Credit: Shutterstock photoMicrosoft's ( MSFT ) second-quarter earnings report wasn't a disaster. It may have seemed that way to investors, coming at the end of a three-month 25% rally, but what it revealed was a company doing some things right, and some things wrong. For Microsoft, that's business as usual.
The glaring problem was the Windows division. Sales fell 6% year-over-year, reflecting a 15% decline in revenue from OEM (Original Equipment Manufacturer, i.e. PC) sales. IDC and Gartner both reported that PC shipments declined 11% in the second quarter, which suggests that inventory drawdown might have eaten into Microsoft's top line. The weak results cannot be blamed on Windows 8 alone, as Apple ( AAPL ) also reported a 7% decline in Macintosh shipments.
Price cuts on the Surface RT tablet resulted in a $900 million write-down, which wasn't wholly unexpected. When the Surface Pro was released -- running PC hardware and the full version of Windows 8 -- many reviewers felt it better represented Microsoft's strengths, and in the first quarter the Pro handily outsold the RT , despite poor battery life and a hefty price tag. Windows is the only touch-capable PC operating system, and its great opportunity lies at the high end of the market -- tablet PCs -- and not with inexpensive consumer devices, where it has few advantages over Google's ( GOOG ) Android and Apple's IOS. We should know by year-end whether Microsoft's gamble is paying off, as lower price points combine with Windows 8.1 and Intel's ( INTC ) battery-saving Haswell architecture.
Initially, Microsoft held back Surface sales by limiting its distribution; only last week -- nine months after the launch -- was the decision made to open up the enterprise distribution channel. That's inexplicable because enterprise is Microsoft's great strength. In the second quarter, nearly two-thirds of total revenue came from the Business and Server divisions, and their combined operating income was $7.2 billion (versus $7 billion for Microsoft as a whole; the rest of the company ran at a loss). Both have seen consistent growth and high margins in recent years, a trend that continued in the second quarter. Server and Tools revenue rose 9% year-over-year, while Business sales were up 3% after adjusting for deferred revenue and a favorable currency impact. Operating margins were essentially unchanged at 42% and 64%, respectively. Cloud products like Office 365 and the Azure platform have the rare distinction -- by cloud standards -- of being both profitable and popular.
To put it simply, what's good for the Business and Server divisions is good for Microsoft. Windows RT and Phone are unlikely to provide either division with much follow-on business - and that makes them distractions. Windows 8 and Surface are intended to ensure Microsoft's presence in the workplace, where its productivity software is legion - and that makes them important. There may be good reasons to fight over the consumer device market, but Microsoft's future is in the office, where it can offer a combination of mobility and functionality that post-PC devices can't match. So far, enterprise adoption of Windows 8 has been slow - very slow - compared to Windows 7, but we need to keep in mind that it's really competing with iOS and Android.
The Online and Entertainment divisions are, like Windows RT, distractions. Entertainment -- the Xbox ecosystem -- suffered a weak second quarter, hit by seasonality and an old product cycle. Online Services -- Bing and MSN -- had a somewhat worse quarter, posting the worst loss in a year. Both divisions have been a drag on Microsoft; over the last two years, Entertainment pulled in sales of nearly $20 billion but only $1 billion in operating income, while Online Services lost $3 billion on $6 billion in revenue. Bing is slowly grabbing market share, and Xbox dominates the US console market , but without profits, and without synergy, their success is of only philosophical importance.
All in all, Microsoft is doing well where it counts and poorly where it doesn't. That's routine -- and reorganizations, like the one announced in early July, are also routine. Redmond's core competency is surviving. It's reasonable to expect that Windows 8 and Surface will accomplish what they need to... and it's probably unreasonable to expect anything more. In all likelihood, the enterprise business will continue to perform well, and Microsoft will continue to waste energy chasing after competitors and colonizing nonstrategic industries.
Like I said -- business as usual.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
