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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

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