surfaceproOne of the luxuries of Microsoft’s longtime focus on software development — and one of the secrets to its financial success over the years — has been the profit margins. The Windows team has traditionally borne the cost of developing the code, without having to worry about the expense of costly hardware and physical components.

That started to change with the release of the Microsoft Surface — for better and worse, as illustrated by the company’s earnings report yesterday.

On the top line, revenue from the Microsoft tablet is one reason why the company’s Windows results looked a lot better at first glance than many people expected. Removing the impact of accounting technicalities, revenue in the Windows division was flat at $4.6 billion compared to the same quarter a year ago. That was a surprise in light of reports that PC shipments were down 14 percent for the quarter, according to IDC.

The Windows division now includes revenue from the Surface tablets — i.e., hardware — which adds up quickly to hundreds of millions in additional revenue even though Surface sales have reportedly been lower than expected.

Here’s the problem: Hardware isn’t a high-margin business, and it can easily be unprofitable, especially in a product’s early days. One chart included in Microsoft’s 10Q filing (Page 29) tells the story — showing Windows operating profit dropping to about $2.4 billion in the March quarter, from nearly $3 billion in the same quarter last year.

Rick Sherlund, a longtime Microsoft analyst who’s now with Nomura Research (who recently downgraded the company’s stock) noted the trend in a report to clients this morning.

About 65% of Windows revenues are from OEM’s and the OEM revenues was down about 15% in the quarter. The negative effects of this on Windows revenues is masked by the inclusion of Surface and Surface Pro hardware in the Windows Division and to a lesser degree the growth of annuity Windows revenues from enterprise customers on Software Assurance (maintenance and support). … To see the effects of adding low margin hardware into the Windows Division, we note that the operating income excluding the tech guarantees was down 20% on a y/y basis for the Windows Division.

Microsoft overall was able to beat Wall Street’s expectations yesterday with an increase in earnings to 72 cents per share. But as the company adopts more of a “devices and services” strategy, this fundamental shift in the bottom line will be fascinating to watch.

PreviouslyMicrosoft profits top expectations, finance chief Klein leaving

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  • Seth Thomas

    If only Microsoft had history building computing devices that ran their own OS. I bet if they did, they would try to create some kind of “premium subscription” in order to access applications like “Netflix” or do social activities like play games with friends. What a folly that would be, it would definitely mark an “X” on their past and be a major flop.

    • Guest

      Actually, if you go back in the 30 years of Microsoft, they have built all kinds of hardware devices. Sure, they are building a tablet for the 1st time, but look at the storied past and you see that they built a ton of hardware. They even built hardware cards that plugged into mother boards that ran CP/M.

      But, that is interesting that they made the number up on expensive hardware compared to selling units of Windows. Interesting play on numbers.

    • Jason Farris

      Like the Xbox360? What a flop that was.

      • Guest

        Are they historically net positive yet? Certainly not a flop, but not quite a raving success either.

        • Guest

          Nevermind, I just looked it up. MS’s Xbox division lost close to $3 billion over the last 10 years. So let’s agree on a popular flop.

          • Jason Farris

            Rolling in the 4.5 billion in losses from Xbox1 as a way of saying Xbox360 is a flop is a bit disingenuous, especially in response to a comment about the 360 specifically.

          • Guest

            Nice try. 1) This is exactly how MS’s own board sees it, they question if the Xbox division is starting to make actual money or not. 2) Even if we only look at Xbox 360 completely isolated, they have yet to become net positive since its introduction in 2005. 3) You can’t just cherry pick one aspect of a product (360 vs Xbox division) and declare that it’s a success. Now THAT’s disingenuous.

            But let’s play your game for chuckles and exclude the supposed “$4.5 billion in losses from Xbox1” from the $3 billion total losses (that would be everything, not just the last 10 years). This would equate to $1.5 billion in net “profits” over say 8 years since the Xbox 360 was launched. Even this ridiculously rose-colored math would merely produce less than $200 million per year from the Xbox. Sure not a raving success so far. But again, you can’t cherry pick like this.

            The Xbox is popular in the US, no doubt. But financially MS would have been overall better off (so far), if they had never entered gaming.

          • guest

            Sunk costs are sunk. Accounting 001.

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