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A small footnote in a new Microsoft filing reveals a big trend: Windows, the PC operating system that fueled the company’s rise as a tech giant, is falling further behind the Microsoft product lines that are shifting more aggressively to the new world of software subscriptions and cloud services.

Microsoft is releasing its Windows 10 Anniversary Update today, with updated features designed to spark new interest in the operating system, especially among companies and people running older Windows versions. But the trend points to the need for a more radical change in the Windows business.

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The new numbers, from Microsoft’s annual 10-K filing with the Securities and Exchange Commission, show Microsoft’s revenue by product line in new detail. The clear leader now is Office, with $23.6 billion in revenue in the fiscal year ended June 30, up slightly from the year before, according to the filing. But catching up fast is server products and tools, with $19.2 billion in revenue for the year, up from $18.6 billion in 2015.

Windows was third in annual revenue, at $14.7 billion, after adding back in the $6.6 billion deferred because of accounting rules related to the Windows 10 rollout. That was down from $14.8 billion in 2015, and more than $18 billion at its peak in 2010, according to historical filings.

Microsoft CEO Satya Nadella at the Windows 10 consumer unveiling in January.
Microsoft CEO Satya Nadella at the Windows 10 unveiling in January 2015. (GeekWire File Photo)

The trend, as shown in the chart above, demonstrates the importance of Microsoft’s transition to cloud technologies and services under CEO Satya Nadella. The rise of the Azure cloud computing platform is lifting Microsoft’s server product and tools business. The Office 365 subscription service and mobile apps have likewise kept the company’s overall Office business relevant in this new world, and the company is banking on its $26.2 billion LinkedIn acquisition to keep that momentum going.

The company tried a different approach with the Windows 10 introduction, offering free upgrades for a year to people running Windows 7 and Windows 8.1, which naturally impacted revenue. But the drop in Windows revenue also reflects the decline of the traditional PC market. Global PC shipments are expected to decline by 7.3 percent this year, 2 points worse than previously expected, according to the IDC research firm.

Microsoft recently acknowledged that it’s unlikely to reach its previous goal of having 1 billion devices running Windows 10 within two or three years of the operating system’s 2015 release.

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“What’s happening on Windows is that the PC market is declining rapidly, and most Windows revenue still comes from sales with new PCs,” said analyst Rob Helm, managing vice president at the Directions on Microsoft research firm.

He explained, “Microsoft is trying to compensate by getting companies to buy premium editions of Windows on subscription, like the Windows Enterprise E5 it rolled out (this week). It will be a while before it takes effect: Businesses have been slower than consumers to move to Windows 10, which is where the new editions are being rolled out.”

Another sign of the change: Microsoft now refers to Windows usage based on “monthly active devices,” a metric more common to an online service than to a traditional software licensing model. The company refers to “Windows as a service” and is making regular updates to the operating system. But it’s stopping short of offering Windows as a consumer subscription service.

With more than 350 million active devices, Windows 10 represents “the fastest adoption rate of any prior Windows release,” Nadella said during Microsoft’s earnings conference call last week. In the year since its release, Windows 10 has risen to more than 21 percent of the desktop PC market, according to the latest data from NetMarketShare. That’s more than twice the combined market share of Windows 8 and 8.1. Windows 7 still has more than 47 percent of the market.

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Chart: NetMarketShare

However, the newly disclosed product results reveal a clear trend of the Windows business shrinking, as measured by revenue.

The numbers were disclosed on page 93 of Microsoft’s annual 10-K filing with the Securities and Exchange commission last week, providing an unusually clear long-term view of the performance of the company’s major product lines. Microsoft’s numerous reorganizations and financial reporting changes — splitting up major product lines into divisions such as “Productivity and Business Processes” and “More Personal Computing” — have made it more difficult to track Microsoft’s well-known products.

However, the footnote called “Revenue from external customers, classified by significant product and service offerings,” has been consistent in the 10-K filings for several years, making it possible to trace the revenue from those products back to 2008.

Microsoft’s overall revenue for the June 30 fiscal year was just under $92 billion, after adding back in the Windows 10 revenue deferrals. That was down from $93.5 billion the year before. The company reported $23.3 billion in annual profit, after adjusting for the deferrals, up from $21.7 billion the year before.

In addition to the trends among Microsoft’s biggest product lines, the filing confirms a surge in the company’s advertising business, as Microsoft’s Bing search engine has boosted its market share. Advertising revenue topped $6 billion for the year, up from $4.5 billion a year before. That was more than 40 percent of Windows revenue — and if the trends continue, that ratio will only go up from here as a new Microsoft emerges.

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