Category Archives: Surface

Earnings, Microsoft, Q3 2016, Smartphones, Surface

Microsoft’s Evolving Hardware Business

October 21, 2016 Jan Dawson

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:

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:

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:

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:

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:

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:

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:

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.

Laptops, Microsoft, Surface, Tablets, Windows Phone

Every device is a compromise, part 2

October 6, 2015 Jan Dawson 4 Comments

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.

Cloud, Earnings, Microsoft, Office, Q2 2015, Surface, Windows, Windows Phone

A deep dive on Microsoft’s Q2 2015 numbers

August 3, 2015 Jan Dawson

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 and the Nokia acquisition
Product revenue breakdowns
Cloud revenue, AWS, and growing margins
A broader look at margins
Consumer Office 365 revenue growth is slowing
Surface, Lumia and other phone sales

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.

Product 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:As 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:
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.

Lastly, 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.

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:Essentially, 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 segment Licensing 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:However, 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:What’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:However, 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:I 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.

iPad, Microsoft, Surface, Tablets

Surface Pro 3, like every other device, is a compromise

May 20, 2014 Jan Dawson 6 Comments

Microsoft today announced the Surface Pro 3, its latest Windows 8-based tablet, with the tagline “The tablet that can replace your laptop”. That sounds great in principle, and it’s a great slogan, but the reality is that the Surface Pro 3, like any other device – be it smartphone, tablet, laptop or whatever – is a compromise. Microsoft’s biggest mistake in marketing the Surface – and Windows 8 – is its repeated claims that there is no compromise, or that the Surface can somehow meet needs normally served by a combination of tablets and laptops or desktops.

Satya Nadella provided the setup for the launch with talk about “dreaming the impossible” and creating a device which (I’m paraphrasing based on my notes) “enables any individual to be able to read, create and write. Allows you to watch a movie and make a movie. To enjoy art and create art.” To me, that sounded just like the reality of the iPad. There was nothing unique in this vision, nothing impossible about it – it’s a reality we’ve had with us for the last four years. But the point is, Apple has never claimed that professional moviemakers should be using the iPad camera for shooting movies or iPad apps to edit them. Apple knows better than anyone that professionals want professional-grade equipment and software (including Apple’s own Mac Pro and Final Cut Pro products) to make movies. And the same goes for many other professions. The iPad offers great benefits – smaller, lighter, longer battery life, more personal and interactive – over laptops and desktops. But the tradeoff is that it lacks the power, the large screen, the peripherals and so on of a larger device. Apple will happily sell you a device from five different major product lines: the iPhone, the iPad, the MacBook Air, the MacBook Pro and the Mac Pro – because it knows no single device meets all needs, and doesn’t try to convince consumers that it can.

The problem for Microsoft is that it only makes one device, the Surface, itself. And so its mission from the start has been to turn that device into the holy grail – the single device that can meet all your needs, replacing both other tablets and laptops. It has good strategic reasons for wanting to do this, which I’ve covered elsewhere. But the result is that it has to constantly claim that its single device can replace two devices from any other vendor, notably the MacBook Air and iPad shown repeatedly at today’s launch event. But it fails to acknowledge the compromises such an approach entails. Though Panos Panay repeatedly compared the Surface Pro 3 to the 13″ MacBook Air, he never compared it to the iPad Air or even the 11″ MacBook Air, which has a much more comparable size. Here’s why:

It’s because Microsoft recognizes that this isn’t really a tablet that can replace your laptop: it’s a laptop that happens to have a detachable keyboard. It’s priced like a premium laptop, and it weighs the same as a premium laptop.Start comparing it to the best tablet on the market, though, and it starts to look much less attractive: the iPad Air and iPad Mini cost substantially less (even if you add a good third party keyboard for $100), and weigh much less. They’re much easier to hold in the hand and they come with a far greater number of tablet-optimized apps.

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. If it isn’t willing to do that, it should probably just cede the market to its OEMs.

Beyond Devices