Microsoft takes $900 million hit for unsold Surface RTs in 4Q13 earnings

Microsoft logoAn otherwise healthy earnings statement from Microsoft was overshadowed by a substantial $900 million charge attributed to "Surface RT inventory adjustments." The ARM-powered tablet, Microsoft's first foray into selling computers, recently had its price cut by $150 to $349 amid long-standing reports of poor sales. With this $900 million charge, those poor sales and price cuts are hitting Microsoft's bottom line.

Revenue for the fourth quarter was $19.896 billion, up 10 percent on the same quarter last year. Operating income was $6.073 billion and earnings per share $0.59, both essentially unchanged from a year ago.

As ever, Microsoft also published non-GAAP numbers. The GAAP numbers defer revenue that was taken for Office 2013 and Windows 8 prior to the availability of the software, not booking the revenue until the software is actually delivered. The non-GAAP numbers book the revenue as soon as it's taken. Under that metric, quarterly revenue was $19.114 billion, up three percent year on year. Operating income was $5.291 billion, down 24 percent year on year, and earnings per share were $0.52, down 29 percent on a year ago.

Microsoft Surface RT

For the full 2013 financial year, revenue was $77.849 billion, up six percent on 2012. Operating income was $26.764 billion, an increase of 23 percent, and earnings per share were $2.58, a 29 percent improvement. Much of this improvement is due to 2012's $6.193 billion write-down over the aQuantive purchase.

Though Microsoft has announced a significant corporate reorganization, its financial reporting uses the same divisional model and could continue to do so even as the reorganization is implemented. Full details of this will be disclosed in September.

Windows division revenue—which includes Surface RT—saw the fourth quarter grow by six percent to $4.411 billion, with operating income down 54 percent to $1.099 billion. For the full year, the division had revenue of $19.239 billion, up 4.6 percent, and an operating income of $9.504 percent, down 18 percent.

The division continues to suffer from the downturn in the broader PC market. OEM revenue was down 15 percent, driven by the decline of x86 sales. Non-OEM revenue was up 22 percent, with double digit growth in volume licensing. The company says that close to three quarters of enterprise desktops are now using Windows 7.

The Server and tools division posted quarterly revenue of $5.502 billion, up nine percent year on year. Operating income was $2.325 billion, up 14 percent. For the full year, revenue was $20.281 billion, up nine percent on 2012, and operating income was up 13 percent at $8.164 billion.

Both product revenue and Enterprise Services showed nine percent growth. System Center showed growth of 14 percent, SQL Server increased revenue by 16 percent. The company reports growing Azure momentum, too, with 25 percent more enterprise customers.

Microsoft Business Division had quarterly revenue of $7.213 billion, up 14 percent, with operating income of $4.873 billion, an increase of 18 percent. Over the full year, revenue was up three percent to $24.724 billion and operating income was up two percent to $16.194 billion.

Business revenue, representing about 85 percent of the division's revenue, was up seven percent. Business subscription revenue was up 10 percent, offsetting a one percent drop in license-only transactional revenue. Consumer revenue was hammered, however, falling by 27 percent due to the weakness of the x86 market. Office 365 is now on track to have annual revenue of $1.5 billion, with more than one million users of the consumer-oriented Office 365 Home Premium version. Exchange, SharePoint, and Lync all experienced double digit growth.

Online Services division revenue for the quarter was $0.804 billion, up nine percent on the same quarter last year. Operating loss was $0.372 billion. The loss a year ago was $6.672 billion, but most of this was due to the aQuantive write-down. Excluding that, the loss has been reduced by $0.107 billion, or 22 percent. Full year revenue was $3.201 billion, up 12 percent.

Entertainment and Services division had quarterly revenue of $1.915 billion, up eight percent on last year. The division posted an operating loss of $0.110 billion, a 57 percent reduction on last year. Full year revenue was $10.165 billion, up six percent on 2012, with operating income of $0.848 billion, up 123 percent from last year.

Even as it heads towards replacement, Xbox 360 is continuing to sell, with the company shifting a million units last quarter. Xbox LIVE revenue was up by about 20 percent. Windows Phone-related revenue, covering both Windows Phone and patent licensing agreements, was up $0.222 billion.

The company also offered guidance for the first quarter of the 2014 financial year. Windows division will continue to suffer from the poor PC market, with OEM revenue (about 65 percent of what the division turns over) expected to decline by the mid teens. Server and Tools revenue is expected to grow by high single digits. Business division enterprise revenue is anticipated to grow by mid single digits, but consumer revenue will lag the PC market by five percent. The company estimates that Online Services revenue will grow by double digits. Entertainment and Devices revenue will decline by low single digits.

The quarterly and full year results for the Business and Server divisions were both strong. Online Services continues to lose money, though it's losing less each quarter. Entertainment and Devices seemed to perform decently, considering the age of Xbox and the significant seasonal variations it experiences. Setting aside the Surface adjustment, even the Windows division performed reasonably well, considering the general malaise of the PC market.

But that Surface adjustment is huge. The company said that it's for Surface RT and related parts and accessories. We don't know the exact breakdown of the $900 million figure. Worst case, it implies that the company has six million Surface RTs ($900 million divided by $150 price cut per unit) sitting unsold. The true number may be a little lower, due to some of the hit coming from parts and accessories. But Microsoft is still sitting on several million—perhaps as many as five—Surface RTs.

That the company is struggling to sell them is perhaps not so surprising. The value proposition of the Surface RT was never clear. For those who wanted an out and out tablet, the Nexus 10 and iPad were in the same price ballpark but with much richer ecosystems. For those who really wanted Windows software, Atom-powered devices provided a lot more compatibility and a bit more performance, again with prices in the same ballpark. Surface RT was stuck awkwardly in the middle.

What is surprising, however, is that the company so grossly overestimated demand for the product that it apparently had its manufacturers build many millions, such that it would then have to write down the value of millions of units of unsold Surface RT stock. That's a spectacular misjudgment.

Source: Ars Technica

Tags: Microsoft, report, Surface

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