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Microsoft's quandary: Big profits from software or shrinking margins with devices

Gregg Keizer | Jan. 28, 2014
Company's Q4 financials illustrate the hit Ballmer's strategy takes on gross margins.

"In a general way, they're using hardware as a loss leader," said Patrick Moorhead, principal analyst at Moor Insights & Strategy, after studying Microsoft's financial statements and spreadsheets. "The Surface, for example, is more of a PC than a tablet, and PCs have smaller gross margins [than tablets]."

Rajani Singh, of research firm IDC, concurred.

"Cost of revenue is high in any device manufacturing segment because fixed costs, works-in-progress and overhead are very high," she said in an email reply to questions. "But the Surface looks like a loss-making venture, unless there are accrual revenue associated with the Surface business, which Microsoft has not mentioned anywhere."

For the fourth quarter of 2013, Microsoft booked record revenue of $24.5 billion, representing a year-over-year increase of 14.3%. But the company's profit rose just 2.8%, to $6.6 billion.

Microsoft chart
The vast bulk of Microsoft's gross margin — an indicator of profitability — came from its software sales, while other businesses, including its hardware efforts, generated next to nothing. (Data: Microsoft, SEC filings.)

Much of the gap between those gains was attributed to the Devices & Consumer Hardware unit, which under Microsoft's new corporate structure is responsible for the Xbox and Surface, some video game royalties, Xbox Live subscription revenue, and PC and Xbox accessories like Microsoft's keyboards and controllers.

Unlike software, which historically generates very high margins — with costs that approach zero for each additional unit once development has been amortized — component and distribution costs for hardware not only never vanish but result in much smaller profits, especially at the beginning of a product's lifecycle when a vendor cannot capitalize on large-scale component orders or leverage high sales volume to squeeze distributors and retailers.

The trick is to reap the large revenue that hardware can generate, but also produce significant profits. Among device manufacturers, only Apple has been able to consistently do both, though more recently Samsung has proven capable of the same with its consumer-driven smartphones and tablets.

Last quarter, Microsoft showed in spades how tough it is to mimic those rivals.

The Devices & Consumer Hardware group posted sales of $4.7 billion, up a whopping 68% from the same quarter a year earlier. Microsoft credited the Xbox for nearly two-thirds of that revenue jump, particularly the launch of the Xbox One, which sold 3.9 million consoles in less than half the quarter. Microsoft also sold 3.5 million of the older Xbox 360 in the three-month stretch.

For the Surface, revenue rose even sharper, climbing to $893 million, or up 123% when compared to the third quarter, not the usual year-before period. Although Microsoft did not disclose unit sales — it has never revealed them for its tablet line — it said they also more than doubled over the previous quarter.


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