Windows revenue takes another bad beating

Third consecutive quarter of double-digit declines, but CEO is confident Windows 10 will 'restore growth'

Microsoft building
Credit: Amit Chattopadhyay

Microsoft on Tuesday said that Windows revenue again declined by double digits, the third straight such quarter, with sales of licenses to computer makers down 22% from the same period last year.

For the June quarter, Windows revenue from OEMs (original equipment manufacturers) was off $683 million relative to the same three-month span in 2014, making the decline for the fiscal year -- Microsoft's ended on June 30 -- approximately $1.9 billion.

The bulk of Windows' revenue comes from sales to OEMs, which pre-load the operating system on PCs, 2-in-1s, tablets and a few smartphone models. In the past, Microsoft has said 65% to 72% of Windows revenue stemmed from OEM sales.

Second quarter revenue from OEMs was down 27% for what Microsoft calls the "non-Pro" category and off 21% for the "Pro" class. The terms refer to the kind of Windows license, with non-Pro indicating the OS for consumer PCs and tablets, and Pro for devices targeting businesses. In Windows 10, for instance, the former will be Windows 10 Home while the latter will be Windows 10 Pro.

The declines of both non-Pro and Pro were both slightly larger than for the first quarter of 2015.

Microsoft blamed the consumer licensing downturn on slack in the sales channel as OEMs prepared devices for Windows 10, a 180-degree turn from the prior quarter, when it said the channel was still stuffed with PCs left over from the holidays.

"OEMs tightly managed PC inventory ahead of the Windows 10 launch, particularly in developed markets," said CFO Amy Hood in prepared remarks during the front end of an earnings call with Wall Street Tuesday. "In our view, this is a healthy state for the channel as we head into a transformational launch that starts next week," she added, referring to the July 29 debut of Windows 10.

Hood returned to the scaled-back OEM inventories when she responded to a question about whether Windows 10 would make up some of its second-quarter declines caused by the emptying retail sales channel. "Before every launch, we tend to have a tightening in the channel as they prepare and run reasonably lean," Hood answered. "This is a healthy state. It's within the range of normal."

Meanwhile, Hood said Pro license revenue was still hamstrung by the tough comparisons in 2014 when sales of business PCs jumped as companies purged Windows XP -- which was retired in April of that year -- from their organizations. Microsoft has used XP as the whipping boy for the last several reporting periods, and gave the 2001 OS a few more licks Tuesday.

Also in play, although not stressed much by Microsoft, perhaps because it's a broken record: The underlying problems of the PC industry, which continued a 14-quarters-and-counting contraction, and seems destined to be almost entirely a replacement market, with little signs of any meaningful growth down the line.

Both Hood and CEO Satya Nadella, who was also on the call, spun the Windows declines as less about the loss of revenue in the quarter just past and more about the opportunities ahead with Windows 10.

"With Windows 10, we expect momentum to build throughout the year, as we and our partners bring new devices, applications, and services to market," said Hood. "We expect this to benefit our business results in the second half of the fiscal year." Microsoft's fiscal year runs from July to the following June, so Hood was referring to the first half of 2016.

Nadella pitched in as well. "Our aspiration with Windows 10 is to move people from meeting to choosing to loving Windows," he said, repeating remarks he made earlier this year.

Not surprising -- because it's part of every CEO's job description, no matter what industry or under what circumstances -- Nadella was confident Windows 10 would turn around the company's OS fortunes, if not in direct licensing revenue then in sales of after-market services and software, and advertising opportunities in its Bing search site.

"While the PC ecosystem has been under pressure recently, I do believe that Windows 10 will broaden our economic opportunity and return Windows to growth," Nadella said. He touted the large number of devices and configurations in the testing process for Windows 10 certification, most of which won't be available until later this year, as well as some revenue and gross margin growth possibilities from Microsoft's own hardware, primarily the Surface Pro portfolio.

"Third, we will grow monetization opportunities across the commercial and consumer space," Nadella pledged. "For consumers, Windows 10 creates monetization opportunities with store, search, and gaming."

The three money-makers Nadella ticked off were the same ones Hood outlined to financial analysts in May, when she fleshed out the firm's "Windows as a service" monetization strategy. Microsoft intends to shift revenue generation from its decades-long practice of licensing Windows to one more reliant on revenue from search ads within Bing results, gaming and apps sold through the Windows Store.

That strategy has led Microsoft to a number of radical decisions, including giving away Windows licenses to smartphone and small tablet makers -- a move that hasn't done much for the OS's share in those categories -- subsidizing Windows to makers of cut-rate notebooks, and most importantly for Windows 10, giving away upgrades to the new OS from Windows 7 and Windows 8.1.

The biggest contributor to that money-making strategy in the June quarter was clearly Bing. In a filing with the U.S. Securities and Exchange Commission (SEC), Microsoft said that Bing search advertising revenue had increased 21%, or $160 million, in the second quarter compared to the same period the year prior. Adding Cortana, Microsoft's digital assistant and prognosticator, to Windows 10 was also part of the plan to increase Bing's importance to the OS -- which features strong links to the search engine in multiple components, including the new Edge browser -- and use Windows 10 to drive the search service's revenues.

While the growth in Bing ad revenue was less than a fourth of the decline in Windows revenue during the quarter, it was something.

Microsoft said nothing in the SEC filing about app revenue -- perhaps because it remains minuscule -- but it did boast of a $205 million increase, representing a 58% boost, from Xbox Live, its subscription-based multi-player network. Xbox Live is baked into Windows 10, and Microsoft has pinned significant revenue hope on the OS and Xbox Live reinvigorating the company's PC gaming business, with the monetization angle coming from the ties between the two platforms -- console and PC -- and sales of and on the former since the service will be free on PCs and tablets running Windows 10.

"Gaming is an important scenario for Windows 10, and our success with Xbox this quarter gives us a strong starting position heading into launch," said Nadella Tuesday.

And he remained glass-half-full. "We are confident that these are the right levers to revitalize Windows and restore growth," Nadella said.

In general, Microsoft's second quarter was a mess because of $8.4 billion in charges and layoffs in its phone division, resulting in the biggest-ever single-quarter loss and the first since 2012.

Microsoft took a $3.2 billion net loss for the quarter, compared to a $4.6 billion net profit for the second quarter of 2014, a $7.8 billion flip.

Devices & Consumer Licensing for Q2 Microsoft

Microsoft's Devices & Consumer Licensing reporting division -- Windows OEM licensing revenue is just one component -- took a bath in the June quarter, with year-over-year revenue down 34% as all three of the group's big pieces booked big declines.

This story, "Windows revenue takes another bad beating" was originally published by Computerworld.