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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.

But while device revenue was up — Microsoft's Hood gave a nod to "a successful holiday" — so were costs.

The Hardware group's gross margin was just $411 million, down 46% from the same quarter in 2012 because of a 111% increase in the cost of revenue, which Microsoft said takes into account cost of goods, assembly, distribution and marketing. Again, the Xbox accounted for most of the additional costs — and thus the decline in the margin — because of the larger console sales volume and, of course, the new Xbox One's launch.

The Surface actually earned less in revenue than the cost of that revenue, Microsoft admitted, pegging the gap between the two at $39 million.

Overall, the Hardware division's margin as expressed as a percentage was about 9%. For every $100 Microsoft collected on hardware, it retained $9. That's low for premium-priced goods like the Xbox and Surface, low compared to Apple's gross margin, which has hovered in the mid-30s, and strikingly low — just a tenth as much — compared to the company's software margins.

"You can't run a super-successful hardware business with gross margins at 10% or lower," said Moorhead, who before he became an analyst worked at both Compaq and chip-maker AMD.

Also troubling for Microsoft's device strategy was that the 9% gross margin for Q4 was only a third that of the same period in 2012, when Microsoft launched the first-generation Surface tablets and retained 27% of each dollar of revenue. The trend has been downward since the Surface debut, with gross margin for the Hardware unit falling to 22% by June 2013, then slumping again to 14% in September before sliding to 9% for the year's fourth quarter.

Moorhead, however, urged patience, saying that one should think of Surface specifically, and Microsoft's Hardware group in general, as a start-up, even though its biggest money maker, the Xbox, has been around 12 years.

"I wouldn't expect them to be profitable for a few years in hardware," said Moorhead, speaking specifically of the Surface line. "You just cannot make money without scale. And to get that, Microsoft would have to selling tens of millions of Surface tablets."

The gross margin for Microsoft's Devices & Consumer Hardware unit, which produces most of its revenue from sales of Xbox and Surface devices, has steadily fallen over the last six quarters. (Data: Microsoft, SEC filings.)

Microsoft's Hood wasn't as explicit as Moorhead — no surprise — but she said something similar last week. "I do think it's more to think about it as a goal we absolutely have," Hood said of future Surface profitability.

Hood dodged a question from Brad Reback, an analyst with Stifel Nicolaus, who wanted to know what Surface sales volume would put the business in the black.


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