Microsoft's quandary: Big profits from software or shrinking margins with devices

Company's Q4 financials illustrate the hit Ballmer's strategy takes on gross margins

For all his talk of "devices and services," when Steve Ballmer hands over the reins to a new CEO, he will leave an economic powerhouse that prints money by making software, but not one that makes much on anything else.

The next chief executive will have to figure out a way to turn Ballmer's words into reality, or, much less likely, pivot the company back toward its very lucrative roots.

"Their devices strategy is more aspirational, and the 'devices and services' strategy is in some ways a misnomer. They are still a software company," asserted David Mitchell Smith, an analyst at Gartner.

Perusing Microsoft's most detailed financial report, the one it filed with the U.S. Securities and Exchange Commission (SEC) last Thursday, makes it clear why Smith spoke of software, not of Microsoft's professed turn to a strategy that emphasizes devices and services.

Two of the company's five business units -- Devices & Consumer (D&C) Licensing and Commercial Licensing -- generated 66% of the company's total revenue for the fourth quarter of 2013 and 93% of its gross margin. Those units, as their names imply, primarily sell software licenses: Windows to OEMs in D&C's case, Office and a slew of other products to enterprises in Commercial's.

And their margins were stratospheric, above 92% in each case. In other words, for each $100 brought in by those two units, from software sales, Microsoft retained at least $92. That's close to printing money.

The other units -- D&C Hardware, D&C Other and Commercial Other -- had gross margins of 9%, 24% and 23%, respectively, but contributed less than 3% each to the total gross margin for the quarter, showing that they were not only less profitable than the software units, but were nearly invisible on the bottom line.

Microsoft, of course, knows full well the profit-making disparity between what it has historically done -- sell software -- and what it wants to do in the future, particularly with its own home-grown devices, of which it made much last week when it reported record revenue, improved Surface sales and the launch of Xbox One.

"But [Xbox] is never going to be an 83% gross margin," said CFO Amy Hood last week, when asked what Microsoft's margins would look like as a devices- and services-centric firm. "It's just a different business, even for the market leader, and even successfully generating cash and returns."

Indeed.

While sales of Microsoft's Xbox game console and Surface tablet were in large part responsible for the company beating Wall Street expectations, a closer look at the numbers reveals high costs and declining margins for devices, a fact of life that the Redmond, Wash. company must learn to live with as it continues to push its strategic revamp.

"In a general way, they're using hardware as a loss leader," said Patrick Moorhead, principal analyst at Moor Insights & Strategy, after studying Microsoft's financial statements and spreadsheets. "The Surface, for example, is more of a PC than a tablet, and PCs have smaller gross margins [than tablets]."

Rajani Singh, of research firm IDC, concurred.

"Cost of revenue is high in any device manufacturing segment because fixed costs, works-in-progress and overhead are very high," she said in an email reply to questions. "But the Surface looks like a loss-making venture, unless there are accrual revenue associated with the Surface business, which Microsoft has not mentioned anywhere."

For the fourth quarter of 2013, Microsoft booked record revenue of $24.5 billion, representing a year-over-year increase of 14.3%. But the company's profit rose just 2.8%, to $6.6 billion.

Microsoft chart
The vast bulk of Microsoft's gross margin -- an indicator of profitability -- came from its software sales, while other businesses, including its hardware efforts, generated next to nothing. (Data: Microsoft, SEC filings.)
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