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

January 27, 2014 06:29 AM ET

Much of the gap between those gains was attributed to the Devices & Consumer Hardware unit, which under Microsoft's new corporate structure is responsible for the Xbox and Surface, some video game royalties, Xbox Live subscription revenue, and PC and Xbox accessories like Microsoft's keyboards and controllers.

Unlike software, which historically generates very high margins -- with costs that approach zero for each additional unit once development has been amortized -- component and distribution costs for hardware not only never vanish but result in much smaller profits, especially at the beginning of a product's lifecycle when a vendor cannot capitalize on large-scale component orders or leverage high sales volume to squeeze distributors and retailers.

The trick is to reap the large revenue that hardware can generate, but also produce significant profits. Among device manufacturers, only Apple has been able to consistently do both, though more recently Samsung has proven capable of the same with its consumer-driven smartphones and tablets.

Last quarter, Microsoft showed in spades how tough it is to mimic those rivals.

The Devices & Consumer Hardware group posted sales of $4.7 billion, up a whopping 68% from the same quarter a year earlier. Microsoft credited the Xbox for nearly two-thirds of that revenue jump, particularly the launch of the Xbox One, which sold 3.9 million consoles in less than half the quarter. Microsoft also sold 3.5 million of the older Xbox 360 in the three-month stretch.

For the Surface, revenue rose even sharper, climbing to $893 million, or up 123% when compared to the third quarter, not the usual year-before period. Although Microsoft did not disclose unit sales -- it has never revealed them for its tablet line -- it said they also more than doubled over the previous quarter.

But while device revenue was up -- Microsoft's Hood gave a nod to "a successful holiday" -- so were costs.

The Hardware group's gross margin was just $411 million, down 46% from the same quarter in 2012 because of a 111% increase in the cost of revenue, which Microsoft said takes into account cost of goods, assembly, distribution and marketing. Again, the Xbox accounted for most of the additional costs -- and thus the decline in the margin -- because of the larger console sales volume and, of course, the new Xbox One's launch.

The Surface actually earned less in revenue than the cost of that revenue, Microsoft admitted, pegging the gap between the two at $39 million.

Overall, the Hardware division's margin as expressed as a percentage was about 9%. For every $100 Microsoft collected on hardware, it retained $9. That's low for premium-priced goods like the Xbox and Surface, low compared to Apple's gross margin, which has hovered in the mid-30s, and strikingly low -- just a tenth as much -- compared to the company's software margins.

"You can't run a super-successful hardware business with gross margins at 10% or lower," said Moorhead, who before he became an analyst worked at both Compaq and chip-maker AMD.

Also troubling for Microsoft's device strategy was that the 9% gross margin for Q4 was only a third that of the same period in 2012, when Microsoft launched the first-generation Surface tablets and retained 27% of each dollar of revenue. The trend has been downward since the Surface debut, with gross margin for the Hardware unit falling to 22% by June 2013, then slumping again to 14% in September before sliding to 9% for the year's fourth quarter.

Moorhead, however, urged patience, saying that one should think of Surface specifically, and Microsoft's Hardware group in general, as a start-up, even though its biggest money maker, the Xbox, has been around 12 years.

"I wouldn't expect them to be profitable for a few years in hardware," said Moorhead, speaking specifically of the Surface line. "You just cannot make money without scale. And to get that, Microsoft would have to selling tens of millions of Surface tablets."

Microsoft chart
The gross margin for Microsoft's Devices & Consumer Hardware unit, which produces most of its revenue from sales of Xbox and Surface devices, has steadily fallen over the last six quarters. (Data: Microsoft, SEC filings.)

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