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Microsoft loses cash on each Surface slab – but core biz strong as ever

You won't go broke selling business software, and Redmond sells lots

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Microsoft again reported solid earnings for the second quarter of its fiscal 2014 on Thursday, beating analyst estimates with figures that in some cases exceeded its own expectations.

Sales were up for Redmond's Devices & Consumer and Commercial divisions alike, for total revenues of $24.5bn (£14.73bn) for the three months ending December 31 – a 14 per cent gain from the year-ago period that raced past the highest estimate gathered by Yahoo! Finance.

Profits similarly showed modest gains, with net income up 3.3 per cent over last year's quarter, to $6.56bn. That translated into diluted earnings of $0.78 per share, which likewise beat the analysts' best estimate.

Curiously enough, the business unit that increased sales the most was Devices & Consumer Hardware, the group that makes Microsoft's own-branded kit. That division posted revenues of $4.73bn for the quarter, a hefty 68 per cent gain from Q2 of 2012.

So Surface sales are up? Yes, but you can't credit them for most of those gains, even given the late-2013 launch of Surface 2 and Surface Pro 2. Although Surface revenue more than doubled since the first quarter, it still accounted for just $893m of the total.

Rather, the lion's share of the Hardware division's $1.9bn revenue hike came from a 54 per cent increase in Xbox sales, owing to the launch of the Xbox One console in time for the holidays. Between Xbox One and Xbox 360, Microsoft says it sold 8.6 million consoles in the first two quarters of fiscal 2014.

That said, even a few billion dollars' worth of sales isn't much to crow about in this segment, given the paper-thin margins on hardware. Gross margins for the Devices & Consumer Hardware group were just $411m, all told, down 46 per cent from the year-ago period because of the cost of manufacturing all of that new gear.

Redmond spent $932m on Surface alone in the quarter, meaning it once again lost money on its fondlesabs, to the tune of $39m. In a conference call with analysts on Thursday, Microsoft CFO Amy Hood dodged the question of what kind of volume it would have to shift for Surface to break even.

Meet the new cash cow, same as the old cash cow

The division that experienced the next strongest revenue gains was Commercial Licensing, the group that covers most of Microsoft's traditional, on-premise business software offerings and Windows sold through Volume Licensing. Sales for this unit totaled $10.9bn, a 7.4 per cent gain from last year's Q2. And unlike the hardware business, most of this money is pure profit; the group posted operating margin of $10.1bn for the quarter, an 8 per cent hike.

The consumer software side was a bit more wobbly, though. Devices & Consumer Licensing revenues – which includes retail and OEM software sales and Windows Phone – shrank 6 per cent to $5.38bn, and the group's operating margin shrank 3 per cent to $4.98bn.

Sales of Office to consumers were down 24 per cent, though Hood said a chunk of that could be attributed to customers switching to Office 365 Home Premium subscriptions, which are reported under a different unit.

But there's no disguising the effect the overall PC market downturn has had on Microsoft's Windows business. Retail and OEM sales of Windows were down 69 per cent from last year's Q2, and while that makes sense given that Windows 8 launched in the year-ago period, it's hardly encouraging.

On a more positive note, Windows Phone revenues increased 50 per cent to $1.02bn. That's good, since Microsoft will soon have the additional burden of moving most of the Windows Phone hardware on the market itself, once its acquisition of Nokia's smartphone business closes later this quarter.

But then again, some portion of those revenues actually comes from licensing Microsoft's mobile phone patents, rather than Windows Phone per se – and Redmond isn't telling how big that portion is.

That leaves Microsoft's two "Other" business units, the ones into which are lumped its various online services and a host of other miscellany, ranging from advertising revenue and sales of Xbox games on the consumer side, to premier support offerings on the commercial side.

Devices & Consumer Other brought in revenues of $1.79bn, a 10 per cent decrease. Worse, its gross margin was down 51 per cent, to $411m. Most of this was down to the fact that Microsoft launched a major video game title, Halo 4, during the year-ago quarter, but Redmond's online ad business struggled, too.

By comparison, revenues for the Commercial Other division were up 28 per cent to $1.78bn, mainly due to strong growth in subscriptions to Microsoft's online business services, including Windows Azure and Office 365 (not including Office 365 Home Premium). Commercial Office 365 revenue, in particular, was up 107 per cent. Gross margin for this division was up 92 per cent to $415m, indicating its promise.

In all, each of Microsoft's new business units looked essentially healthy this quarter, even though some of them face tough market conditions. But the massive weight of the Commercial Licensing division as compared to all of the others proves that for all Redmond's efforts to break into new areas such as hardware and the cloud, it still a company that's very much grounded in the traditional business software model. That could help it or hurt it as we enter calendar year 2014 and beyond. ®

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