Microsoft's new financial reporting format makes it much harder to get a grip on how two of its most important software franchises, Windows and Office, are performing, an analyst said last week.
And the company did that deliberately, contended Rajani Singh of IDC.
"There's no way we can figure out how Windows and Office are doing," Singh said. "They're purposefully using the new format to cover the ailing Windows client business. They are gradually transitioning to the new strategy, and although Surface RT has done relatively well, better than we expected, in the meantime they have to cover the ailing Windows division. They've tried to hide it a bit by spreading it into several segments."
Singh was referring to the new format that Microsoft used for the first time Thursday as it reported third-quarter revenue of $18.5 billion, or about $700 million more than Wall Street expected.
The format changes were made after Microsoft announced this summer that it would reorganise the company by dumping the product-specific divisions - including one for Windows, another responsible for Office - and instead mashing multiple products into new groups, and in some cases dividing revenue from one product line into several of those groups.
Microsoft is now organised into two large divisions - Devices and Consumer (D&C) and Commercial - that, in turn, are split into three and two buckets, respectively. Windows revenue, which was previously reported in a single division, now appears in three of the five buckets: D&C Hardware, which contains the Surface tablet line; D&C Licensing, where sales of Windows to computer makers is reported; and the Commercial division's Licensing group, which includes sales of Windows to large enterprise customers as well as Windows revenue from Software Assurance, an annuity-like programme that gives customers the right to upgrade to newer editions.
"There's no way we can figure it all out," said Singh, of wrestling with the new format in an attempt to parse Windows' performance.
Fortunately, Microsoft also listed the third-quarter numbers in the old format for comparison purposes. It's not clear how long it will continue to report revenue in both the old and new formats, however.
In the old format, Windows generated $4.6 billion, up 4% from the same period in 2012 and triple what Microsoft told Wall Street in July to expect, when it forecast a 2% decline. But operating income - earnings before taxes - sunk to $2.2 billion, a decline of 20% from last year.
On October 24, Microsoft credited the better-than-anticipated revenue to increased sales of its Surface tablets, particularly the heavily discounted Surface RT; a 6% growth in Windows licensing to OEMs for business PCs; and to some extent, the ramp-up for the holiday selling season by computer manufacturers, which built up inventory for expected sales in November and December. Overall, however, Windows sales to OEMs (original equipment manufacturers) were down 7% from the year before because of a major slide of 22% on the consumer side.
Singh pointed out that while Windows revenue was up, profits were down: Windows' operating income, as reported in the old format, was down 20% from last year's $2.8 billion.
That wasn't unexpected, as hardware like the Surface incurs much higher costs than does software. The more Microsoft shifts to a device strategy - selling its own hardware - the higher those costs will climb. "The more you are into hardware, the lower the margin," Singh said. "The bottom line will go down as their product mix changes."
Amy Hood, Microsoft's chief financial officer, echoed that in the call with analysts. "In Devices and Consumer, the sequential change in gross margin dollars reflects the progress we are making towards our strategy of delivering a compelling family of devices and services," she said.
Surface revenue jumped to $400 million, Microsoft said in accompanying documents released last week, and the company sold twice as many of the tablets as in the second quarter. However, the company has never disclosed unit sales for the tablet line, so it's tough to suss out sales from the revenue number, what with aggressive price cuts to the Surface RT during the period, and less-dramatic discounts for the high-priced Surface Pro.
Office revenue was even harder to analyze under the new reporting regime, as sales - once limited to the Microsoft Business Division (MBD) - have been split between four of the five buckets: D&C Licensing, where consumers sales are allocated; D&C Other, which includes Office 365 Home Premium subscriptions, now up to two million; Commercial Licensing, where volume Office sales and Software Assurance income are recorded; and Commercial Other, which books enterprise Office 365 subscriptions.
According to the old format, MBD revenue - the vast bulk of it derived from Office - was up 5% over the same quarter of 2012, reaching $6 billion, with operating income up 1% to $3.9 billion. Both numbers were the largest for any of the old divisions, with MBD accounting for 32% of total revenue and 60% of all operating income.
But teasing that out of the new reporting format was nigh impossible. "There's no way to find out Windows or Office performance using the new format," said Singh.
Singh wasn't the first to contrast Microsoft's promise that the new format would be more transparent with the reality of number crunching. Last month, others, including Michael Cherry of Directions on Microsoft and Al Gillen of IDC, said the new financial reporting structure was opaque.
"Lumping all software products into two broad categories makes it difficult, if not impossible, to see how any individual software product is doing," Gillen said of the D&C and Commercial divisions.
Some of what boosted Windows revenue in the quarter, Singh said, was not sustainable after the next six months.
"They are getting volume license renewals as XP heads to retirement, which will certainly also help in Q4 2013 and Q1 2014," Singh said, referring to the last push by enterprises to ditch Windows XP and migrate to Windows 7. Sales of Windows licenses to PC makers for business PCs were also up 6% in the quarter that ended September 30, another indication of a late rush to retire XP.
And while Singh was impressed by Microsoft's results, even more hinges on the current quarter, which ends December 31, if it's to prove to investors that the new devices-and-services strategy is bearing fruit.
"On the consumer side, the next quarter, where more PC shipments are recorded than any other, is the very most important in PCs and also in tablets," Singh said. "Q1 is also important, as the post-holiday quarter where consumers look for discounts and sellers get rid of excess inventory."
Microsoft's own Surface tablet strategy will be especially on the line. If the company can sell significant numbers of the tablets, it will show that the move was smart.
"We saw a lot of progress in sales execution on Surface in particular this quarter," said Hood last week. "And that does give us more confidence about our ability to execute again well in Q4. In particular, as you know, our RT did do quite well this quarter. And I look forward to seeing that continue with the Surface 2 device, as well, in holiday."
Hood tacitly acknowledged that Surface Pro - the more expensive model powered by Windows 8 Pro, not the touch-only Windows RT, which runs on the Surface RT and the new Surface 2 - did poorly during the quarter. "With Surface Pro, we saw some customers delay purchase in anticipation of Surface Pro 2, which delivers significantly improved battery and processor performance," Hood said.
"I think they're being a bit too optimistic about the Surface and the fourth quarter," countered Singh. "I don't think it's going to be as great as they're thinking." She based her analysis on what she sees as very tough competition in the tablet market from Apple's new iPad and iPad Mini models, from inexpensive Chromebooks from the likes of HP, and even from Microsoft's own OEM partners.
Hood noted that the 32GB Surface RT sold particularly well in the consumer and education markets; those are prime territories for the iPad and Chromebooks, respectively, Singh argued.
Outgoing CEO Steve Ballmer pivoted to a new corporate strategy and reorganised the firm's structure in the throes of an historic contraction in personal computer shipments, which have now shrunk six straight quarters. Windows revenue has always been tied to sales of new PCs, since two-thirds of the licenses have been sold to OEMs, not directly to customers. And increases in Office sales have also been linked to PC sales.
To keep growing, Microsoft must somehow make up for the slowing Windows and Office revenue streams with others. Ballmer's answer was to reinvent the company, turning it from a purveyor of packaged software into a provider of hardware devices and cloud-hosted services.
The latter was the most successful last quarter, as server software like SharePoint, Exchange and Lync grew by double digits, and enterprise cloud services, including Office 365 and Azure, jumped 100%. Under the old reporting format, the Server and Tools division posted an 11% revenue increase.
Singh was impressed with the third-quarter results, but withheld judgment about the strategic shift's success. "Overall, they have done well, but this is going to be bumpy," she concluded.