Recently Microsoft released its earnings from the 4th quarter of 2013, and the results pleased Wall Street. The company posted strong earnings of $0.78 per share, significantly higher than the street’s expectation of $0.68. The strong earnings were a result of a 14% revenue increase that many news reports have tied to increased sales of hardware platforms such as the Surface tablets and Xbox One game consoles. So let’s all rejoice, this is a new Microsoft, one that is a major player in consumer devices and cloud services.
However, if we take a closer look at Microsoft’s numbers, we see that really isn’t the case. Sales of corporate software still generates about two-thirds of Microsoft profits. The bulk of corporate software comes from big anchor products such as Office, Windows, and Exchange. These businesses operate with a gross margin north of 80%, whereas the ‘exciting’ new hardware products return under 10% gross margin — quite a contrast in business models. These numbers don’t even include the Nokia handsets which, when added, will bring gross margins down even further.
Why the big discrepancy? Well, with it’s legacy products, Microsoft has monopoly-like market share, and the company has done an excellent job of marketing to the IT pro, who was the primary decision-maker for these software products. Because of this, Microsoft had a significant competitive advantage, and the company used this advantage to generate boatloads of cash. In its new markets, though, of gaming, cloud services, and consumer products, Microsoft has no advantage — in fact, they are considered to be lagging behind in some cases. Take the Surface Tablet for instance: while sales of these tablets have been OK, Apple and Google dominate those markets. Frankly, Microsoft would have been well served to launch the product with a brand that disassociates it from Windows, as that brand tends to have a “legacy” perception with today’s millennials. Low market share and mindshare leads to significantly lower gross margins.
Even if Microsoft did have leading products, the new markets Microsoft is trying to monetize are significantly more competitive, making it very difficult to achieve the profit margins that it had with its corporate products. Apple managed to, but they redefined several markets, such as music players and mobile phones, and Microsoft hasn’t shown really any ability to redefine markets.
So what does this mean for Microsoft over the long term? As the mix of business continues to shift, Microsoft just cannot expect to generate the same levels of cash that it has in the past. This gives the company less money to invest back into the business, making it harder to move into new markets as well as to continually update new products. So to answer the question, I believe the recent good quarter Microsoft posted to be more of a shorter term trend, and that the good ship Redmond has not yet righted itself.
The wildcard for Microsoft is that fact it has over $80 billion in cash on hand. The company needs to continue the transformation that outgoing CEO Ballmer had laid out last year.
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