The new shape of Microsoft’s entertainment unit: More diverse, less profitable

Microsoft’s Entertainment & Devices Division has long been synonymous with the Xbox 360 and video games, which have traditionally represented the vast majority of the division’s business.

That’s starting to change. For the first time, non-gaming products were responsible for more than 25 percent of the division’s revenue last quarter, based on GeekWire’s crunching of the numbers from Microsoft’s latest financial report.

At the same time, the division posted its first quarterly loss in years — $229 million in the red, a big swing from its $210 million in quarterly profits a year ago. It was the only one of Microsoft’s five major divisions to report a decline in quarterly revenue for the quarter, down 16 percent.

In short, a key part of Microsoft’s business is in the middle of a major transition. The underlying trends are worth understanding, because Microsoft is counting heavily on this consumer-oriented division to strengthen the company beyond its traditional (and profitable) Windows, Office and server products.

This is what’s happening in Entertainment & Devices:

  • The traditional game console industry is slumping, hurting not just Microsoft but the other major console makers. Microsoft has been leading the industry by many measures, but sales of Xbox 360s, Kinect motion sensors and video games aren’t what they were a year ago. Xbox Live revenue is rising but not enough to make up for those declines. Microsoft’s Xbox 360 platform revenue fell last quarter by $584 million, or 33 percent, to $1.18 billion.
  • Windows Phone and Skype are boosting the division’s non-Xbox revenue. Although the company doesn’t break out the financials for those businesses, it’s likely that the bulk of the increase is coming from the addition of Skype, which Microsoft acquired last year. Skype reported $860 million in annual revenues (and an annual loss of $7 million) two years ago, when it was an independent company preparing to go public.
  • Patent licensing is contributing to the division on a larger level. Microsoft doesn’t break this number out, either, but the company’s regulatory filings now mention patent licensing as a factor in the division’s revenue. Microsoft has been seeking royalties from makers of Android devices, striking patent licensing deals with many of the major manufacturers.
  • Microsoft is making quarterly “platform support payments” to Nokia in return for the mobile phone maker’s commitment to Windows Phone. Nokia’s financials show that Microsoft paid $250 million in each of the last two quarters. Last quarter, $250 million would have been enough to cover the Entertainment & Devices Division’s losses. Over time, money coming back from Nokia should make up for these payments, but for now it’s a big up-front bet by Microsoft.

One of the biggest red flags is the first item, the decline in the game console business. Part of this is because the Xbox 360 (and competing consoles) are approaching the end of their life cycles.

But the trend also reflects a longer-term shift toward games on Facebook, mobile phones and tablets. Despite the diversity of Microsoft’s overall business, the company hasn’t been in a strong position to capitalize on that shift because of its weakness in mobile phones and tablets.

That helps to explain why the company is taking a chance on those big up-front payments to Nokia, trying to boost Windows Phone; and why Windows 8 is so critical to Microsoft’s future, as the company tries to use its flagship product to compete against the iPad.

Bottom line, for anyone tracking Microsoft’s business, these will be interesting trends to watch.

Previously: Microsoft beats estimates as most divisions see growth

  • Guest

    Overall I am encouraged by Microsoft’s strategy in this arena. Having won the battle for the home entertainment center, Microsoft does not want to become the next Nintendo. “Big Mike” is continuing to diversify, recognizing that more and more consumers want to enjoy video, gaming, and shared social experiences across many form factors. Where Nintendo has staked its future on the off-line devices that we enjoyed in the 1980s and 1990s, Microsoft knows that we want to take our entertainment rainbow everyplace we go.

    We are very encouraged by the direction that Microsoft is taking even though short-term investors may not be satisfied with these long-term investments.

    Thank you, Microsoft, for pursuing a strategy that is both broad and deep.

    • Guest

      LOL. Holly, by “short term investors” do you mean the people who have held MS since 2000 and still lost money?

  • Guest

    The assumption that WP (non-patent rev) is contributing to the rev increase in E&D (as compared to the addition of Skype) is dubious at best year over year.  Last year there were significantly more WP7 phones shipping in the CYQ1, as compared to this year.  The vast majority of this non-xbox revenue is Skype.  Now patent revenue may also be a significant contributor, but MS does not specify how those contributions are spread between divisions or overall.

    Whether rev coming back from Nokia will ever offset the payments is a pretty big if.  If rev back to MS is calculated as a percentage of sales price to carriers, and Nokia has to do significant discounts (as the stated after their quarterly #’s) then this crossover may be far in the future.

    • http://geekwire.com Todd Bishop

      I agree with you, as I mentioned in the post: Skype is probably the bulk of the increase in the division’s non-Xbox revenue. 

      But Microsoft says Windows Phone revenue from Nokia was a factor, as well. Here’s the relevant blurb from the company’s 10Q filing.

      “EDD revenue decreased primarily reflecting lower Xbox 360 platform revenue, offset in part by Skype revenue and Windows Phone software license revenue from Nokia. Xbox 360 platform revenue decreased $584 million or 33%, due mainly to decreased volumes of Xbox 360 consoles and standalone Kinect sensors sold, offset in part by higher Xbox LIVE revenue.” 

      http://sec.gov/Archives/edgar/data/789019/000119312512170665/d313493d10q.htm

      Nokia says in its latest financial report that over time, “the total amount of the platform support payments (from Microsoft) is expected to slightly exceed the total amount of the minimum software royalty commitments (from Nokia).”

      In other words, the *minimum* royalty commitments from Nokia to Microsoft over time should almost make up for the upfront payments from Microsoft to Nokia.

    • Guest

      You’re right that MS doesn’t specify exactly how this royalty revenue gets handled. I guess their commitment to transparency is situation dependent. But it’s a fairly safe assumption that the Entertainment unit claims the majority of the Android-phone related royalty and justifies it as part of their mobile mandate. Also, since they’re likely losing a lot of the money on phones anyway, you can assume Ballmer and the CFO are happy to see that royalty revenue flow there in order to reduce reported losses. Otherwise, Ballmer would be having to justify the continued investment even harder. 

      • Guest

        I would not assume that at all.  It is much more likely that they are using that royalty income to offset losses on the Windows side of the house, and then E&D get’s whatever’s left.  

        • Guest

          Windows doesn’t have losses. Mobile does.

        • Guest

          “EDD offerings include the Xbox 360 entertainment platform (which
          includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360,
          Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories), Mediaroom (our
          Internet protocol television software), Skype, and Windows Phone, including
          related patent licensing revenue
          .”

  • Guest

    In other words, the new shape pretty much mimics the old shape that prevailed for most of this unit’s existence. Indeed it’s likely the unit is still deeply in the red despite more than twelve years of effort and investment. And with MS now a niche player in mobile, iPhone/iPad disrupting traditional console gaming, and MS’s assorted other efforts like TV having fallen far short of initial expectations, it doesn’t seem like this unit will ever be the revenue or profit engine that MS hoped for at the outset and so desperately needs now. In fact I don’t see where MS’s future growth will come from at all. Apparently they’re either hoping PC sales come back in a big way or resigned to slow/no growth moving forward.

    • Guest

      “Hoping PC sales come back”? They haven’t gone anywhere. Independent researchers expect customers to buy more than 500 million PCs this year, a figure that continues to grow year-over-year, and almost all of them will run Windows 7 or 8.

      Hoping PC sales come back? They never went away!

      • Guest

        Is there some particular reason you decided to ignore responding to the overall content of the comment and instead selectively edited part of it? What I said was come back “in a big way”. The entire comment is about growth rate for the company overall. As currently structured, PC growth rate is the single most important determinant of that. And PC growth is way down.

    • Bob

      Yeah, I’d agree that their long term growth strategy is murky at best. It seems to be more of a survival strategy based on the dubious concept that Apple and Google will eventually tire if MS can just absorb enough body blows in the meantime.  

  • http://ebluar.com/video-games/xbox360-accessories.html Microsoft Xbox 360 Accessories

    Microsoft Xbox 360 has a wonderful profitable consoles. It will bring good revenue for the year.