Microsoft posts second straight double-digit downturn in Windows OEM revenue

Can Redmond make enough from consumers in services to offset the decline in OS revenue?

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Todd Bishop

Microsoft last week acknowledged that Windows revenue took a beating in the first quarter, with sales of licenses to computer and device makers falling $698 million, or 22%, compared to the same stretch in 2014.

The quarter's downturn was the second straight double-digit decline, following a 13% drop in revenue during the last three months of 2014 that represented a $455 million weakening.

So far this fiscal year -- which ends June 30 -- Microsoft has booked $1.2 billion less in Windows OEM (original equipment manufacturers) revenue than during the first three quarters of the year before.

First quarter revenue from computer and device makers was down 26% for what Microsoft calls the "non-Pro" category and off 19% for the "Pro" class. The terms refer to the kind of Windows license, with non-Pro indicating the OS for consumer PCs and tablets, and Pro for devices targeting businesses. In Windows 8.1, for instance, the former is simply Windows 8.1 while the latter is Windows 8.1 Pro.

Microsoft blamed the consumer licensing downturn on a packed sales channel left over from the holidays, and to a lesser extent the move to very low prices on PCs and the company's corresponding licensing subsidies for those devices.

"As we talked about last quarter, inventory in the channel was higher than normal," said CFO Amy Hood during a conference call with Wall Street last week, talking about consumer licenses. "This quarter ... we exited [the quarter] with channel inventories at more normal levels. This channel inventory reduction was the main driver of our Windows non-Pro revenue decline. We continued to see a mix shift to opening price point PCs ... however, it was significantly less than the impact holiday sales favored lower price point PCs."

Meanwhile, Pro license revenue dramatically decreased compared to 2014 because of upbeat sales that year as businesses frantically dumped Windows XP. "This quarter Pro revenue declined by 19%, and is essentially flat to our [year ago] levels as both business PCs and Pro mix in that segment returned to pre-XP refresh levels," Hood explained, repeating a theme Microsoft has used for the last several reporting periods.

While that was true, when compared to Q1 2013 -- before the last-second XP refresh cycle kicked in -- Microsoft's revenue from all device and consumer licensing was still down, to the tune of a 20% decline representing almost $1.1 billion.

That last comparison was not quite apples-to-apples, as those figures account for not only Windows licenses to OEMs, but also for consumer retail sales of Office, Windows Phone licensing -- which has essentially disappeared -- and patent licensing. Windows OEM licenses, however, historically make up the bulk of the division, 71.2% in Q1 2015, for example.

Both Hood and CEO Satya Nadella spun the decrease in consumer OEM licensing as less about the loss of revenue and more about the opportunities ahead, especially for the upcoming Windows 10.

"We're also transforming the consumer Windows business to adapt to the changing market dynamics, including lower price point devices," said Nadella in the same conference call last week. "This quarter, while non-Pro revenue declined, activations were up. Importantly, we are now at a place where we can start to see early signs of how usage increases in services like search and gaming can drive new monetization opportunities over the lifetime of a Windows consumer device."

That's Microsoft's new strategy, best evidenced by Microsoft's decision to give away Windows 10 to consumers running Windows 7 and Windows 8.1. Previously, Nadella and others have dubbed that "Windows as a service," although executives have been coy about what that actually means other than an attempt to convince people to pay for add-ons like OneDrive and Office 365.

Evaluating that switch won't be easy, said Jan Dawson, chief analyst at Jackdaw Research. "There are so many different moving parts moving in many directions," Dawson said in an interview when asked whether growth in other areas, particularly its cloud-based businesses such as Azure, were making up for the drop-off in revenue from the company's long-time powerhouses, Windows and Office. "I think it will take two to three years to get a better sense of where this will end up," Dawson predicted.

That's an eternity for a publicly traded company like Microsoft, whose financials are examined by investors with short attention spans and less patience.

Dawson wasn't optimistic that Microsoft would pull it off. "Long term, Windows revenue will continue to decline," he said, and it remained unclear how Microsoft could replace the billions with service income. Dawson and other analysts have repeatedly pointed out the difficulty any vendor, even Microsoft, faces in making money from an operating system in a world where OSes are handed out free, as is Google's Android, or packaged with proprietary hardware, as is Apple's OS X and iOS.

"What's the new level of total revenue for Microsoft?" Dawson asked. "They bought the [Nokia] phone business, but the underlying trend is that they're losing far more on the hardware and on the consumer side than they will make up on the cloud and commercial. That's a fundamental problem."

Microsoft did increase revenue for the quarter -- sales were up 6% over the same period in 2014 -- and earnings beat Wall Street estimates, which has fueled a 10.5% jump in the stock price since the firm released its financials Thursday. But Microsoft's operating income -- also called "operating profit" -- dipped 5% as the higher costs and lower margins of hardware hit home, due, said Hood, to ongoing restructuring and Nokia integration costs as well as the strong dollar, which has affected foreign sales.

"Microsoft's challenge is to move from software, where its traditional business has had a 90% margin, to cloud, where the gross margin is around 40%," said Dawson. "It's heading toward a very different set of businesses from what they have traditionally sold."

Copyright © 2015 IDG Communications, Inc.

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