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

January 27, 2014 06:29 AM ET

Microsoft's Hood wasn't as explicit as Moorhead -- no surprise -- but she said something similar last week. "I do think it's more to think about it as a goal we absolutely have," Hood said of future Surface profitability.

Hood dodged a question from Brad Reback, an analyst with Stifel Nicolaus, who wanted to know what Surface sales volume would put the business in the black.

"Our goal was really to create a product that showcased what can happen when you innovate in hardware, in the service, and in the software," Hood said, repeating a mantra Microsoft has used to portray Surface as a model for others to follow, not necessarily a business meant to turn a profit. "We've learned a lot over the course of this journey. And we have to make more meaningful progress."

IDC's Singh would have agreed wholeheartedly with Hood on that last bit. Singh blasted the decision to stray outside software.

"Microsoft is selling software, adding a little bit of services," said Singh in an interview Friday. "But devices are not something that Microsoft can benefit from in either the short or the long run. Devices are altogether a different animal, and a highly, highly competitive business."

She dove into the financial statements to make her case. "Hardware had a GM [gross margin] of 9%, but software had a GM above 90%. And you're trying to move out of a business with a GM of over 90% and locating your resources in something that has a GM of just 9%? That's not very prudent."

Her take was reminiscent of opinions expressed by Wall Street analysts who have been down on the company's foray into devices, and have said Microsoft should spin off its less profitable businesses -- Xbox and Bing are those most often mentioned -- to improve the bottom line and boost the stock price.

Those analysts have a point: Delete D&C Hardware from the spreadsheets, and Microsoft's gross margin jumps from the actual 66% to a stunning 80% company-wide.

Nor did Singh see much chance of improving Microsoft's financial situation by adding another big piece to the device group, which is what will happen when Microsoft wraps up the $7.4 billion acquisition of Nokia's handset business this quarter.

"Nokia may benefit the revenue of Devices & Consumer Hardware, but not Microsoft as a whole," Singh contended. "Smartphones are not a high-profit product, and in developed markets, smartphone sales may go down or at least growth rates may go down."

Her argument was that it's foolish for Microsoft to divert energies and resources into new markets -- like devices -- unless those moves made the whole company more profitable. "When venturing into new segments, the pieces should build synergy, and the whole should be worth more than the pieces," Singh said.

She saw no evidence of that in Microsoft's numbers. "Microsoft's gross and net profit margins are falling," Singh said, pointing to last quarter's company-wide gross margin of 66%, down 7 percentage points from the 73% the year before.

But perhaps Moorhead put it best.

"Financially, Microsoft is doing just fine," he said Friday. "They're doing pretty well in a down market for both PC and enterprise spending, they out-performed the market in both consumer and commercial.

"But strategically, I can't make a case that they are doing well at all," Moorhead continued. "In mobility, smartphones and tablets, but even in the cloud, I'm not impressed."

covers Microsoft, security issues, Apple, Web browsers and general technology breaking news for Computerworld. Follow Gregg on Twitter at Twitter @gkeizer, on Google+ or subscribe to Gregg's RSS feed Keizer RSS. His email address is

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