Microsoft's Nadella Gets It

| About: Microsoft Corporation (MSFT)

Summary

On Microsoft's earnings call, CEO Satya Nadella announced that MSFT will pursue a single converged Windows OS for all devices from desktop to mobile.

While strong in the enterprise, MSFT faces losses in its mobile device activities and a “perfect storm” for its Windows ecosystems.

The bet on a single converged OS represents a risky but necessary attempt to leverage its current Windows user base to create a viable mobile ecosystem.

Mobile Convergence

Microsoft's (NASDAQ:MSFT) CEO Satya Nadella is really starting to impress me, not just with his native intelligence but with his ability to make the tough decisions that have long needed to be made. Of course, it doesn't hurt my estimation of him that he appears to be charting a course in mobile I've long advocated and expected.

During the earnings conference call on July 22, Nadella stated that Microsoft needed to streamline its efforts in mobile and PCs by converging its three operating systems into a single system. What exactly that entails may be open to question, however. When probed a little more deeply by analysts, Nadella managed to muddy the waters a bit, stating that MSFT would still offer "multiple SKUs."

David Goldman of money.cnn.com drew the conclusion that Microsoft intended to kill off Windows RT, Microsoft's Windows 8.x OS for ARM (NASDAQ:ARMH) based systems. But then, Goldman also concluded recently that Microsoft intended to kill off the Android-based Nokia X low-end smart phone. Stephen Elop's email to employees seemed to offer a slightly different take, reiterating that Microsoft would still continue to sell and support "existing" Nokia X models, while redirecting efforts away from Nokia X in the future.

This could be mere face-saving on Elop's part (it appears he championed Nokia X after returning to Microsoft), and Goldman is probably right on both counts. Here, I'll acknowledge some bias on my part. These are both actions I've long advocated. Moving to an all-Intel (NASDAQ:INTC) approach to computing (desktop, laptop, tablet and phone) is something I reiterated as the "path of least resistance" for Microsoft in my "Surface Pro 3: Why Intel Is Microsoft's Mobile Future." But this is something I've been saying since Surface RT was unveiled. In an article from December, 2012, I wrote:

Giving up on ARM is a retreat, I realize, but a vitally necessary defensive measure to protect the Wintel base of support of roughly 1.5 billion users. Once the base is secure, it will be possible to carry on the fight for the "next billions" of mobile users from a position of strength.

Do I expect Microsoft's management to realize that Windows on ARM is a lost cause immediately? No, I don't. Such realizations usually take a painfully long time, and in Microsoft's case, will probably require regime change.

So, after a painfully long time, and with the necessary regime change, the realization appears to have been made. Moving to a single OS is fundamentally about moving to a single hardware platform (Intel), and that means Intel in phones as well. So I expect that Goldman's conclusion also applies to the other ARM platform that Windows is on, Windows Phone. And yes, Nokia X really is as dead as I expected it to be earlier this year.

Not that moving to all-Intel is a panacea. It isn't, but it's the only chance to establish a viable mobile ecosystem that Microsoft has. Surface sales, never very strong, declined sequentially from $429 million last quarter to $409 million. At an ASP of $700, that comes to unit sales of 584 K, miniscule compared to Apple's (NASDAQ:AAPL) iPad shipments of 13.276 million for the quarter. Microsoft Windows Phone sales (now reported in a separate Phone Hardware segment) were also small at 5.8 million Lumias.

In the Midst of the Perfect Storm

Earlier this year, I wrote "Microsoft's Perfect Storm" in which I defined the three fundamental crises facing Microsoft in its Devices and Consumer group:

1) Growing Microsoft's mobile device platforms into a profitable business.

2) Transitioning the remaining Windows XP users onto Microsoft platforms.

3) Creating a popular successor to Windows 8.

Now, at mid-year, it's appropriate to assess Microsoft's progress in facing these crises.

1) Mobile profitability: This has been made a little difficult by Microsoft's reorganizations and reporting approach. MS doesn't report operating income for the Phone Hardware segment, but with a gross margin of $54 million on revenue of $1.985 billion, I think it's safe to say that Phone Hardware is a money loser.

Similarly, Surface is buried in the Computing and Gaming hardware segment, and despite the success of Xbox One, that segment achieved only an $18 million gross margin on sales of $1.441 billion. Once again, I think it's safe to say that Surface is losing money.

Assessment: no progress yet.

2) Transitioning Windows XP users: Incredibly, despite the long expected cessation of support, XP still commands a 25% usage share according to netmarketshare.com. But there has been progress. Windows 7 and 8.1 usage shares are trending up, and overall share for all Microsoft Windows OS platforms has also trended up over the past year, indicating that Microsoft hasn't suffered significant defections from its user base.

Assessment: some progress, but not enough.

3) Successor to Windows 8: Windows 9 is reportedly in the works, although it remains unclear whether it will represent the converged single OS vision of Nadella. My view is that it must. Microsoft can't wait another OS development cycle for the converged OS.

Assessment: progress unknown.

Enterprise Powerhouse

Microsoft would really be in trouble were it not for its enormous strength in the enterprise. Even Devices and Consumer Licensing, which was a profit bright spot this quarter (gross margin of 94% on revenue of $4.7 billion) derives much of its revenue from OEM licensing of business PCs, which was up 19% y/y. Meanwhile, consumer licensing was down 15%.

Commercial Group revenue was up 7% overall to $12.23 billion on the strength of Microsoft's server and cloud offerings. Cloud services and the cloud based Office 365 were particularly strong with revenue growth y/y of 31%. Commercial gross margin grew by 6% to $9.91 billion.

Microsoft's enterprise profitability affords it a window of opportunity to turn its mobile efforts around, and it's clear from Nadella's statements and the "productivity and platforms" theme that Microsoft intends to leverage its enterprise presence.

More than anything else, Microsoft's success in its mobile endeavors will depend on its converged Windows OS (Windows 9 probably). Building a single OS that works well for all screen sizes is a tall order. To the extent that Microsoft achieved platform convergence with Windows 8.x and its ARM variants, it was far from an unqualified success.

I believe that a single OS works in theory, but whether it works in practice remains to be seen.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.