Microsoft revealed its quarterly earnings today for the second quarter of the 2015 financial year. Overall revenue was up, and sales of the Surface Pro 3 computer were strong according to the company. But the Windows market declined and operating income was down, as the Nokia integration and reorganization continues to cost money.
Revenue for the quarter was $26.47 billion, up eight percent on the same quarter a year ago. Gross margin was also up, climbing by one percent to $16.33 billion. Operating income, however, fell two percent to $7.78 billion, and earnings per share dropped nine percent to $0.71.
The lower operating income is attributed in part to $243 million in expenses incurred by Microsoft’s reorganization and by the integration of Nokia’s Devices and Services division. Earnings per share were also hit by an income tax bill as a result of an IRS audit.
Device & Consumer Licensing saw steep declines. Revenue was down 25 percent to $4.17 billion, with gross margin down 22 percent to $3.88 billion.
Windows OEM revenue as a whole was down 13 percent, falling $455 million. Revenue from OEM sales of Windows Pro SKUs was down 13 percent. A big part of this drop was attributed to the end of the Windows XP upgrade cycle, with the number of licenses sold reverting to levels comparable to prior to the Windows XP end-of-life. Average selling price also declined somewhat due to a reduction in the price of academic licenses.
OEM revenue of non-Pro Windows SKUs also fell by 13 percent, with this decline attributed to growth in sales of low cost Windows devices causing an overall reduction in ASP. As revealed last week by Mary Jo Foley, OEMs shipping sub-9 inch devices with the “With Bing” SKU pay $10 with a $10 discount for a net zero cost. Larger devices the “With Bing” SKU cost $25, and those also have a $10 discount for a net cost of $15.
Office consumer revenue was down 25 percent, falling by $208 million. Microsoft said that part of this was due to a broader switch from perpetually licensed Office to Office 365 Home and Personal subscriptions, and it’s partly due to a decline of PC sales in Japan, where Office has a particularly high attach rate.
Windows Phone revenue was also down substantially, dropping by 61 percent or $635 million. This largely represents the loss of royalty payments from Nokia.
Microsoft expects this segment to remain relatively weak, with revenue for next quarter forecast at $3.4 to $3.6 billion—if this target is hit, then the 25 percent year-on-year decline will be preserved for a second quarter in a row.
Computer and Gaming Hardware revenue was down 11 percent to $4.00 billion, with gross margin up 12 percent to $0.46 billion. On the one hand, Xbox revenue was down $703 million or 20 percent; total sales volume was down 10 percent, with the company selling 6.6 million Xboxes in the quarter, and average selling price also fell due to the Xbox One price cut.
On the other hand, Surface revenue was up $211 million or 24 percent, totally $1.1 billion for the quarter. This growth was driven by the Surface Pro 3, released in June 2014.
This reporting segment will continue to show strong seasonality, with next quarter’s revenue predicted at $1.5 to $1.7 billion, which would be a 15 percent year-on-year decline.
Phone Hardware revenue was $2.20 billion, with a gross margin of $0.33 billion. In the quarter, 10.5 million Lumia handsets were sold, representing a 30 percent year-on-year increase. This growth was driven by the low-end 500 and 600 series devices. Sales of non-Lumia feature phones were down an unspecified amount to 39.7 million handsets.
D&C Other revenue was up 30 percent to $2.44 billion. Gross margin fared even better, up 42 percent to $0.55 billion. Much of that was driven by Xbox. There were strong performances from first party games, with Halo: The Master Chief Collection, Forza Horizon 2, and the newly acquired Minecraft all contributing to a $171 million increase in revenue. A greater volume of Xbox Live transactions added $168 million as well.
The online business continues to improve. Search advertising revenue was up 23 percent, offsetting a decline in display advertising for overall growth of 10 percent or $110 million
Office 365 Consumer revenue was up $97 million, or 169 percent, for a total of 9.2 million subscribers.
D&C Other is estimated to post revenue of about $2 billion next quarter.
Commercial Licensing revenue was down two percent to $10.68 billion, and gross margin fell two percent to $9.92 billion. Similar factors were mentioned here as in the Consumer licensing side: revenue in Japan is down, the Windows XP replacement cycle is over, and there’s an on-going switch from perpetually licensed Office products to Office 365 subscriptions. Office revenue, in particular, dropped $633 million or 13 percent. Weakness in China was also noted.
Offsetting this somewhat was seven percent growth of server products and three percent growth in Windows volume license revenue. In both categories there was a shift from transactional revenue to annuity revenue.
The still relatively small but fast-growing Commercial Other segment remains a highlight. Revenue was up 46 percent to $2.59 billion, and gross margin was up 117 percent to $0.90 billion. Cloud revenue grew 114 percent, driven by growth in Azure, Office 365, and Dynamics CRM Online, and commercial cloud revenue now has a run rate of $5.5 billion.
The Commercial Licensing outlook was for next quarter’s revenue to come in at $9.7 to $9.9 billion, and for Commercial Other revenue to be $2.6 to $2.7 billion.
During the financial analysts call that came with the results, Microsoft offered some clarification on the impact Windows 10 will have. The company announced last week that Windows 10 would be a free upgrade for existing Windows 7 and Windows 8 users for the first year after its release.
However, this does not mean that Microsoft has abandoned Windows sales. The company confirmed today that the OEM royalty model will continue, and Windows licenses that ship with new hardware will continue to be paid for. The difference is solely in updates.
Today, the owner of an OEM license will receive a series of updates and security fixes for the operating system for a period of 10 years (the first five years including feature improvements, the second five years being strictly security updates). However, if that same user wants to bump their operating system to the latest major version, they must buy an upgrade license. If they don’t—and most people don’t—then they’ll continue to use the major version that their computer came with.
Under Windows 10? Those upgrade licenses are going away. The OEM will still pay Microsoft for a Windows license, but it will be just that: a Windows license, and not, say, a Windows 8.1 license. The license will entitle the user to continue to upgrade to new major versions for the lifetime of their machine.
As such, the impact on Microsoft’s financial performance shouldn’t be enormous. With the introduction of each new release there does tend to be a small benefit from upgrade sales (along with a complicated mess of revenue deferrals due to upgrade entitlements that kick in if you buy a PC shortly before a new version of Windows comes along), and that benefit will now go away. But the bread and butter Windows sales—OEM preinstalls on new machines, and corporate volume licenses and Software Assurance subscriptions—will be substantially unaltered.