workflows don’t change overnight just because a new computer comes along, especially if there’s an existing commitment to another ecosystem. The role of this device is to signal to creatives that Microsoft is serious about serving them, which is notable in its own right, but won’t sell millions of devices by itself.
  • Thirdly, Microsoft’s bigger creativity push is around software, with 400m plus Windows 10 users getting a bunch of new creativity software in the Creators Update in the spring. This will be much more meaningful in terms of spreading that creativity message far and wide than the new hardware.
  • Lastly, even with all this, Microsoft’s efforts to associate its brand with creativity and not just productivity will take years to take hold. Perceptions don’t change overnight either.

Apple’s event today was a nice reminder that it still takes these creative professionals very seriously – both the Adobe and DJ Pro demos were creativity-centric, and these new machines are clearly intended for creative professionals among others (the RAID arrays would be an obvious fit for people editing high-bandwidth video, for example). Apple isn’t going to cede this ground easily, but it will be very interesting to watch over the next few years how this aspect of the competition plays out.


Microsoft’s Evolving Hardware Business

Note: this blog is published by Jan Dawson, Founder and Chief Analyst at Jackdaw Research. Jackdaw Research provides research, analysis, and consulting on the consumer technology market, and works with some of the largest consumer technology companies in the world. We offer data sets on the US wireless and pay TV markets, analysis of major players in the industry, and custom consulting work ranging from hour-long phone calls to weeks-long projects. For more on Jackdaw Research and its services, please visit our website.

Microsoft reported earnings yesterday, and the highlights were all about the cloud business (Alex Wilhelm has a good summary of some of the key numbers there in this post on Mattermark).  Given that I cover the consumer business, however, I’m more focused on the parts of Microsoft that target end users, which are mostly found in its More Personal Computing segment (the one exception is Office Consumer, which sits in the Productivity & Business Processes segment).

The More Personal Computing segment is made up of:

  • Windows – licensing of all versions of Windows other than Windows server
  • Devices – including Surface, phones, and accessories
  • Gaming – including Xbox hardware, Xbox Live services, and game revenue
  • Search advertising – essentially Bing.

Microsoft doesn’t report revenues for these various components explicitly, but often provides enough data points in its various SEC filings to be able to draw reasonably good conclusions about the makeup of the business. As a starting point, Microsoft does report revenue from external customers by major product line as part of its annual 10-K filing – revenue from the major product lines in the More Personal Computing Group are shown below:

External revenue for MPC group

Windows declining for two reasons

It’s worth noting that it appears Windows revenue has fallen off a cliff during this period. However, a big chunk of the apparent decline is due to the deferral of Windows 10 revenue, which has to be recognized over a longer period of time than revenue from earlier versions of Windows, which carried less expectation of free future updates. At the same time, the fact that Windows 10 was a free upgrade for the first year also depressed revenues. As I’ve been saying for some time now, going forward it’s going to be much tougher for Microsoft to drive meaningful revenue from Windows in the consumer market in particular, in a world where every other vendor gives their OS away for free. That means Microsoft has to find new sources of revenue in consumer: enter hardware.

Phones – dwindling to nothing

First up, phones, which appear to be rapidly dwindling to nothing. It’s become harder to find Lumia smartphone sales in Microsoft’s reporting recently, and this quarter (as far as I can tell) the company finally stopped reporting phone sales entirely. That makes sense, given that Lumia sales were likely under a million in the quarter and Microsoft is about to offload the feature phone business. The chart below shows Lumia sales up to the previous quarter, and my estimate for phone revenues for the past two years, which hit around $300 million this quarter:

Phone business metrics

Surface grows year on year but heading for a dip

Surface has been one of the bright spots of Microsoft’s hardware business over the last two years. Indeed – this home-grown hardware line has compared very favorably to that acquired phones business we were just discussing:

Surface and Phone revenue

As you can see, Surface has now outsold phones for four straight quarters, and that’s not going to change any time soon. Overall, Surface revenues are growing year on year, which is easier to see if you annualize them:

Trailing 4-quarter Surface revenue

However, what you can also see from that first Surface chart is that revenues for this product line are starting to settle into a pattern: big Q4 sales, followed by a steady decline through the next three quarters. That’s fine as long as there is new hardware each year to restart the cycle, but from all the reporting I’ve seen it seems the Surface Pro and Surface Book will get only spec bumps and very minor cosmetic changes, which leaves open the possibility of a year on year decline. Indeed, this is exactly what Microsoft’s guidance says will happen:

We expect surface revenue to decline as we anniversary the product launch from a year ago.

I suspect the minor refresh on the existing hardware combined with the push into a new, somewhat marginal, product category (all-in-ones) won’t be enough to drive growth. The question is whether the revenue line recovers in the New Year or whether we’ll see a whole year of declines here – that, in turn, would depress overall hardware sales already shrinking from the phone collapse.

It’s also interesting to put Surface revenues in context – they’ve grown very strongly and are now a useful contributor to Microsoft’s overall business, but they pale in comparison to both iPad and Mac sales, neither of which have been growing much recently:

Surface vs iPad vs Mac

Ahead of next week’s Microsoft and Apple events, that context is worth remembering – for all the fanfare around Surface, Microsoft’s computing hardware business is still a fraction of the size of Apple’s.

Gaming – an oldie but kind of a goodie

Gaming, of course, is the oldest of Microsoft’s consumer hardware businesses, but its gaming revenue is actually about more than just selling consoles – it also includes Xbox Live service revenues and revenues from selling its own games (now including Minecraft) and royalties from third party games. However, it’s likely that console sales still dominate this segment. Below is my estimate for Gaming revenue:

Gaming revenue

In fact, Microsoft actually began reporting this revenue line this quarter, though unaccountably only for this quarter, and not for past quarters. Still, it’s obvious from my estimates that this, too, is an enormously cyclical business, with a big spike in Q4 driven by console sales and to a lesser extent game purchases, followed by a much smaller revenue number in Q1 and a steady build through Q3 before repeating. Microsoft no longer reports console sales either, sadly, likely because it was coming second to Sony much of the time before it stopped reporting. Still, gaming makes up almost a third of MPC segment revenues in Q4, and anything from 8-20% of the total in other quarters. In total, hardware likely now accounts for 30-50% of total revenue from the segment quarterly.

Search advertising – Microsoft’s quiet success story

With all the attention on cloud, and the hardware and Windows businesses going through a bit of a tough patch, it’d be easy to assume there were no other bright spots. And yet search advertising continues to be the undersold success story at Microsoft over the last couple of years. I’ve previously pointed out the very different trajectories of the display and search ad businesses at Microsoft, which ultimately resulted in the separation of the display business, but the upward trajectory of search advertising has accelerated since that decision was made.

Again, Microsoft doesn’t report this revenue line directly, but we can do a decent job of estimating it, as shown in the chart below:

Search advertising revenue

There are actually two different revenue lines associated with search advertising – what I’ve shown here is total actual revenue including traffic acquisition costs, but Microsoft tends to focus at least some of its commentary on earnings calls on a different number – search revenue ex-TAC. As you can see, the total number has plateaued over the last three quarters according to my estimates, though the year on year growth numbers are still strong. However, the ex-TAC number is growing more slowly. In other words, this growth is coming at the expense of higher traffic acquisition costs, which seems to be the result of the deal Microsoft signed with Yahoo a few quarters ago and an associated change in revenue recognition. Still, it’s a useful business now in its own right, with advertising generating 7% of Microsoft’s revenues in the most recent fiscal year.

Operating system user bases

Related: two previous posts on the patterns in Android adoption rates (December 2013, March 2014), a post contrasting iOS and Android adoption patterns, and a post from last month on iOS 9 adoption.

Both Apple and Google have just updated their mobile OS user stats, while Microsoft shared a new number for Windows 10 adoption at its event this week, giving us a rare opportunity to make some comparisons between these major operating systems at a single point in time. We now have the following stats straight from the sources:

  • The stats provided by both Apple and Google on their developer sites with regard to the user distribution across their mobile operating systems (Android and iOS)
  • The 110 million Windows 10 number provided by Microsoft this week
  • The 1.4 billion total active Android user base number provided by Google at its event last week
  • Total Windows users of around 1.5 billion, as reported by Microsoft several times at recent events.

In addition, there are various third party sources for additional data, including NetMarketShare and its estimate of the usage of other versions of Windows. Lastly, I have estimated that there are roughly 500 million iPhones in use now, and around 775 million iOS devices in use in total (including iPads and iPod Touches).

If we take all these data sets together, it’s possible to arrive at a reasonably good estimate for the actual global user bases of major operating system versions at the present time. The chart below shows the result of this analysis:User bases all iOSThere are several things worth noting here:

  • Each company has one entry in the top three, with Microsoft first, Google second, and Apple third.
  • However, only one of these entrants is the latest version of that company’s operating system (iOS 9), while the other two are the third most recent versions (Windows 7 and Android KitKat).
  • Google has three of the top six operating systems, none of which is its latest operating system (Marshmallow, released this past week). Even its second most recent version (Lollipop), now available for a year, is only the third most adopted version after KitKat and Jelly Bean.
  • Both iOS 9 and iOS 8 and the three most used versions of Android beat out every version of Windows but Windows 7.
  • The most recent versions of the three companies’ major operating systems are used by a little over 400 million (iOS 9), 110 million (Windows 10), and a negligible number (Android Marshmallow) respectively.
  • The second most recent versions are used by around 330 million (Android Lollipop), around 250 million (iOS 8), and around 200 million (Windows 8) respectively.

There are lots more data points to tease out here, but to my mind it’s a striking illustration of the differences in the size and adoption rates of these three major operating systems.

Two additional thoughts

Just for interest, I’m including a couple of additional thoughts below.

First off, here’s the same chart, but with iOS reduced to just the iPhone base. The order changes a fair amount, but iOS 8 and iOS 9 still make a good showing:

User bases based on iPhone onlyLastly, I wanted to revisit my post from a couple of weeks ago about the initial adoption of iOS 9, especially as it relates to Mixpanel’s data. In that post, I showed how Mixpanel’s iOS adoption data tends to be pretty close to Apple’s own data except for the month or so after a new version of iOS ships, when it tends to skew way lower than Apple’s own data. Now that we’re a few weeks on from the initial launch, and Apple has released the second set of iOS adoption data since the launch, I wanted to revisit that pattern. Interestingly, the very same pattern is playing out again – despite the initial significant discrepancy, Mixpanel’s data is now once again very close to Apple’s own:Mixpanel iOS data October 2015

Every device is a compromise, part 2

In May last year, when Microsoft unveiled the Surface Pro 3, I wrote a piece about the new device but also about the way it was unveiled, titled, “Surface Pro 3, like every other device, is a compromise.” In that piece, I wrote about Microsoft’s insistence that the Surface Pro 3 was a no-compromise device, when in fact all devices represent compromises of one sort or another. I went on to say:

The biggest change in Microsoft’s Surface strategy over the last several years has been the locus of the compromise it’s still inevitably making. The first Surfaces were intended to be good tablets first and good laptops second (and ended up being neither). But with the Surface Pro 3, Microsoft has created a competitive laptop first, and a compromised tablet second. But it’s still pretending that there’s no compromise, and that is why the Surface line will continue to perform poorly. At some point, Microsoft has to stop pretending that a single device can meet all needs and start optimizing for different use cases with different devices, just like every other manufacturer.

Fast-forward to today, and we got the next version of the Surface Pro, the Surface Pro 4. And we saw two of the same phrases from that first event repeated: “no compromise” and “the tablet that can replace your laptop. So far, so predictable.

But then, immediately after the SP4 was introduced, we were shown the Surface Book. Which is a laptop. And Panos Panay, the presenter, started out by talking about all the things a laptop does that the Surface Pro does poorly – a better typing experience, a bigger screen, and so on. This was one of the most bizarre juxtapositions I’ve ever seen at a tech event. After 30 minutes of talking about how the Surface Pro 4 could replace your laptop with no compromises, the very same presenter offered up a laptop which was clearly better, because it didn’t make certain of those compromises.

Taking a step back for a minute, both products look really promising. I’ll withhold final judgment until I get to use these devices (or at least until others I trust have done so and shared their opinions). But this “no compromise” nonsense continues to do a massive disservice to Microsoft and to its customers. As I said in that earlier piece, every device involves a compromise. That compromise might involve features, functionality, look and feel, size, weight, price, or any number of other elements. But every device does involve compromises. And instead of pretending that it doesn’t, Microsoft needs to embrace what’s distinctive and best about each of the devices it offers. However, when you look at the Surface Pro 4 and Surface Book side by side, you start to realize that the Surface Book is really just the concept of the Surface Pro taken to its logical conclusion – thin, light, with a detachable keyboard and pen.

Is there anything that the SP4 does better than the Surface Book? Yes, it’s slightly smaller, and quite a bit lighter than the Surface Book if the keyboard is attached. To my mind, the only benefit to the SP4 is that it’s cheaper – in other words, it’s an inferior but more affordable version of the Surface Book. By the end of the Surface Book demos, I saw people asking on Twitter, “why does Microsoft even need the Surface Pro 4?” and as far as I can tell, the answer is “because the Surface Book starts at $1499”.

One quick comment on OEMs. Unlike the Surface, with which Microsoft said it was creating a new category, and therefore has somewhat been able to skirt around the fact that Microsoft is now competing with its partners, the Surface Book was not burdened with any qualifiers. It was simply positioned as the best, the thinnest, the most powerful Windows 10 laptop. Period. If I’m one of Microsoft’s OEM partners, I’m betting I’m not very happy about that at all. However, those OEMs have only themselves to blame if Microsoft, which has zero experience in making laptops, is able to produce a more compelling computer than the OEMs that have had decades of experience. What does it say about Microsoft’s OEM partners that Microsoft has been able to do this to them, and that it’s willing to do so? The one saving grace is that the vast majority of Windows PCs are sold at well under $1500, and so this really isn’t targeted at the core of the Windows PC market. But it’s still a finger in the eye of the Windows OEMs.

Lastly, this parting thought. Satya Nadella took the stage at the end of the event and gave the kind of speech he’s given at almost every event Microsoft has had since he took over as CEO – big picture themes, Microsoft’s mission statement, and so on. I’m a fan of Nadella, but this speech felt like so much waffle after what was a really compelling set of device introductions. All the energy seemed to go out of the event when he took the stage. The other thing that happened was that, as he mentioned them, I suddenly remembered that Microsoft had introduced a new Band and the Lumia 950 devices earlier in the event. I had almost completely forgotten those by the time the Surface stuff was over with. They were so completely overshadowed by what came after, and for all Panos Panay’s attempts at enthusiasm about the Lumias, it was very clear that he had inherited those products and his true loves were the Surface products. I might still write about the Lumias separately at some point, but for now I see little in them that’s going to transform the fortunes of Windows Phone or Microsoft’s phone hardware business.

A deep dive on Microsoft’s Q2 2015 numbers

Following Microsoft’s earnings is always interesting, because like any other company it releases many of the key data points in its press release, but to a greater extent than others it releases lots more little details in its regular quarterly SEC filings. And once a year, the 10-K provides an additional set of very interesting data. As such, I often hold off on writing analysis of Microsoft’s earnings until all these details are out. This piece builds on past pieces on Microsoft’s earnings, in some of which I’ve laid out the methodology I use for calculating some of the revenue numbers for individual businesses. Last year’s deep dive following the release of the 10-K is here.

Note: here as elsewhere on this blog, I use calendar quarters rather than companies’ fiscal quarters in my commentary and in charts. The only exceptions in this piece are specific references to Microsoft’s fiscal years (denoted as FY 2015 etc.)

Because this is a longer post, I’ve provided some links to specific sections below:

Employee numbers paint a stark picture of the Nokia acquisition

I’ll start with some of the stuff that Microsoft only reveals once a year in the 10-K, and that’s employee numbers and a product-level breakdown of external revenues.

From an employee perspective, the overall number is always interesting by itself, but this time around I found the categorization of the workforce particularly interesting. The three charts below show this split both by job function and by geography.

This first chart gives you some sense of the overall numbers as well as how they break down. As you can see, the workforce two years ago was just under 100k, but a year later it was almost 130k. What happened? The acquisition of Nokia’s devices business (NDS) is the main answer. But of course, since the acquisition Microsoft has pared back that workforce quite a bit. As I wrote in my piece on the Nokia impairment a few weeks ago:

By the time it’s done with the layoffs announced today, Microsoft will also have jettisoned around 80% of the employees associated with the Nokia acquisition. It took on around 25,000 (down from the 32,000 originally anticipated) when the acquisition closed, but laid of around half three months later, in July last year. Now, a year later, it’s losing another 7-8,000, taking the remainder down to just 5,000, or 20% of those originally brought on board.

Some 25,000 of that 29,000 bump from June 2013 to June 2014 was Nokia-related, but by June 2015 the number was back down to 118,000, or 10k lower, but that’s the net impact after hiring in other areas. The most dramatic impact from a job function perspective was manufacturing and distribution, which is shown in light blue at the top of the columns below, and is broken out separately in the second chart below. It’s also worth noting the strong growth in the Product Support and Consulting category during the last two years – this is organic hiring to support some of Microsoft’s newer businesses, and it’s accelerating rapidly. The third chart shows a geographic breakdown, and there too you can see the dramatic impact of the Nokia acquisition on overseas employees (up 25,000 exactly from 2013 to 2014) and subsequent loss of 8,000 of those employees a year later.

Stacked employees by functionEmployees by function Employees by geographyProduct revenue breakdowns

I always do quite a bit of reading between the lines every quarter to establish estimated figures for various product lines, but once a year Microsoft gives us a breakdown of “external revenues” from major product lines. This is about the only way to build a complete picture of products like Windows and Office, which are otherwise spread through Microsoft’s various reported segments. The chart below shows this breakdown on a stacked basis:External revs by productAs you can see, reported revenues have grown strongly for each of the last few years. However, these aren’t pro forma figures: the acquisition of NDS isn’t factored into past years’ revenues, so both in FY 2014 and in FY 2015 Microsoft got an artificial bump from NDS (in 2014 only for a very short period since the acquisition closed late in the year, and in 2015 for a full year’s worth of revenues). If you compare 2015 to 2014, you can see that Surface and Phone by themselves accounted for essentially all the growth in that period. Strip out the Phone business alone and revenue would have been roughly flat. But underneath that, there’s actually a lot going on too, as the year on year growth rates below show:
Year on year growth
Xbox is easily the spikiest of these revenue sources, rising and falling with new product releases as you can see in 2011 and 2014. Windows has seen the most dramatic fall, from strong growth in 2010 to flat growth the next few years and now negative growth (in part, but not entirely, due to currency effects). Office, too, has seen a steady decline and shrank this past year. Server Tools and Products and Consulting and Support services are the most consistent growth drivers for Microsoft at this point, while Advertising has also contributed strong growth most quarters (and the rate of growth will increase with the disposition of the display advertising business). What’s interesting to me, though, is the paucity of information about the sale of the display ad business to AOL – the only references to it label it as outsourcing of the business to AOL and AppNexus, but there’s no discussion of the impact on revenues going forward or anything else. My past calculations – shared in that earlier post linked to above – suggest that this business was worth just under a billion dollars a year, so it’s not nothing. The omission of any discussion of this impact in the 10-K feels odd.

As a result of all this, the two historical mainstays of Microsoft’s business – Office and Windows – make up an ever smaller proportion of the company’s revenues. If you take the PC version of Windows alone, that and Office now account for just 41% of Microsoft’s revenues, while adding in Server Products and Tools brings the total up to 61%. Obviously, the addition of NDS is a big reason for the drop off the last two quarters, but as we saw above Windows and Office are also shrinking in their own right.

Windows and OfficeLastly, it’s interesting to note that Microsoft did indeed hit a milestone I had predicted they would this time last year: international revenues have now eclipsed domestic revenues for the first time in Microsoft’s history, at least on an annual basis, though the transition probably happened sometime in the second half of FY 2014.
US vs international rev

Cloud revenue, AWS, and growing margins

Last quarter, when Amazon first broke out AWS revenue separately, I wrote a piece comparing Microsoft and Amazon’s respective cloud revenue buckets, and provided all kinds of caveats about the limits to the comparability of these two businesses. Here, then, is an update based on information in the 10-K:MS cloud and AWSEssentially, the pattern from last quarter continued – AWS remained just a little ahead of Microsoft’s “Cloud Services” reporting line this quarter, and for the last four quarters was just ahead at a hair under $6 billion, compared to just under $5.8 billion for Microsoft. Interestingly, though cloud services are not one of the product lines Microsoft breaks out in the numbers I analyzed above, they are broken out just below that, rounded to $5.8 billion, and Microsoft says they’re reported in several of those segments that are reported.

Unfortunately, unlike Amazon, Microsoft provides no good sense of how profitable this business is. The only small hints are references to data center spending sprinkled throughout the 10-K. They include this interesting snippet in a description of Microsoft’s main drivers of expenses:

Our most significant expenses are related to compensating employees, designing, manufacturing, marketing, and selling our products and services, datacenter costs in support of our cloud-based services, and income taxes. (emphasis added)

Further along in the 10-K, we get another mention of data center costs, which apparently rose by $396 million in FY 2015. Given that cloud services revenues rose by $3 billion in the same period, that’s almost nothing. Obviously, data center costs aren’t the only expenses associated with cloud revenue, but they have to be one of the largest. In FY 2014, by contrast, data center costs rose by $575 million, while revenue rose by $1.5 billion, so the return on that investment is increasing significantly. Gross margin in the bigger segment that commercial cloud services are part of (Commercial Other) rose significantly – by $2.3 billion or 126% – in FY 2015, much of which was due to Office 365 growth at enterprises, as well as growth in Azure. Total cost of revenue in this same broader segment only grew $946 million, or 17%, so it’s clear that Microsoft is hitting its stride in terms of achieving economies of scale and higher margins, though it’s still elusive exactly what level those margins have now reached.

A broader look at margins

If we take a step back and look at that larger segment, Commercial Other, we can see that gross margins are rising steadily, and are now above all the other non-software categories at this point:

MS gross margins by segmentLicensing continues to have the highest gross margin – cost of sales are tiny compared to revenues in that business since the incremental cost of an additional sale is close to zero. But Commercial Other, composed primarily of cloud services and enterprise services, is becoming increasingly profitable, and with its growth is also becoming an increasingly important contributor to overall margins. It’s at around 9% of gross margins now, up from under 2% at the beginning of 2013, and growing fast. Commercial licensing continues to account for the lion’s share of gross margins, at 64.5%, while consumer licensing accounts for 20% or so. Note, however, the margins in the phone hardware business, which were never great to begin with, but have fallen steeply the last two quarters and are now negative. Remember, too, that these are gross margins, so operating margins in this business are likely substantially lower still. Computer and gaming hardware (Xbox, Surface, and a few other things) is becoming increasingly profitable at a gross margin level, however, helping to justify the continued investment in two products many people consider non-core to Microsoft’s business.

Consumer Office 365 revenue growth is slowing

For the last several quarters, Microsoft’s additions of consumer Office 365 subscribers have been pretty strong:Consumer Office 365 subsHowever, the worrying thing is that the revenue from these subscribers seems to be stagnating. This isn’t a number Microsoft reports directly, but it does provide enough data points to allow us to estimate it with reasonable accuracy, and the trend isn’t good:Consumer Office 365 revenuesWhat’s interesting is that the lines in these two charts track quite closely in their shape for the fist five or six quarters, but they then begin to diverge. So what changed? Well, two main things, I think: Microsoft introduced the Personal (single user) version of Office 365, at $70 versus $100 per year for the multi-device standard version; and secondly, Microsoft has been doing lots of free trials and other deals which either heavily discount or entirely remove the fees for some subscribers for a certain period (often as much as a year). I suspect that both have had an impact, but the rate at which growth has dropped off suggests that the free trials in particular are eating into growth substantially. What I’d really like to see from Microsoft is a paid subscriber number (much as Netflix reports in its financials), which would give a much truer picture of both real subscribers and revenue per paid subscriber. The big problem here, of course, is that Office 365 consumer revenues need to grow to offset the rapid decline in legacy Office sales to consumers, but with no growth, the overall consumer Office revenue line is now declining rapidly too – it dropped 17% in FY 2015. Some of this is because of the way revenue is recognized on Office 365, but that’s certainly not the entire impact, as revenue per subscriber appears to have dropped from around $100 per year to closer to $50 over the past year or so.

Surface, Lumia and other phone sales

Lastly, I just wanted to cover quickly sales of Microsoft’s three main first-party hardware categories – Surface, Lumia phones, and non-Lumia phones. The first two are actually going fairly well, posting year on year increases in sales several quarters running:Surface revenuesLumia unit salesHowever, non-Lumia phone sales (feature phones) have fallen off a cliff these last few quarters, and as I wrote previously, I suspect the impairment and restructuring of the phone business was at least as much about this business as the smartphone side:Non-Lumia phonesI continue to believe that the launch of Windows 10 on phones, and the flagship(s) Microsoft will launch later this year, will be the last big test for Windows on phones, and whether Microsoft can indeed make a go of this business.

Microsoft’s devices restructuring

Microsoft today announced a restructuring of its devices business which I think most of us have been expecting to land any day since CEO Satya Nadella’s memo to employees a couple of weeks ago indicating tough choices were ahead (and indeed, which the company strongly hinted might be coming back in April). However, even though this was widely anticipated, the exact meaning of it is less obvious. I see many taking it as a capitulation, but Microsoft clearly isn’t getting out of the phone business at this point. Below are my thoughts on what this move means, and what might still come later.

Not a concession of defeat – yet

Though clearly a concession that things haven’t been going well for its devices business, this isn’t a concession of total defeat just yet, and there are two reasons why I say that:

  • Microsoft accounts for almost all Windows Phone device sales itself, with over 95% of the market according to AdDuplex. As such, killing its own devices business would simultaneously kill Windows Phone as a platform
  • Microsoft’s positioning around Windows 10 has had a heavy mobile component, with universal apps and various tools for porting apps from other mobile platforms major focus areas in the announcements over the last several months.  As such, it seems extremely unlikely that Microsoft would be ready to kill off Windows Phone.

In short, the timing just doesn’t seem right for abandoning either Microsoft’s first party phone business or Windows Phone as a whole. That’s not what’s happening today, though that doesn’t mean it’s not coming somewhere down the line, as I discuss below.

Windows 10 and focus

It’s clear that at least some within the business believe that Windows 10 and some of the related efforts targeted at developers will help to turn the fortunes of Windows Phone around. I’ve shared my skepticism about that hope in several pieces here over the last few months (including the two linked to in that second bullet above), and wrote an in-depth report about Windows Phone and its prospects too (available here). I continue to believe that Windows Phone suffers from several more or less insurmountable challenges, and don’t see any clear way out of this situation even with Windows 10.

At least part of the problem with Windows Phone has been that it was losing money at its current scale and that scale wasn’t growing rapidly enough to make a difference. By scaling down the business still further, Microsoft likely shifts the equation slightly in favor of profitability, though at the rate the feature phone business has been declining, that may not be enough. But the focus Microsoft is planning to bring to its portfolio is a good thing – for such a small devices business, Microsoft (and Nokia before it) has had a bewildering array of devices on sale, and could likely get by with a much smaller number, say one or two in each of its series (500, 600, 700 etc). But amid this “focus” comes this statement reported by Mary-Jo Foley at ZDNet:

Microsoft will focus its phone efforts on three segments: Businesses, value-phone buyers and flagship phone customers, moving forward.

This is a funny kind of focus! As far as the smartphone market is concerned, flagship and value phones are basically all there is at this point in many markets, so that’s no focus at all. And the mention of business users reflects a basic misunderstanding of the phone market which Nokia seemed to have overcome way back, when it abandoned its E-Series devices. The fact is that business users are just the same as anyone else – they want phones they like to use, that allow them to do not just work but personal stuff too. I’m also curious what this all means about the feature phone business and whether Microsoft will now abandon that entirely. There was a theory that being in feature phones would allow Microsoft to provide a migration path to smartphones over time, but I’ve always been skeptical about that, and at the rate of decline this business is seeing, it’s more of a liability than an asset at this point.

Microsoft shrugged

Meanwhile, the impairment charge is so large that it’s hard to imagine that it’s for anything other than the whole value of the business acquired from Nokia. Remember that though the total price paid to Nokia was 5.44 billion euros (reported as $7.2 billion at the time it was announced), only 3.79 billion (or $5 billion) was for the devices business, while the other $2 billion or so was for patents. The $7.6 billion impairment charge is therefore not just more than the original purchase price, but significantly more than the price paid for the devices business specifically. That either means that Microsoft is also writing down some of the value of the patents or accounting for a significant additional investment in the business since the acquisition (or both). However, at the end of the day, the key point is that Microsoft has at this point basically unburdened itself of the value of the acquisition, such that if it does have to wind the business down it likely won’t have to take another significant impairment charge.

By the time it’s done with the layoffs announced today, Microsoft will also have jettisoned around 80% of the employees associated with the Nokia acquisition. It took on around 25,000 (down from the 32,000 originally anticipated) when the acquisition closed, but laid of around half three months later, in July last year. Now, a year later, it’s losing another 7-8,000, taking the remainder down to just 5,000, or 20% of those originally brought on board.

As such, if Microsoft does have to abandon Windows Phone and its own devices business (I simply don’t see how it’s going to get more OEMs on board for Windows Phone, so the two are inextricably linked), at least it’s now written down much of the value of the acquisition, and will have eliminated most of the employees by the end of this year. That will make it much easier financially and operationally (if not emotionally) to pull the plug when the time comes. But it will be a huge sea change for Microsoft to concede defeat in operating systems for mobile devices after 15 years of trying.

Postponing the inevitable

I suspect today’s move is just another step along the road that eventually leads to an abandonment of this business, even if Microsoft isn’t ready to concede defeat today. The good news is that Microsoft has a strong alternative strategy in place with its third party mobile apps business, which has produced some good results recently, so that it’s not putting all its mobile eggs in the Windows Phone basket as in the past. I continue to worry that a third-party apps business may struggle as both Apple and Google increasingly tie their first party services tightly into their operating systems and virtual assistants, but it certainly seems to have a better shot at gaining users than Windows Phone for now.

However, the other big challenge is monetizing that usage, which continues to be my biggest concern for Microsoft. Its traditional software licensing model simply isn’t going to cut it in consumer markets, and I suspect the SaaS model will be equally challenging. As such, as I outlined in my “Thesis on Microsoft” piece a while back, Microsoft is going to have to make its money more or less exclusively through enterprise cloud services while using the consumer market to drive continued scale.

Quick thoughts: Microsoft’s ad business

Given today’s news about Microsoft selling its display ad business to AOL and in turn replacing Google as the search advertising provider for AOL, I thought I’d quickly revisit some of my earlier analysis on Microsoft’s ad business.

By way of background, Microsoft has never directly reported the financials for its advertising business, but it has provided enough detail in its past financial reporting that I’ve been able to build a pretty good picture of this business over time. This past quarter, perhaps as a precursor to today’s announcement, Microsoft stopped providing any sort of information about its display ad business, but here’s a quick view of my estimates of Microsoft’s two major ad revenue streams over the past couple of years:

Screenshot 2015-06-29 16.02.44As you can see, Search advertising has been growing very well indeed, almost reaching the $1 billion per quarter mark last quarter, and likely to hit it very shortly, especially with the help of the AOL deal. By contrast, though, Display advertising has been heading south for some time now, and was under a quarter of a billion in revenue for each of the last two quarters of 2014. The split between the two, then, is roughly as shown in the chart below:Screenshot 2015-06-29 16.04.58In other words, search advertising was not only vastly outperforming display advertising in growth terms, but as a percentage of Microsoft’s overall online advertising business. As such, it’s made sense for some time for Microsoft to jettison this part of the business in favor of focusing on the part that’s working: search advertising. Part of the reason for the disparity between the two is general industry dynamics – display has been struggling for other companies too, while search continues to be one of the most effective forms of advertising and to command commensurate rates.  Microsoft’s display ad business, though, was also sub-scale, and hadn’t made the transition to mobile devices and native advertising effectively. Search, meanwhile, has benefited both from positive industry trends and the growth of Bing and Yahoo’s growth in search market share in the last couple of years.

The impact on Google

AOL’s decision to switch from Google to Microsoft is not enormously impactful on Google by itself, but in the context of Firefox’s earlier switch to Yahoo as its default search engine in the US, and the potential for a much more significant switch away from Google by Apple sometime this year, it’s part of a drumbeat of bad news for Google. One of Google’s challenges at this point is that it’s come to compete with many of its erstwhile partners, with Apple as perhaps the most striking example, and it’s arguably starting to pay the price for that strategy.

Ten quick thoughts on WWDC

Yesterday was a busy day, as these keynote days always are – several hours of waiting around with very little to do, followed by several hours of frenetic activity both during and immediately after the keynote, as I prepare a quick comment for reporters, talk to some reporters, and do quick write-ups for clients. I feel like my head is still spinning, and although I have a variety of things I want to write about, I don’t feel quite ready to do a deep dive on any of them yet. As such, I’m going to do something a bit different – post several short thoughts here, some of which I may expand on with proper blog posts later, and some of which we may talk about on the Beyond Devices Podcast later this week (we’ll be recording Wednesday and the podcast will hopefully go up Thursday).

Music majors on what I said it should

Apple Music majors in part on what I said it should in this piece I wrote back in April – that is, it differentiates partly on the basis that it gives you a single home for your existing collection of music and the new stuff you access through the service, with the ability to easily add new material to your library. I also said in that piece that I thought Apple Music might be most relevant to older folks with more money than free time, and that still feels right.

Beats 1 is a weird hybrid

Beats 1 is a funny mix – neither algorithmic curation nor human, personalized curation, but generic human curation, just like traditional radio. To my mind, Beats 1 is the strangest part of the Music launch – the piece that feels like it doesn’t belong, and perhaps was Apple’s desperate attempt to provide a headline feature to set Apple Music apart from other subscription music services. In my mind, it wasn’t needed – as I said above, I think Apple Music already differentiates itself in the most important way. Then, behind Beats 1 is now hiding a series of more customizable radio stations, which used to be known as iTunes Radio. Lumping all this together as radio also feels like it might be confusing, but at least iTunes Radio is being infused with some Beats smarts, which should make it better. I also wonder if Beats 1 is a concession to trying to appeal to the younger crowd, despite the older appeal I think most of Apple Music will have.

Connect feels more significant

On the other hand, Connect feels more interesting, and more unique. Whereas Spotify (and to a lesser extent Deezer, Rdio etc) has always seemed the target (victim?) of Apple Music, Connect feels like it’s going after SoundCloud and YouTube, where many undiscovered artists make their start. The problem today is that once an artist breaks through they tend to withdraw from these platforms and become increasingly distant from fans. Some artists (Taylor Swift seems a great example) maintain a direct connection with fans through social media, but for many others there’s this disconnect. I feel like Connect could be the first platform that gives artists a home that will work whether they’re undiscovered in their bedroom or coming off a platinum record. Connect also feels like a big tool for appealing to younger users.

The Music launch should have been its own event

Music was the “one more thing” at the end of the keynote, but it really didn’t fit there – in days past, this launch would have had its own event (likely in the fall, Apple’s traditional time for such events), but instead it was squeezed in here. This was a mistake – it didn’t do the service justice, and the Music segment felt rushed and cluttered, but still left all of us somewhat unsure about exactly how it works. It really should have been its own event, separate from WWDC (which is, after all, a developer conference, and there’s no developer angle to Apple Music – yet).

Developer events are getting cluttered

This brings up a broader point – each of the major developer events – Microsoft’s Build, Google’s I/O, and Apple’s WWDC – feels increasingly cluttered. As the aspirations and reach of these companies grows, a single annual two-hour keynote is becoming an increasingly poor way to communicate all that needs to be communicated. Microsoft does two keynotes, which is one way to deal with the problem (Google has done this in the past). But it just highlights the degree to which this two month period in the late spring is becoming a huge pile-up of news, that doesn’t really serve anyone well. All three companies should be thinking about spreading this stuff out more.

The Apple TV news merits its own event too

Speaking of all this, where in the world would Apple have fit the three major pieces of Apple TV news at this year’s WWDC? With a keynote that already felt light on detail and rushed, how could it ever have hoped to also announce new Apple TV hardware, and Apple TV SDK, and the Apple TV service? Thankfully, we didn’t have to find out, and that will likely all be announced together at a later date. I just hope it won’t all be crammed into September’s iPhone event. Perhaps the iPad event in October?

Native apps on Watch are the biggest developer news

Although iOS and OS X are the two big focus areas for WWDC each year, to my mind the most significant news by far was watchOS 2, and especially the ability for developers to create native apps and tap into the hardware and software features of the Watch directly. I’ve always felt that third party apps will be a huge part of the mainstreaming of the Apple Watch (just as they were for the iPhone and iPad before it), but the early model of companion apps and WatchKit just wasn’t going to cut it. I see a huge swathe of much more compelling Watch apps later this year when watchOS 2 becomes available, and I think we’ll see a huge growth and broadening of the appeal of the Watch as a result.

Google and Apple did stability releases while Microsoft goes big

There was some interesting timing this year at the developer events – Apple did its big overhaul of iOS in 2013 and OS X in 2014, while Google also did its major overhaul of Android in 2014. This year, both these companies focused on stability releases with relatively incremental improvements and lots of polish. By contrast, Microsoft is releasing its biggest Windows upgrade in years, across all device categories. I haven’t yet thought through all the implications of that (beyond mere intellectual curiosity), but it’s interesting to ponder.

Siri advancements reinforce Apple’s privacy stance

The Siri announcements were a wonderful validation of the piece I published last week on Apple and privacy. In that piece, I wrote that nothing in Apple’s privacy stance should prevent it from being able to do clever and useful things in iOS and beyond to better serve users with machine learning, and its WWDC announcements reinforced that. Enhancements in Siri and Spotlight are the best examples, but the natural language processing improvements in multiple individual apps are part of this broader picture too.

Apple is retaking control of content

Apple has been big in content for twelve years, since the launch of the iTunes Store in 2013, and continuing with major launches like TV shows and movies in iTunes, iBooks, Newsstand, and so on. However, for the last several years Apple has seemed adrift in content, a victim rather than a driver of trends, and has seen its content revenues stagnate and fall even as third party apps explode (along with the associated revenue stream for Apple). This year, Apple finally seems to be retaking control of control, with the News app, Apple Music, and presumably the Apple TV service later this year. Apple finally seems to be embracing subscriptions in music and video, and recognizing that some of its other content platforms (notably Newsstand) aren’t working and rethinking them. News puts it uniquely in control of a certain form of content, while Music also gives it some unique ownership of artist-created and DJ-created content, which is a fascinating shift.

Microsoft’s Build announcements: breaking the vicious circle

Microsoft’s first-day keynote at its Build developer conference today focused first on Azure and Office platform advancements, but finally moved on to Windows, where the real meat of the day was in my mind. When it comes to Windows, and Windows Phone in particular, one of the key challenges continues to be what I refer to as the user/app vicious circle. Simply put, in our post-iPhone world, when there are no users on a platform it’s tough to attract developers, and when there are few developers and hence few apps, it’s tough to attract users. Windows Phone suffers from a number of issues (see my free in-depth report on the platform), but one of the biggest continues to be the app gap and the app lag.

Attempts to break the vicious circle

The challenge for Microsoft is that’s really tough to break this vicious circle unless you can somehow goose either user numbers or the number of apps. What I saw in today’s keynote was an articulation of Microsoft’s strategy to do both, as shown below:
Screenshot 2015-04-29 13.37.38 Continue reading

Comparing Microsoft and Amazon’s cloud businesses

Amazon finally provided the first direct visibility over the finances associated with its AWS business today, and it provides an opportunity to compare them with one of the other two big enterprise cloud businesses which compete with it, Microsoft’s. Microsoft doesn’t explicitly report its cloud revenues, but “Commercial Cloud” is one of a number of revenue categories it provides enough detail around in its 10-Q to allow us to calculate it with some accuracy. Here, then, is a comparison of Amazon’s AWS revenues and Microsoft’s Commercial Cloud revenues over the same five quarters:

Screenshot 2015-04-23 18.09.34As you can see, the two are almost neck and neck at this point, with Microsoft’s cloud revenues catching up to Amazon’s over time. It seems likely that they will pass AWS revenues in the next couple of quarters. But the obvious problem with this chart is that they’re not measuring the same thing: AWS is a discrete business, largely focused on public cloud services, whereas Microsoft’s revenues reflect several quite different businesses that it’s lumped together under this heading. However, this reflects something I wrote about last quarter, which is that Amazon would actually quite like to have a cloud business that looks more like Microsoft’s:

It continues to be critical for both companies (and Google) to migrate their way up the cloud stack to the higher-layer services (as both I and Nadella called them), but Microsoft is already there, while Amazon continues to try to compete in a space I’m really not sure they can.

Where the two businesses overlap, Amazon’s is certainly quite a bit larger, but Microsoft’s cloud business looks a lot like the kind of business Amazon is trying to build, and quite rightly. The kind of business Amazon is in today is rapidly commoditizing, and its chances of moving up the stack are much slimmer than Microsoft’s, which has a much longer history in this space and a massive legacy customer base to migrate over to it.

One other thing we don’t know about Microsoft’s cloud business is its profitability. It sits within the Commercial Other category at Microsoft, which reports gross margins of 41% last quarter, but those margins have been rising rapidly as Microsoft builds scale in this business. Amazon’s operating margins on AWS, meanwhile, are far higher than in its core e-commerce business, but they appear to have fallen quite a bit year on year, likely reflecting that commoditization and the increasing competition in this space. I’m not sure Amazon will be able to turn those margins around in the near future unless it is able to execute that transition to higher-stack services and therefore better differentiate its offerings. Microsoft’s trend currently looks healthier on both the revenue growth and margin side. And of course Microsoft has quite a few other more profitable segments to lean on while it builds this business, whereas Amazon continues to struggle to break even in its core business.