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Investing in Microsoft: A comprehensive primer and key analysis

Part 3
Investing in Microsoft: A comprehensive primer and key analysis (Part 3 of 7)

Microsoft’s consumer business lags behind its enterprise segment

Microsoft’s reporting segments

The company’s five reporting segments are broadly classified under two main headings—Devices and Consumer (D&C) and Commercial.

The D&C segments develop and market products and services for consumers. Compared to the enterprise segment, the consumer business is seeing sluggish growth. Devices and consumer revenue grew only 4%, to $7.46 billion in 1Q 2014. There are also several challenges facing the consumer business in the form of declining PC sales, a shift to mobile computing, and high competition in the tablet, gaming, and online advertising space.

D&CEnlarge Graph

The D&C segment has three sub-segments.

D&C Licensing comprises: Windows, including all OEM licensing and other non-volume licensing and academic volume licensing of the Windows operating system and related software (collectively, “Consumer Windows”); non-volume licensing of Microsoft Office, the core Office product set, for consumers (“Consumer Office”); Windows Phone, including related patent licensing; and certain other patent licensing revenues.

D&C Licensing revenue decreased $335 million, or 7%, to $4.34 billion in 1Q 2014. The decrease resulted primarily from the impact on revenue of a decline in consumer demand. In the case of Consumer Office, the decline was also influenced by the transition of customers to Office 365 Home Premium. However, Windows Phone revenue increased $102 million, including an increase in patent licensing revenue.

The company said in its 4Q 2013 earnings call that as customers transition from a licensing model to a new subscription model, there will be a short-term impact to revenue due to changes in the timing of revenue recognition. With the subscription model, the company is providing greater value to customers through frequent product updates, new cloud services, and attractive pricing. Microsoft said it saw strong early adoption of the subscription offering, and the Office 365 Home Premium subscribers have doubled to over 2 million in 1Q 2014. The company said the impact of the shift to Offices services in the cloud was “in line with expectations,” and Microsoft expects the revenue will grow with the increase in subscribers.

Microsoft expects revenue from this segment to be $5.2 billion to $5.4 billion in 2Q 2014. The enterprise PC market is expected to be stable, but the consumer PC market is subject to more volatility.

D&C Hardware comprises: the Xbox 360 gaming and entertainment console and accessories, second-party and third-party video games, and Xbox LIVE subscriptions (“Xbox Platform”); Surface; and Microsoft PC accessories.

D&C Hardware revenue increased $401 million, or 37%, to $1.48 billion in 1Q 2014, due primarily to Surface tablet revenue of $400 million. Surface 2 and Surface Pro 2 were launched October 22, 2013. With improved sales and marketing effort, combined with pricing and promotional activities, Surface revenue grew sequentially from 4Q 2013, with the 32GB Surface RT singled out as a robust performer. According to a report from Ad network Chitika on Holiday Mobile Progress, Microsoft’s Surface and Surface 2 has captured 2.3% of all post-holiday U.S tablet usage in the United States and Canada. The tablet is ahead of Google in terms of market share, the report said.

Xbox 360 sold 1.2 million consoles in 1Q 2014, down 29% year-over-year. Microsoft said recently that over 3 million Xbox One consoles sold to consumers in 13 countries before the end of 2013. The company expects revenue to grow between 35% and 45%, to between $3.8 billion and $4.1 billion in 2Q 2014, reflecting the expanded Surface line-up and the Xbox One launch.

D&C Other comprises: resale, including Windows Store, Xbox LIVE transactions, and the Windows Phone Marketplace; search advertising; display advertising; subscription, comprising Office 365 Home Premium; Studios, comprising first-party video games; retail stores; and certain other consumer products and services not included in the other segments.

D&C Other revenue in 1Q 2014 increased $235 million, or 17%, to $1.63 billion. This rise was mainly due to higher advertising revenue, which increased $106 million or 13%.

Xbox Live transactional revenues were up 25% 1Q 2014. The service has 48 million members in 41 countries, according to Microsoft’s website.

The segment includes search engine Bing, which saw its U.S. market share at 18.0%, up 210 basis points in 1Q 2014. Microsoft has been criticized for investments in Bing, which was part of the earlier online services division and has yet to be profitable. Dave O’Hara, chief financial officer for Microsoft’s Applications and Services, said in a UBS conference last month that the company has made substantial investments in its online services division. Although the division has constantly posted operating losses, it’s expected to break even in the upcoming quarter. Bing has also been integrated into a host of Microsoft products such as Xbox, Windows Phone, Office, and Windows 8.

According to Comscore, Bing continued to grow its market share in October 2013 and hit a new high of 18.1%, although Google still leads market share in search engines. Microsoft forged a deal with Yahoo in 2009, under which Bing will be the search engine for all Yahoo sites. News reports stated that Yahoo disclosed to the SEC that 31% of its revenue came from this deal with Microsoft. Yahoo is trying to look for ways to end the partnership, as its revenue is declining due to lower search market share. To learn more about Yahoo’s own turnaround initiatives, see Why Marissa Mayer’s Yahoo (YHOO) turnaround shows signs of life.

In the Devices and Consumer Other segment, Microsoft expects revenue to reach between $1.7 billion and $1.8 billion. Search revenue should continue to grow, reflecting improved revenue per search and query volume.

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