Windows, Surface and phones post revenue declines as Microsoft's MPC segment falls 17%

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Outside Building 99 in Microsoft's Redmond, Washington, campus.

Credit: Microsoft

Hardware and OS anchor turns into dead weight that drags down growth in cloud business

Microsoft yesterday reported declines in revenue for Windows, its Surface line of hardware and its smartphones, key components to the new More Personal Computing group that debuted its earnings with the September quarter.

Last month, Microsoft shuffled pieces of its wide-flung empire into three new reporting groups, an effort, the company said then, to better align financial reporting with CEO Satya Nadella's emphasis on the cloud, mobile and productivity platforms. One of the segments, More Personal Computing (MPC), includes Windows, Bing search revenue, Xbox Live and all of Microsoft's own hardware, from Surface and smartphones to the Xbox game console.

The changes make it tougher to parse how some of Microsoft's individual elements, particularly its hardware, are really doing, said Jan Dawson, chief analyst at Jackdaw Research.

"We're getting less visibility into individual segments," Dawson said in a Friday interview. "Phone hardware, gaming hardware and Surface have all been subsumed under the More Personal Computing group, which also includes Windows."

The inclusion of the typically very profitable Windows in the MPC division offsets and hides the profitability, or lack thereof, of Microsoft's hardware endeavors, Dawson added.

Total revenue for MPC in the September quarter was $9.4 billion, down 17% from the same period in 2014, or down 13% if currency exchanges had not hurt the business. And while the group accounted for 46% of the company's total revenue of $20.4 billion, the most of any of the three segments, its operating income -- the amount of profit after deducting operating expenses, which include not only cost of goods but also sales costs, wages and depreciation -- was just 17% of its revenue, making it the least profitable unit by far.

Much of the problem with MPC could be traced to Microsoft's smartphone business, which declined by $1.5 billion in revenue as the company retrenched from a more expansive portfolio after it wrote off most of the disastrous Nokia acquisition.

But the Surface line of tablets also dropped, down 26% from the same quarter in 2014.

"As expected, Surface revenue slowed with the market anticipation of a new Surface Pro device for the holidays," said Amy Hood, Microsoft's CFO, in the earnings call Thursday with Wall Street analysts.

Dawson pointed out that the comparable quarter in 2014 also included brisk sales of the Surface Pro 3, which had launched in May of that year. "I buy it," said Dawson of Hood's explanation for the downturn in Surface revenue. "Some people may have held off in the expectation of new devices. But we have absolutely no guidance on the profitability [of the Surface]."

Microsoft refreshed the Surface Pro and introduced the Surface Book, its first-ever laptop, two weeks ago. Revenue from sales of the new devices won't show up on Microsoft's books until January 2016.

Microsoft's revamped reporting -- and what it includes in filings with the U.S. Securities & Exchange Commission (SEC) -- make it impossible to now even guess at the Surface line's profitability. (The last time Computerworld, with Dawson's help, estimated the Surface's gross margin -- in April for the first quarter of 2015 -- the number was 19.2%, far below the 90%-and-up gross margins of the Windows and Office software segments.)

Things were somewhat clearer on Windows' revenue: Overall, the OS money maker brought in 7% less, with revenue down $322 million from the September quarter of 2014. Within the Windows whole, revenue from license sales to OEMs (original equipment manufacturers) was down 6%, while licensing Windows to enterprises was off 3% (but up 4% when foreign currency headwinds were eliminated).

Although still in contraction, Windows' revenue downturn was not as steep as previous periods. In the June quarter, for example, Microsoft reported a revenue decrease of 22% in OEM licenses, the third quarter running with double-digit declines.

Nor were the reductions as large as Microsoft had expected, said Hood. "The way to think about the early signs of the impact [of Windows 10] were the strong device mix, some higher-priced units across a wide variety of OEMs as we build into holiday, did provide some slightly better-than-expected results," she said when answering an analyst's question during the call.

Both Hood and Nadella also made a point to highlight Microsoft's Bing search business, and credited the 23% increase in its revenue -- and the fact that it finally turned profitable -- to the knock-on effect from Windows 10. The new OS ties tightly into Bing within the default Edge browser, the in-OS search feature, and the Cortana digital assistant technology.

"Some of the other upside that we saw in the quarter was from things that are the second sort of derivatives of [Windows 10], which was our search results were better than we had thought," Hood said.

Microsoft has long featured Bing as one of the ways it planned to monetize Windows 10, especially the free upgrades it will give away through July 2016.

Microsoft may not have acknowledged the negative impact of those upgrades on revenue -- instead, Nadella trumpeted the fast adoption pace of Windows 10, again citing that it had reached the 110 million mark -- but Dawson wasn't as shy.

"Normally, you'd see a big spike [in revenue] at a Windows launch, but there's the [free] upgrade this time," Dawson said. "It's not going to have the same positive effect [as previous Windows launches]."

Company-wide, Microsoft's September quarter was mixed, with revenue down more than 12% year-over-year, but with profits up 2%. Most financial analysts tapped the 8% growth (up 14% in constant currencies) in Microsoft's Intelligent Cloud segment, the group that blends the Windows server licensing business, enterprise services and Microsoft's Azure cloud platform, as the biggest positive news.

Intelligent Cloud's operating income was a robust 42% of its revenue, second only to the Productivity and Business Processes group, which covers Microsoft's Office business.

Investors seized on Microsoft's results, notably the continued growth in the cloud, to push the Redmond, Wash. company's share price up more than 11% in trading as of 3 p.m. ET Friday.

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