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On Thursday, Microsoft announced fiscal fourth-quarter earnings that missed Wall Street estimates by a significant margin. The company also announced a $900 million write-down related to unsold Surface RT inventory, a revelation that exposes the desperate subtext of the product's recent $150 price cut.
Overall, Microsoft's posted $19.9 billion in sales, with earnings of 59 cents per share. Analysts had expected revenue of $20.7 billion and earnings of 75 cents per share. Investors lost 7 cents due to the Surface charge.
[ Not everybody cares about Windows 8. Read Microsoft's XP Eulogy: Not Everyone's Listening. ]
Last week, Microsoft CEO Steve Ballmer unveiled a sweeping company restructuring. Dubbed "One Microsoft," the plan is designed to make the company more collaborative, such that it delivers products more quickly, and creates better synergies among the various platforms and devices in the Windows ecosystem.
In hindsight, the plan telegraphed the disappointing financials. CFO Amy Hood, leading her first conference call since replacing Peter Klein in May, conceded as much. She said Microsoft "needs to do better," and that the recent reorg will help the company to do so.
Now that the PC market has finally revealed some of Microsoft's vulnerabilities, investors and IT observers have a better sense of not only the challenges Steve Ballmer and his re-organized company will face, but also some of the new strengths that are already developing.
Here are nine major takeaways from Microsoft's lousy earnings report.
1. Microsoft remains a very profitable company.
Microsoft had a surprisingly bad quarter, but revenue was still up 10% year-over-year. The company continues to dominate important enterprise markets, and to build reliable, multi-billion dollar revenue streams
2. Windows has never been this vulnerable.
To be clear, "vulnerable" is a relative term. Windows will be at the core of hundreds of millions of enterprises for years to come.
But Microsoft's empire was built by leveraging the ubiquity of Windows, both in the office and among consumers. If consumers reject Windows 8 for other platforms, particularly on tablets, then Microsoft's core business can only recede. There's a line that separates a huge business from a de facto monopoly, and Microsoft could soon learn the difference.
For the quarter, Windows Division revenue grew 6%, but this includes deferred revenue from a previous Windows Upgrade Offer. If this sum is subtracted, Windows sales actually declined 6%. This confirms what market share reports had already indicated: Windows 8 hasn't sold well in general, and in the months since promotional pricing ended, the OS really hasn't sold well.
Consumers might not be the only problem; Windows XP users aren't upgrading as fast as Microsoft would like, meaning that hundreds of millions of potential Windows 7 and Windows 8 licensees are still in flux.
3. The Surface RT is an epic flop.
Microsoft's Surface RT write-down confirms that buyers have rejected the much-hyped tablet -- but most observers had already assumed as much. But a $900 million write-down -- a jaw-droppingly huge figure -- was a surprise.
Based on Microsoft's disclosure, Alex Wilhelm, a reporter with The Next Web, estimated on his blog that Microsoft has between 3 million and 6 million unsold Surface RT tablets. If Microsoft actually produced anywhere near this much inventory, the company misread the consumer market by a comical degree.
CFO Hood said the Surface RT's price reduction will accelerate the tablet's adoption. But the device is still more expensive and less consumer-friendly than many competing tablets.
Hood attributed poor Windows sales to the ongoing PC slump, but she noted that Microsoft's enterprise products continue to generate high demand. The Business Division grew 14% relative to Q4 of last year, thanks to strong Office 365 and server product sales. But this growth included deferred revenue from an Office Upgrade Offer. With that sum omitted, the division's revenue grew by only 2%.
The Server & Tools division, meanwhile, grew 9%, thanks to strong performances from SQL Server and System Center products. Wall Street analysts had expected the division to grow by 12%, however, showing that in this quarter, even Microsoft's victories are tinged with disappointment.
[ Will price cuts make a big difference? Read Microsoft's Cheaper Surface Tablet: 8 Key Facts. ]
On the bright side, Microsoft recently announced that its data centers include more than 1 million servers, demonstrating that the company is willing to take on all comers in the cloud market.
5. Office 365 is doing great, but the larger Office business is a mixed bag.
When Microsoft announced Q3 results a few months ago, the company said Office 365 was on track to generate $1 billion annually. On Thursday, Microsoft said that its cloud-oriented, subscription-based version of Office is now on pace for revenue of $1.5 billion per year. The rapid growth represents fantastic progress, especially since recurring subscriptions will positively influence Microsoft's bottom line for years to come.
That said, Hood noted that the depressed PC market is hurting Office sales. As mentioned above, the productivity suite's revenues were somewhat inflated due to sales carried over from an Office Upgrade Offer. If this value, which totals almost $800 million, had been excluded from Thursday's report, per-share earnings would have dropped by 7 cents to 52 cents.
6. Microsoft is generating money from mobile phones -- but maybe not Windows phones.
Nokia, the primary maker of Windows Phone 8 devices, continues to lose money, but its recent earnings were still better than expected because of the strong performance of its Lumia handsets, which run Microsoft's smartphone OS.
As a result, Windows Phone revenue increased $222 million during the fourth quarter, though it's not clear how much of that is related to patent royalties Microsoft receives for Android devices. Even so, Microsoft has eclipsed BlackBerry as the third largest smartphone player. It's a long way behind Android and iOS, but Microsoft still has a foundation to build from.
7. Microsoft's OEM relationships are a mess.
Microsoft's OEM relationships have been strained since at least last year. Some partners didn't appreciate when Microsoft entered the hardware game with its Surface tablets. Almost all of them have abandoned Windows RT.
Shortly before Microsoft announced its earnings, Lenovo become the newest Win RT defector. The company's Yoga 11 laptop, which runs Windows RT and can switch between laptop and tablet modes, has been discounted. The company will continue to sell its Yoga 11s, a similar model that runs the full version of Windows 8. Companies including Samsung and Asus, meanwhile, are releasing Win8 devices that shift to Android when in tablet mode -- a clear sign that these OEMs have little faith in the Modern UI's current state.
8. Windows 8.1 needs to succeed.
Enterprise sales guarantee that Windows will continue to generate billions in revenue, but Microsoft needs consumers if it is going to maintain its industry-dominating stature. As a company, Microsoft has the resources to recover from rough quarters -- but on the consumer front, another holiday season of consumer indifference will really hurt.
It was always important that Windows 8.1 succeed -- but now that the Windows division's rocky quarter has been disclosed, it's clear that the stakes are even higher than previously thought.
Intel CEO Brian Krzanich said during his company's Wednesday earnings call that the PC market could pick up thanks to low-cost devices with Intel's new chips. Between the new products and Windows 8.1, Microsoft has a chance to rebound. If not, Steve Ballmer will be under more pressure than ever.
9. At least Microsoft has good company.
Yes, Microsoft's quarter was disappointing. But many other major tech companies are also struggling to adjust to the evolving mobile market.
On Thursday, Google announced profits of $9.7 billion, a 16% year-over-year increase, but still fell short of analyst projections. The company underperformed because more of its revenue is coming from mobile advertisements, which are cheaper and require Google to sell ads in greater volume. Apple, meanwhile, is contending with a saturated smartphone market, which might result in the release of a low-cost iPhone model, and the continued invasion of Android tablets into the iPad's market.