Memo To Microsoft: Spin Off Devices And Hardware

| About: Microsoft Corporation (MSFT)


Return on equity, not size, drives shareholder returns.

Microsoft should spin off its Devices and Consumer Hardware operating segment to balance out competing shareholder interests.

Microsoft Devices and Consumer Hardware may emerge as a formidable competitor within the mobile space -- if granted the option to separate away from the Windows operating system.

Bigger is not always better. Ironically, Microsoft (NASDAQ:MSFT) shareholders may have been better served if the company had actually lost its late 90s war against the U.S. Department of Justice and been forced into a break-up. The parallels between Microsoft, Standard Oil, and Big Oil, in the aggregate, are somewhat striking. Standard Oil, of course, was broken up into multiple firms that emerged to include large shares of today's ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), and BP Plc (NYSE:BP). In recent years, the oil majors have largely divested themselves away from the downstream retailing of gasoline. On May 1, 2012, ConocoPhillips (NYSE:COP) was to complete the spin-off of its Phillips 66 (NYSE:PSX) refining business altogether.

Big Oil has evolved to rotate its business model towards higher-margin exploration and production activities. Going forward, Microsoft should tear a page out of the Big Oil playbook, and recognize that return on equity is of greater importance to shareholders than is size for the sake of size. Microsoft would unlock shareholder value if it were to spin off its Devices and Consumer Hardware division. A leaner Microsoft would then be left to focus its efforts upon a core mission of delivering software to enterprise customers. Microsoft insiders and executives may be now tasked with the challenging proposition of deconstructing the work of Steve Ballmer and his capstone Nokia (NYSE:NOK) acquisition.

The Microsoft Business Model

Prior to 2014, Microsoft classified its businesses according to Windows, Server and Tools, Online Services, Business, and Entertainment and Devices. For 2013, Microsoft indicated that its Office software suite accounted for more than 90% of the Business Division revenue. Be further advised that the Entertainment and Devices operating segment included sales of the popular Xbox gaming console, alongside Windows Phone, Skype, and Surface revenue. Last fiscal year, Entertainment and Devices generated a mere $848 million in operating income off $10.2 billion in segment revenue. For the sake of comparison, Microsoft Business accounted for a staggering $16.2 billion in 2013 operating profits upon $24.7 billion in net sales. In all, Microsoft posted $26.8 billion operating profits off $77.8 billion in revenue for fiscal 2013.

Again, a brief review of the 2013 classifications and results would confirm the idea that Microsoft has remained a software company for big business. Beyond Microsoft Business, the Windows and Sever and Tools divisions also posted relatively stellar results. Interestingly, servers have delivered solid growth for both Microsoft and Intel (NASDAQ:INTC), amid the secular decline of the PC market. For 2013, Server and Tools generated $8.2 billion in operating income, which was a 13% advance above the prior year. Perhaps most importantly, the Windows division closed out 2013 with $9.5 billion in operating profits and $19.2 billion in revenue on the books. A more efficient Microsoft would maintain Windows as the backbone for Office software and server operations.

For 2014, Microsoft reclassified its businesses into units that awkwardly blurred the lines between consumer, enterprise, hardware, and software products. Microsoft now reports its business results according to two distinct Commercial and Devices/Consumer groupings. The Devices and Consumer wing includes Licensing, Hardware, and Other subcategories. Meanwhile, the Commercial segment breaks down further into Licensing and Other. The parsing of recent data would still indicate that Windows, Office, and Servers supply the cash that finances Microsoft's misguided foray into Consumer Hardware.

Devices and Consumer Licensing has been defined as "non-volume" licensing of the Windows operation system and Office software package. Devices and Consumer Hardware was created to include the Xbox and Surface, while Devices and Consumer Other was an umbrella category above Windows Store and Office 365 subscription sales. Microsoft Commercial Licensing has emerged as the meat and potatoes at Redmond. Commercial Licensing includes server products, Windows operating system volume licensing, and even Office for business sales. Commercial Licensing generated $9.4 billion in gross margins upon $10.3 billion in revenue for Microsoft's latest Q3 2014, which ended on March 31, 2014. In all, Microsoft closed out its Q3 2014 with $20.4 billion in revenue and $14.5 billion in gross margins on the books. If anything, Devices and Consumer Hardware has been an albatross weighing down Microsoft bottom line results for three years running.

Negotiating A Compromise

A Devices and Consumer Hardware spin-off would perfectly balance the demands of multiple warring factions within the Microsoft camp. The Devices and Consumer Hardware spin-off would maintain the Surface, Phone, and Xbox equipment, while Microsoft would still carry all Windows and Office licensing beneath its checkered flag. At that point, conservative investors may expect Microsoft to dominate mature software, personal computer, and server markets, while returning larger amounts of capital back to shareholders through dividend payments. In effect, Microsoft would transform itself into the tech version of Altria (NYSE:MO), which has historically targeted an aggressive dividend payout ratio at 80% of adjusted earnings per share. For income investors, Microsoft shares would then also serve as a viable alternative to the bond market.

Meanwhile, growth investors would build out stakes within Devices and Consumer Hardware. Over time, this unit may be more so free to expand mobile market share, without being forced to function as a literal outpost for the Windows ecosystem. Devices and Consumer Hardware investors may also take comfort in the idea that the Xbox may emerge further as a centerpiece for gaming, entertainment, music, and telecommunications. Retaining the Nokia team within this product mix would add even more possibilities for design and geographic reach. From here, Devices and Consumer engineers and executives may ultimately challenge Samsung (OTC:SSNLF) as the primary original equipment manufacturer for Android. In this amicable divorce, Devices and Consumer Hardware would cut itself away from the Microsoft ball and chain that Mark Hachman and PC World have already ripped as "fail plus fail equals more fail."

A quick review of information out of comScore (NASDAQ:SCOR) and International Data Corporation may confirm further that Microsoft and its Windows operating system have been largely shut out of the mobile market. On May 2, 2014, research firm comScore published its March 2014 Smartphone Subscriber Market Share report. Be advised that the title of this report was somewhat misleading, as it presented the averages of figures compiled through calendar Q1 2014. Taken together, the Google (GOOG, GOOGL) Android (52.2%) and Apple (NASDAQ:AAPL) iOS (41.4%) duopoly combined to control 93.6% of the Q1 2014 U.S. smartphone subscriber market. Meanwhile, Windows has struggled simply to remain relevant in mobile. According to the comScore data, Windows held onto a meager 3.3% of the Q1 2014 U.S. smartphone market.

To date, the Surface, which Gregg Keizer and Computerworld dismissed as a "debacle," has epitomized Microsoft's misguided mobile strategy. The Surface emerged as an extension of Windows 8, where traditional smartphone, tablet, and desktop interfaces merged beneath one Metro operating system. Microsoft now promotes its Surface Pro 3 machine as "the tablet that can replace your laptop." Microsoft, in trying to be all things to all people, will ultimately end up pleasing nobody. Most likely, the Surface Pro 3 will lose the sales war upon multiple fronts to the iPad, MacBook Pro, and even, HP (NYSE:HPQ) Chromebooks. Again, Microsoft could simply divest itself away from both the Surface and Nokia Lumia 2520, and leave executives of the newly formed company to navigate the tablet market for themselves.

The Bottom Line

The Devices and Consumer Hardware segment has generated a mere $875 million in operating profits off $8.2 billion in revenue through the first nine months of fiscal 2014. A strong case may be made that this unit has actually deteriorated over time. Microsoft Devices and Consumer Hardware posted $1.6 billion in operating profits upon $5.3 billion in revenue for the corresponding nine-month, year-over-year period. Be further advised that Microsoft launched its Xbox One gaming console on May 21, 2013. Xbox One-related cost of sales likely drove down Devices and Consumer Hardware margins for fiscal 2014.

On April 25, 2014, Nokia closed the sale of its very own Devices and Services business to Microsoft for $7.65 billion. Nokia recently defined Q1 2014 results for this former Devices and Services unit as Discontinued Operations. Last quarter, Nokia Discontinued Operations racked up $444.4 million in operating losses off $2.6 billion in revenue. Nokia Discontinued Operations revenue declined by 30% between Q1 2013 and Q1 2014. Microsoft Devices and Consumer Hardware sales actually expanded from $1.4 billion to $2.0 billion through this same year-over-year time frame. The Xbox One was the likely catalyst for Microsoft Hardware sales growth through 2014.

The newly integrated Microsoft and Nokia Hardware division may combine for $20 billion in segment revenue over the next year. This operating segment would be worth approximately $70 billion, if capitalized at 3.5 times sales. Microsoft stock last traded hands at $40.94 per share at the May 30, 2014 closing bell. At these levels, Microsoft prices out for roughly $340 billion in market capitalization. Going forward, an equitable deal would call for Redmond to distribute 0.2 shares of Devices and Consumer Hardware stock for every one share owned of Microsoft. For now, prospective investors should avoid Microsoft stock until serious talks for a Hardware spin-off take place at the negotiating table.

Disclosure: I am long AAPL, XOM, MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.