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Cold Shower for Microsoft Corporation (MSFT) Investors

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Microsoft Corporation (NASDAQ:MSFT)Microsoft’s latest earnings report, released on 7/18, was a cold shower of disappointment for investors. Microsoft’s share price plummeted 11% the following day.  In retrospect, Microsoft’s reorganization announcement, which many regard as an attempt to remake Microsoft Corporation (NASDAQ:MSFT) in Apple’s image, appears timed to deflect criticism of Microsoft’s Q2 performance. The company has been trying to emulate Apple Inc. (NASDAQ:AAPL) as an integrated devices/software/services company for well over a year, and has come up short when it comes to mobile.

Not all bad

To be sure, the financial news was not all bad, or even mostly bad. Quarterly revenue was up 10.17% year over year and operating income was down only slightly by 5% year over year, excluding the $6.2 billion goodwill impairment charge that Microsoft Corporation (NASDAQ:MSFT) took a year ago to downgrade the value of its Online Services Division (OSD).

Microsoft Corporation (NASDAQ:MSFT) Business Division (home of Office) continues to perform well, with nearly 15% revenue growth year over year and operating income growth of nearly 18%.  Server and Tools also did well, with 8% revenue growth year over year and over 10% operating income growth.

However, in areas where there had been high expectations, such as Windows 8, Windows RT, and Windows Phone, the news was disappointing to financial analysts and investors. The earnings presentation delivered a number of unwelcome shocks to the system:

Shock #1:  Windows OEM Revenue drops 15% year over year

In the Windows Division (WD), revenue declined sequentially by 22.6% to $4.4 billion, while operating income dropped by a whopping 68% to $1.1 billion.  Year over year comparisons for WD weren’t much better: a 6.4% revenue gain offset by a huge 54% operating income drop.

The OEM revenue decline confirmed my hypothesis that Microsoft Corporation (NASDAQ:MSFT) had been pushing discounted Win8 licenses onto OEMs (frontloading) in order to boost claimed sales of Win 8 (recall that it announced that 100 million had been sold as of May).

Right now, corporate licensing of Win7 is carrying the revenue ball for Windows Division, with growth in “double digits.”  The company states that 3/4 of enterprise desktops use Win 7, so by the time MS pulls the plug on Win XP support next year, the other 1/4 should be converted, and this “growth” market will go away.

Shock #2: $900 million inventory write-down for Surface RT

Ever since I wrote “Microsoft’s Mobile Crisis” back in November 2012, I’ve been skeptical about Windows on ARM and pointed to signs that Surface RT was not doing well. Since then Surface RT and Windows RT have been suffering a slow, agonizing death by half measures. IDC reported that just 1.8 million Surface RT and Pro tablets were sold in Q4 2012 and Q1 2013. In the same period, Apple Inc. (NASDAQ:AAPL) sold over 40 million iPads.

Windows RT devices were neither simple and intuitive enough to appeal to consumers who might otherwise buy an iPad, nor capable enough to appeal to mainstream Windows users, since WinRT couldn’t run Windows 7 apps, unlike Windows 8 tablets.

Shock #3:  Entertainment and Devices Division posts an operating loss

EDD, the home of Xbox and Windows Phone 8, suffered a steep 24% sequential revenue decline as well as a 132% operating income decline.  Part of this is just start up costs for the new Xbox One, but clearly Microsoft Corporation (NASDAQ:MSFT) has a profitability problem with Windows Phone. Developing a smartphone OS costs bucks, and right now Microsoft Corporation (NASDAQ:MSFT) has little to show for its investment in Windows 8 Phone.

Because of platform support payments required to bring and keep Nokia Corporation (ADR) (NYSE:NOK) in the W8P fold, Nokia gets W8P for free. This will change if sales volume for Windows Phones ever picks up, but so far they haven’t.  Nokia sold 7.4 million Windows Phones in Q2. In Q4 2012 and Q1 2013, about 12 million Windows 8 Phones were sold, according to Gartner research. In the same period, Apple Inc. (NASDAQ:AAPL) sold 85 million iPhones.

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