(Source: VentureBeat)
Microsoft pockets nearly $7B USD, but falls short of lofty expectations

The results of Microsoft Corp.'s (MSFT) fiscal Q4 2014 (calendar Q2 2014, which runs through June) were reported yesterday and the picture is mostly bright as Microsoft sees rising revenue and profit on the back of its cloud computing push.
I. Terrific Cloud/Software Performance, Weak Mobile Performance
But if very cloud has its silver lining, this one had a bit of a gray one.  Microsoft's smartphone efforts saw some progress, but continued to experience pains in their effort to reach maturity.  And Microsoft fell slightly short of analyst growth expectations on some metrics, marring an otherwise stellar report card.

Microsoft logo new size

It's safe to say that a Microsoft miss would be considered a hit for most corporations...
  • For Microsoft (inc. Nokia Devices)
    • Revenue: $23.38B USD (up 2.4 percent year-on-year (YoY))
    • Gross Profit (margin): $15.79B (up 10.5 percent YoY)
    • Operating Income: $6.48B (up 6.8 percent YoY)
    • Net Income: $4.61B (down 7.2 percent YoY)
    • Diluted EPS: $0.55 USD/share (down 6.8 percent YoY)
  • Nokia Devices unit (9 weeks)
    • Revenue: $1.99B
    • Gross Profit (margin): $54M USD
    • Operating Income: -$692M USD
    • Net Income: -$671M
    • Diluted EPS: -$0.08 USD/share
Surveys by Thomson Reuters I/B/E/S and Bloomberg showed an average analyst expectation of $0.60 USD/share. Excluding taxes and the impact from Nokia, the total diluted EPS of $0.66 USD/share beat the analyst expectation of $0.64 USD/share.  
Combined, these two data points suggest that Nokia Devices in its first couple months with Microsoft performed substantially worse than analysts expected, while Microsoft's pre-existing businesses performed modestly better than expected.
Revenue marginally beat the analyst expectation of $23B USD.  And deferred revenue -- which stems from Microsoft's multi-year deals for Windows, Office, System Center, SQL server, Azure, Visual Studio Professional, and other products -- came in at $25.2B USD, nearly 3 percent higher than the analyst expectation of $24.9B USD.
II. To the Cloud
“The cloud” has driven Microsoft’s success.  Microsoft's monetization path is similar to Google Inc.'s (GOOG) when it comes to cloud/internet services -- popularize the service with free consumer offerings weakly monetized by advertising, while monetizing more aggressively with subscription enterprise offerings.
Office 365 is still growing fast, adding over 1 million customers to reach 5.6 million at the end of June.  Bing -- long considered a lost cause -- climbed to a 19.2 percent search stake, and was rewarded with a 40 percent increase in advertising revenue.

Bing logo

After losing nearly $1B USD per quarter for a number of years, Bing may finally be profitable although Microsoft did not discuss specifics.  In addition to serving as the search/indexing backend to Yahoo! Inc.'s (YHOO) popular web portal, Bing is powering internet search on Apple, Inc.'s (AAPL) OS X 10.10 "Yosemite", displacing Google search.
Just how remarkable is Bing's turnaround?  Bing likely operated in Q4 at only a loss of around $50M USD, trimmed from $372M USD in Q4 FY2013 and $6.672B USD in Q4 FY2012.  In Q4 FY2012 Microsoft's "Internet Services" division had revenue of $735M USD.  In Q4 FY2013 it had revenue of $804M USD.  In Q4 FY2014, Bing had an estimated revenue of around $1.125B USD.
With the Apple deal almost at hand, Bing is poised to achieve profitability sometime in Q3 and Q4 -- once a seemingly impossible feat.  That's a testament to the acumen of new CEO Satya Nadella who was appointed on Feb. 4 to lead the company.  A key reason for his appointment was Mr. Nadella's successful campaign to turn around Microsoft's struggling online business, perhaps a microcosm of the macrocosm of problems at the aging firm.

Satya Nadella
Satya Nadella was promoted to CEO after turning around Microsoft's struggling internet services.
[Image Source: Sean Ludwig/VentureBeat]

In an open letter to employees published last Tuesday, Mr. Nadella writes:

Recently, we have described ourselves as a "devices and services" company. While the devices and services description was helpful in starting our transformation, we now need to hone in on our unique strategy.

At our core, Microsoft is the productivity and platform company for the mobile-first and cloud-first world. We will reinvent productivity to empower every person and every organization on the planet to do more and achieve more.

According to Mr. Nadella's comments in a press release Microsoft now earns $4.4B USD in revenue -- or roughly 18.8 percent of its revenue -- from cloud services.  Cloud revenue more than doubled, growing 147 percent on a year-to-year basis.  Both commercial Office 365 subscriptions and Azure -- Microsoft's cloud-hosted enterprise computing environment -- grew by "triple digit" amounts.

Microsoft's veteran software efforts were boosted by the cloud success.  Commercial Windows volume licensing increased 11 percent on the commercial front.  OEM Windows licensing grew a small 3 percent, driven by an 11 percent growth in Windows 8 Pro licensing by PC makers.  That's a relatively good turnaround, considering that excluding an upgrade offer Windows OEM revenue fell 6 percent in Q4 FY2013.

Things should further improve with the release of Windows 8.1 Update 2 (fall) and Windows 9 ("Threshold) (spring) (dates are based on rumor and may change).  When it comes to services Nadella's Microsoft is earning high marks.

III. Xbox One and Surface 3 -- Mixed Bag

But for Microsoft to be a "devices and services" firm as its CEO envisions, it will have to turnaround its hardware division.

Microsoft's Xbox One was outsold by Sony Corp. (TYO:6758) even after it dropped its controversial always-on Kinect 2 sensor to shave $100 USD off the console's price.  According to the earnings report only 1.1 million Xbox Ones were sold in April, May, and June, bringing its lifetime console total to 6.1 million units (see: April 2014, Microsoft hits 5 million).  Sony is estimated to have sold 2.5-3.5 million consoles in the quarter, with a lifetime total of around 8.5-9.5 million PlayStation 4 consoles in the wild [source].  That indicates a nearly 3-to-2 edge for Sony in the sales race.
But game sales were relatively strong, driving Microsoft to a modest 14 percent YoY growth.  Microsoft's press release states that it's "drawing down" sales volume in current markets after facing disappointing sales.  The $399 Kinect-free SKU of the Xbox One did manage to double sales volume.  Microsoft appears resigned that it may not be able to catch up to Sony, but it writes that it is looking forward to releasing the Xbox One "in additional markets beginning this fall."
Surface revenue was similarly a mixed bag.  After the disastrous $900M USD write-down a year ago amidst weak Surface 2 sales, the brand appeared to stabilize with the release of third generation product.

For its third generation Surface tablet Microsoft cut the price of its Intel Corp. (INTC) powered tablet -- similar to a traditional PC -- by $100 USD (to reach $799).  Screen size (10.2 in. --> 12 in.), screen resolution (1920x1080 pixel à 2160x1440 pixel), weight (2 lb --> 1.76 lb), and thickness (11.7 mm --> 9.1 mm) were all improved.  
Surface Pro 3 profile

The Surface 3 Pro also added a new hinge, an improved stylus, and a tweaked keyboard for improved "lapability".  Memory and storage (4 GB DRAM / 64 GB of NAND) remained frozen from the Surface 2 Pro.
Still Surface isn't out of the woods yet.  The 7.5-inch Surface "Mini" was reportedly axed in the eleventh hour amidst internal issues.  And Microsoft continues to offer massive subsidies (up to $650 USD) to try to promote Surface adoption, a sign of lingering sales difficulties.  That said things with Surface look headed in the right direction, at least.
IV. Nokia Device Sales Stagnate, Layoffs Land, Losses Balloon.
The biggest struggles came in the phone department.
Microsoft closed its blockbuster €5.44B ($7.33B USD) purchase of Nokia Devices and related intellectual property rights from Nokia Oyj. (HEX:NOK1Von April 25th.  But the financials for its first several weeks at the helm of the devicemaker aren't pretty.
Nokia Devices in (calendar) Q2 2013 -- then under the tent of Nokia Oyj. -- posted €2.7B ($3.6B USD) in revenue with an operating loss of €33M.  Compared to Microsoft's quarter, this indicates revenue dropped by 45 percent and operating losses soared nearly 16-fold (1,556 percent).  Notably, that's more than Nokia Devices lost in Q2 2012 even, at the height of its struggles.

Windows Phone 8.1 Blue

Device sales remained relatively flat with 5.8m Lumia and 30.3m non-Lumia phones sold in the nine weeks in Q4 FY2014 that Microsoft owned Nokia Devices, for a projected total of 7.7m Lumias and 40.4m non-Lumia devices sold in the quarter. Compared to Nokia's Q2 2014 when 7.4m Lumias and 53.7m non-Lumias were sold, this represents relatively flat sales on Windows Phone end and a substantial drop of approximate 25 percent on the feature phone (Asha and Nokia X) end.
Sales outlook for H2 2014 is uncertain.  Microsoft recently committed to massive layoffs of 12,500 Nokia Devices employees -- roughly half the final workforce (~25,000) it received in the acquisition.
It's already announced it was cutting the low-end non-Lumia (branched Android) Nokia X/X2 phones, strong sellers if perhaps inconsistent with Microsoft's desired message.  Combined with the massive layoffs, Asha is likely to see a gradual ride into the sunset, as well.  The dilemma for Microsoft is what to with the phone unit, which still sees nearly 84 percent of its sales from non-Windows Phone devices.
V. McLaren, Rebranding, and Third Parties Question
With Surface Microsoft has looked to set a gold standard for third party OEMs.  But it's less clear how Microsoft is going to use Nokia Devices to set the standard for Windows Phone.  Multiple reports have indicated plans for a flagship device called "McLaren" have been shelved for (calendar) H2 2014 amidst disappointing performance of its star feature "3D Touch".
At this point Microsoft's best bet would perhaps be to try a follow-up to the Lumia 1020 -- a device that set the standard for high-resolution smartphone imaging when it launched in July 2013.  Such an approach carries less risk, and better yet would be tenable even with Microsoft's cutbacks.  Sales of the Lumia 1020 were less than stellar, but they at least showed the potential of the platform.
Still another uncertainty stems from third party OEMs.

Mira6 from Hisense
China's Hisense Electric Comp., Ltd. (SHE:600060) is among a new wave of Windows Phone licensees.  Its Mira6 has drawn attention. [Image Source: Evolife]

When it comes to Windows tablets, Surface has been content to take a supporting role.  In dropping fees Microsoft clearly hopes to move Nokia Devices into a similar role.  But while curiosity is clearly high, actual hard commitments from OEMs have been harder to come by.  Some partners have even publicly admitted that Windows Phone is a low priority.  Until third party OEMs warm up to Windows Phone Microsoft will have to push Nokia Devices in a more prominent role.
Lastly there's the issue of rebranding/marketing.  Microsoft seems to have reinvented its image on the service front and has gained in brand strength, so there's ample cause for confidence here, at least.  But it has yet to show its hand conclusively on this front so we'll have to wait and see.
VI. Layoffs vs. Royalty Savings
A final thing worth noting is that the cost of Microsoft's Nokia layoff program (which come in addition to 6,500 layoffs within the pre-existing parts of Microsoft) is offset by the savings from the adoption/licensing agreements with Nokia.
Microsoft estimated in saved $382M USD in Q4 FY2014 for terminating 3/4 of its licensing commitment for the quarter.  That hints it was paying around a whopping half-billion dollars a quarter, or $2B USD a year to keep on Nokia.
In Q4 FY2014 layoffs ("expenses... associated with the acquisition and integration of NDS") totaled $127M USD.  In total the Microsoft layoffs are expected to cost $1.1B USD for 6,500 departing employees, while the Nokia Devices layoffs will run $1.6B USD for 12,500 employees.  Microsoft indicates most of these costs should wrap up in the first half of 2015.  Even at $1.6B USD, Microsoft may still save up to $400M USD once licensing commitments are considered.
Looking ahead to the second half of 2014, Lumia volume should rebound with new product announcements of some kind expected and with the new budget Lumia 530 "Rock" -- the replacement to the best-selling Lumia 520/521 -- rolling out.  And on the software front Windows Phone 8.1 looks pretty impressive.

Currently Microsoft is in third place with roughly 4 percent of the market, but Nokia Devices' Windows Phones are being outsold roughly 5-to-1 by Apple -- the biggest non-Android contender.
Microsoft can afford patience -- after all its "Devices and Consumer Licensing" business is pocketing an estimated $250-500M USD per quarter off Android licensing fees.  An estimated 70 percent of Android OEMs agree to pay Microsoft a fee -- typically around $8 USD per device -- which precludes Microsoft from suing for infringement using its 300 most powerful mobile/OS patents, which serve as the crown jewels of the licensing agreement.  
The affects of the nearly $10 USD swing from Windows Phone (free) to Android (free, but with $8+ in licensing obligations) is likely to be felt most strongly on the budget end.
Mr. Nadella has a long way to go before turning around Windows Phone like he did Surface and Microsoft's cloud services.  But there are some positives that can be taken even from a generally disappointing quarter for Nokia Devices.

Sources: Microsoft [press release], Bloomberg, Reuters

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