New Microsoft same as the old Microsoft

No matter what strategy the CEO touts, company's financials show entrenched revenue drivers and money losers

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"At times, we will develop new categories like we did with Surface. And we will responsibly make the market for Windows Phone," Nadella said during the July 22 earning call. "However, we are not in hardware for hardware sake, and the first-party device portfolio will be aligned to our strategic direction as the productivity and platform company."

Other company executives, including former Nokia CEO Stephen Elop, have also deployed the phrase "responsibly make the market." which some analysts have interpreted to mean that losses will not be tolerated in Nadella's regime as they were in Ballmer's.

The mantra of "productivity and platforms" certainly matches Microsoft's revenues better then Ballmer's "devices and services," which was never really defined. The Office productivity family, represented by Commercial Licensing, and the Windows platform, more or less encapsulated in D&C Licensing, accounted for 93% of the firm's second-quarter gross margin.

That was actually down from a year ago, when the two lines combined for 95% of Microsoft's gross margin.

But another group, Commercial Other, which generates most of its revenue from what Microsoft calls "Commercial Cloud" -- Office 365 for commercial accounts; Azure, the company's cloud business; and Dynamics CRM Online -- more than made up the difference. The service-oriented group booked $2.3 billion in revenue during the June quarter, up 44%, and boosted its gross margin to $691 million, a 106% increase.

Commercial Other's gross margin in percentage format was 30.5%: For every $100 in revenue, Microsoft kept $30.50. That was not only a jump from 21.3% a year before, but the highest since the group's creation on the books.

"Commercial Other margins expanded again in this quarter, benefiting from both improved business scale and datacenter efficiency in our cloud services," said CFO Amy Hood last month.

Although Commercial Other was a creation of Ballmer, who regularly cited its offerings as the prime example of the "services" side of his strategy, the group also fits well with Nadella's updated message of productivity (Office 365) and platforms (Azure, as a cloud-based OS).

Add Commercial Other to the two licensing-centric groups, and the cumulative margin drops to 84.7% -- Microsoft keeps $84.70 of each $100 in revenue -- which, while a smaller number than licensing-only, is still a fantastic margin that demonstrates the financial power of software, whether delivered traditionally or as a service.

Nadella knows that, and has even acknowledged as much, although he uses the word "software" sparingly -- just twice, for instance, in the July 22 earnings call. In a May interview at Re/code's technology conference, Nadella said, "We are a software company at the end of the day."

No kidding.

Which makes the hardware divisions and their very low margins stand out even more.

If the Xbox, Surface and Nokia businesses, along with the rest of the peripheral units bundled with them, were purged from Microsoft's balance sheet last quarter, it would have raised the gross margin ten points, from 69% (with hardware) to 79% (without). In other words, Microsoft would be a smaller company -- just under $20 billion in revenue versus the actual $23.3 billion -- but a more profitable one.

That's not gone unnoticed by Wall Street, which has regularly pressed Microsoft to abandon hardware, sell the units or spin them off into independent companies. Industry analysts have also questioned the devotion to hardware.

"The contrast between hardware and licensing couldn't be more stark: one makes enormous gross margins, and the other barely scrapes a profit," said Jan Dawson, chief analyst at Jackdaw Research, in a July 22 analysis of Microsoft's financials. In a follow-up, he wondered how long Microsoft would put up with the losses of the Surface.

"Continued losses will make it harder and harder for Microsoft to keep the Surface project going, so a good performance in the next quarter or two will be critical to justifying its continued existence," he wrote on July 31.

A few days later, in an interview, Dawson elaborated. "My sense is that Nadella is less willing to accept losses than was [Steve] Ballmer," he said.

With a financial disparity like the one shown in the June quarter, who could blame Nadella if he did?

And he has hinted that pressure would be applied to the low-low-margin hardware divisions. "For those supporting efforts such as MSN, retail stores and hardware, we will also ensure disciplined financial execution," Nadella said on July 22 (emphasis added).

Microsoft's margins
While margins for Microsoft's hardware group -- which sells the Surface and the Xbox -- continued to fall in the June quarter, margins have improved for 'Commercial Other,' the group that handles Office 365 for businesses and the Azure cloud. (Data: Microsoft, SEC filings.)

Copyright © 2014 IDG Communications, Inc.

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