Microsoft Buys Market Share in Consumer Tablets in Q2 2014 with its Surface and Surface 2 Products

Microsoft reported a doubling of sales for its Surface tablets in its Q2 2014 earnings report. As the report illustrates, despite this growth in sales, year over year, the product line is not yet generating profits. In its webcast for the quarter, Amy Hood, Microsoft CFO reported ” . . . sequentially, both units and revenue more than doubled this quarter.” (quoted from Microsoft’s Q2 2014 webcast) Nevertheless, included in the report is a 46% decrease in gross margin, to $411 million, for the Surface and Xbox product lines. A slide was presented depicting this year over year decline, during Chris Suh’s portion of the presentation, but he added no verbal commentary on this point.

Heather Bellini, an Analyst from Goldman Sachs, put the broad product margin question on the table during the question and answer session. She asked Amy Hood, CFO ” . . . How do you see the gross margin profile of the company changing as [Microsoft] continues [its] journey to a devices and services company? And as you look out to when the transition is complete, [understanding] you probably don’t know when that’s going to occur, how do we think about what it will look like?”

Amy Hood audibly hesitated prior to answering this question, as if to illustrate how big a question Ms. Bellini had asked. Ms. Hood’s answer began with a citation of where Microsoft’s margin is holding up very nicely, namely, for its Commercial Segment. Despite ” . . . investments in infrastructure . . .” ” . . . our actual gross margin remains flat”. The infrastructure investments were made for the commercial cloud business, where Microsoft, Ms. Hood notes, ” . . . continues to see traction.” She goes onto sum up the impact of commercial cloud business for Microsoft. From her vantage point ” . . . moving to the cloud is a net positive” for the company, and will be a significant contributor to net profit.

She characterized the commercial segment, which maintains an 83% gross margin, as a ” . . . separate bucket from [Microsoft’s] Devices and Consumer (DC) business.” The Surface products are included in this segment. But Ms. Hood’s response, while noting the Surface products are a “separate model”, within this segment, from the XBoxOne product, which, historically, has proven to be ” . . . margin negative at the front . . . “, did not provide a specific comment on the details of how this product is differentiated from the Xbox line within this segment.

Keith Weiss, Morgan Stanley, added another question on the gross margin topic, this one pointed clearly to the DC business: How did this segment exceed expectations and year over year performance for the gross margin metric? Ms. Hood’s answer included an acknowledgement of ” . . . increased COGS [Cost of Goods Sold] . . . ” for the segment.

So the comment by Nick Wingfield of the New York Times, ” . . . The bad, though, is that Microsoft’s gross profit from the hardware business actually fell to $411 million, compared with $762 million a year ago, despite the surge in sales.” (quoted from Mr. Wingfield’s article Microsoft Earnings Illustrate Move to Devices and Services From Software) is entirely accurate and a worthwhile summary of the real cost of entry for this company as it builds a base in an entirely new market — consumer devices.

But it’s also very important to keep in mind the vitality of the commercial software segment and, in particular, the commercial cloud segment. If this segment continues its strong performance for the next few quarters (and I see no reason why it wouldn’t), then the substantial cost of entry will likely be subsidized, which can only be good news for investors. Disclaimer: I am long Microsoft.

Ira Michael Blonder

© IMB Enterprises, Inc. & Ira Michael Blonder, 2013 All Rights Reserved

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