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Microsoft Strikes Back

by Mark W. Hibben
8/5/11

Microsoft's Counter-offensive in the Mobile Internet Wars

Microsoft managed to end its Fiscal Year 2011 on a positive note, pulling out of the nose-dive of the third quarter and posting respectable, if not stellar, revenue and operating income gains for the year.  Annual revenue was up 12% to US$ 69.9 B and annual operating income was up 13% to US$ 27.2 B, which appeared to mollify investors and analysts alike.  To be sure, there are things that Microsoft is doing right: Windows 7 and Office '10 continue to do well in the business world, and Xbox is a hit.  But Microsoft has serious financial problems in the area of phones, tablets and search, problems which receive scant or zero acknowledgement at the Press Release level.  In this article I mine the data available in Microsoft's SEC filings for additional insight into the financial severity of these problems as well as look ahead to some of Microsoft's actions to address them: primarily the release of Windows 8 and the Nokia alliance. 

Segment by Segment

Unlike the press releases, the SEC filings provide more detailed insight into the financial performance of Microsoft's five segments: Windows and Windows Live, Server and Tools, Online Services, Microsoft Business (home of Office), Entertainment and Devices (home of Xbox and Win7 Phone).  In the SEC filings can be found a quarter by quarter breakdown not only of revenue for each segment but operating income as well.  Segment quarterly operating income is to be found nowhere else in Microsoft's published financial data.  In the tables below I summarize the Fiscal Q4 2011 revenue and operating income per segment, providing sequential and year over year quarterly comparisons:

Segment Q4 2011 Revenue US$ Q4 2011 Operating Income US$ Q3 2011 Revenue US$ Q3 2011 Operating Income US$ Sequential Revenue % Change Sequential Op. Income % Change
Windows and Windows Live 4.695E+09 2.866E+09 4.393E+09 2.708E+09 6.9% 5.8%
Server and Tools 4.646E+09 1.716E+09 4.107E+09 1.385E+09 13.1% 23.9%
Online Services 6.620E+08 -7.550E+08 6.480E+08 -7.430E+08 2.2% -1.6%
Microsoft Business 5.812E+09 3.624E+09 5.266E+09 3.164E+09 10.4% 14.5%
Entertainment and Devices 1.396E+09 -5.300E+07 1.898E+09 1.870E+08 -26.4% -128.3%
Segment Q4 2011 Revenue US$ Q4 2011 Operating Income US$ Q4 2010 Revenue US$ Q4 2010 Operating Income US$ Y/Y Revenue % Change Y/Y Op. Income % Change
Windows and Windows Live 4.695E+09 2.866E+09 4.460E+09 2.897E+09 5.3% -1.1%
Server and Tools 4.646E+09 1.716E+09 4.016E+09 1.343E+09 15.7% 27.8%
Online Services 6.620E+08 -7.550E+08 5.660E+08 -7.290E+08 17.0% -3.6%
Microsoft Business 5.812E+09 3.624E+09 5.203E+09 3.089E+09 11.7% 17.3%
Entertainment and Devices 1.396E+09 -5.300E+07 1.615E+09 -2.020E+08 -13.6% 73.8%

The astute (and industrious) reader may notice some discrepancies between the revenue numbers in the tables and quarterly segment revenues reported in the conference call slide presentation of 7/21/11.  This is because the numbers in the slides are GAAP compliant, whereas the numbers in the SEC 10K for the 2011 fiscal year are not.  In the 10K, Microsoft doesn't bother to provide GAAP reconciliation at the segment level, but I still regard the data as valuable since it breaks out segment operating income. 

One of the surprises of the data mining exercise was the quarterly operating loss in the Entertainment and Devices Segment in Q4, which I think is indicative of the financial stress the segment has come under as a result of Windows Phone losses.  Virtually all of the revenue reported by the segment for 2011, US$ 8.716 B (non-GAAP), was due to the Xbox 360 platform, which the filing states contributed US$ 8.103 B (non-GAAP).  Although Microsoft has stopped talking about sales of Win 7 Phones, the number can't be very large.  E&D did well overall for the year, posting operating income of US$ 1.135 B (non-GAAP), with a reduction in income coming in the fiscal third quarter (calendar Q1 2011), just as the losses due to Win 7 Phone were starting to hit.  These losses may continue to mount in the coming quarters as Microsoft and Nokia prepare to roll out new, hopefully more popular, phones based on Windows Phone "Mango" while at the same time having little phone revenue to draw upon. 

Another obvious area of concern is the continuing operating loss in the Online Services Segment.  It's not just the fact of a loss, it's the fact that the loss keeps getting bigger, and is bigger than the segment revenue.  Microsoft have been trying to figure out how to make search profitable for two years now, without success.  Analysts have been remarkably forgiving of this misadventure, which might be understandable if there were some sign of improvement, but there isn't any.  Microsoft management like to highlight the fact that the segment revenues are increasing, year over year, but so are the operating losses.  As the summary table (next panel) shows (this time GAAP compliant), Online Services has been the only money-losing segment for the past two years.


Segment
2011 GAAP Revenue US$ 2011 GAAP Op. Income US$ 2010 GAAP Revenue US$ 2010 GAAP Op. Income US$ Y/Y Revenue % Change Y/Y Op. Income % Change
             
Windows and Windows Live 1.902E+10 1.228E+10 1.949E+10 1.303E+10 -2.4% -5.8%
Server and Tools 1.710E+10 6.608E+09 1.538E+10 5.539E+09 11.2% 19.3%
Online Services 2.528E+09 -2.557E+09 2.201E+09 -2.337E+09 14.9% -9.4%
Microsoft Business 2.219E+10 1.412E+10 1.908E+10 1.137E+10 16.3% 24.3%
Entertainment and Devices 8.913E+09 1.324E+09 6.168E+09 6.180E+08 44.5% 114.2%

 

Microsoft management have generally passed off the decline in their flagship Windows segment as due to the overall slowdown in consumer PC sales, acknowledging the 2% decline for the year.  But this obscures a fact that Apple have harped on (almost ad nauseum)  that consumer interest has shifted away from desktops to mobile and ultra-mobile devices.  Here, Windows declines are being impacted by the failure of the Netbook strategy and the failure to field a credible Windows tablet more than a year after the iPad launch.  But Microsoft have not been sitting on their hands, and are poised to launch Windows 8.  Microsoft's fortunes in the War for Mobile Internet Supremacy (WMIS) will rest mainly on Windows 8 in the coming year.

Windows 8

Windows 8 was demonstrated by Mike Angiulo at COMPUTEX 2011 on June 2.  It represents a very different strategy than Apple's approach (both in a business and technical sense) for implementing a touchscreen based user interface in an operating system.  Apple has neatly segregated in iOS touchscreen devices such as the iPhone and iPad from its Mac OS X computers.  How Apple's two operating systems map into the larger space of computing devices I've tried to illustrate with the diagram on the next panel.

There's no overlap of functionality in the Apple personal computing universe, which according to Jobs is completely deliberate.  Apple had done ergonomic studies on touchscreen enabled desktops and discovered, unsurprisingly, that people stop using the touchscreen after about a half hour as their arms get tired.  Thus, desktop and laptop users have a large trackpad that they can use comfortably with the pad placed horizontally rather than vertically.  Apple has also confined Mac OS X to Intel 64 bit processors, where the greater computational power of the processors supports OS X multitasking to good effect.  On the other hand, iOS runs only on the less powerful (and less power hungry) 32 bit ARM processors and focuses exclusively on the touchscreen interface.  Both OS's work reliably and are relatively efficient in their use of non-volatile storage space.  For instance, OS X 10.6.8 only takes up about 5 GB on my Mac drive, while iOS 4.3 takes up about 1 GB in my iPad flash storage.

Like Apple, Microsoft has created a dedicated touchscreen based OS for ARM processors, Windows 7 Phone, but unlike Apple, this OS is not being expanded in scope to include tablet devices.  Instead, a new touch based user interface has been overlaid on Windows, while at the same time the processor scope of Windows has been broadened to include ARM 32 bit processors.  The mapping of Microsoft OS functionality is illustrated in the diagram on the next panel.

Ever since Windows on ARM was announced at CES in January 2011, Microsoft have been acting as though ARM was just another processor, like Intel or AMD, and that Windows 8 would be an all encompassing OS.  Whether Microsoft will actually market Windows 8 that way remains to be seen.  The instruction sets for Intel and ARM are fundamentally different, so that for all practical purposes, the ARM and Intel-compatible versions of Windows 8 are separate products.  But there's nothing keeping Microsoft from putting the ARM version in the same box just as the x86 and x64 versions are packaged together in retail versions of Windows 7.  Still, I expect that Windows 8 for ARM will come out as a separate product, if only because ARM development seems to be lagging that of Intel, and Microsoft won't want to delay the roll-out of Windows 8 just so ARM development can catch up. 

Microsoft seems to be taking a classic shot gun approach to its re-entry into ultra-portable computing, with a do-everything Windows OS.  The new touch interface is overlaid on top of the traditional Windows OS, allowing the user to switch back and forth at will between the touch UI and the classic Windows desktop.  One can only wonder how many additional megabytes of needed storage this will add to what is already a bulky installation (my 64 bit version of Win 7 tops out at 16.1 GB). 

In the brief demonstration, the UI seemed to be reliable and well thought out, with user controls that slide out from the sides for the OS and slide from top or bottom for applications.  The touch home screen features application tiles reminiscent of Windows 7 Phone in that they update live, and are accessed on multiple screens by swiping side-to side.  So at least there's some UI consistency between Win 7 Phone and the Windows 8 touch UI. 

I honestly can't make up my mind about which is the better approach, Apple's or Microsoft's, to creating a touch-enabled OS.  Although Apple's approach seems cleaner, they may well have omitted some promising device space, specifically Intel-based tablets.  I've always missed the greater power of the Intel processors, and felt that a more powerful (than ARM) processor in a tablet could make the device more generally usable as a substitute for a desktop PC.  Of course, this is a space that Apple could still expand into in the future.  For the time being, Apple seems content to promote the MacBook Air for those wanting Intel power in an ultra-portable package.  On the other hand, I don't regard ARM-based notebooks as at all compelling.  Given that ARM processors (even with dual cores) are even wimpier than Intel Atoms (also available in dual cores), why would anyone bother with an ARM netbook?  The extra battery life?  Oh come on.  This will be the last gasp for netbooks, may they rest in peace.  The 32 bit ARM processors will certainly creak and strain under the load of having to support the Windows 8 approach of providing touch and conventional UIs in a single OS.  This applies whether the ARM processor runs a netbook or a tablet. This may prove to be the fundamental shortcoming of the Windows 8 "be everything to everybody" approach.   We'll just have to see.  If Win 8 doesn't work well on ARM, then Microsoft will have ceded most of the tablet market to Apple (and Google) permanently.  They won't get a third chance. 

Windows Phone

On July 26, 2011, the next version of Windows Phone, codenamed "Mango" was released to manufacturing, which means it should be available for Windows 7 Phone handsets some time this fall.  It has a lot of nice new features such as app multi-tasking, and a hardware accelerated IE 9, which does seem very fast.  But the success, or for the time being apparent failure, of Windows Phone doesn't seem to have much to do with the virtues of its OS.  It's all about the ecosystem, the integration of OS, apps, services and user community that contribute to the overall user experience.  For the ecosystem to be successful, a certain critical mass is required in all of the aforementioned categories.   When the iPhone was all by itself, that critical mass for users was probably pretty small, in the 10-50 M range.   However, with Google and Apple competing for the attention of software and hardware developers as well as the consumer, that bar has been raised considerably.  I would estimate that the critical mass (for profitability) of Win 7 Phone users to be about 100 M, keeping in mind that the worldwide population of iOS devices is over 200 M and Android devices over 120 M. 

This is what Microsoft desperately needed Nokia for, a large base of customers willing to upgrade to Win 7 Phone.  It's not clear that Nokia can actually deliver their customer base into the waiting arms of Microsoft.  There's no easy upgrade path, other than to buy a new Win 7 Phone.  MS-Nokia will need to discount Win 7 Phone purchases for existing Nokia/Symbian smart phone users, a potentially expensive proposition that will further cut into E&D operating income.  I wouldn't be at all surprised if Microsoft has two money-losing segments on its hands next quarter.

  • 1.
    Point
    Man
  • 2.
    Segment Incomes
  • 3.
    E&D Loss
  • 4.
    Windows
    8
  • 5.
    Apple OS Map
  • 6.
    MS OS Map
  • 7.
    Netbooks RIP
  • 8.
    Nokia Win Phone
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