Microsoft Q2– The Good and the Bad

Software looks strong but Nokia smartphones had a shocker.

• While Microsoft reported excellent results, the Nokia smartphone business looks to have suffered badly.

The Good

• Microsoft reported excellent results and guidance confounding the PC sceptics.
• Revenues / EPS were $24.5bn / $0.78 compared to forecasts of $23.7bn / $0.69.
• Enterprise, cloud and even consumer showed unexpected robustness giving hope that the worst is over for the PC market.
• Xbox was strong shipping 3.9m units and large corporate upgrades to Windows 7 from Windows XP were significant factors in the revenue performance.
• I suspect that in many corporations, the PCs are already capable of running Windows 7 but that the IT department has put off the pain of transition.
• With Microsoft ending XP support many hands have been forced and the upgrades commenced.
• Hence, it looks like a meaningful number of devices have simply been upgraded to Windows 7 rather than replaced leading to the discrepancy between Microsoft’s results and those of Intel.
• Corporations also have a much higher attach rate of Office and other products to Windows which was also a factor in the strong performance.
• Hence, the read through for the PC sector for the immediate term is not nearly as strong as many may think.
• I am still looking for hybrid devices to start driving the PC market which I expect that to start happening in Q3. (see here).
• Revenue guidance was in line with expectations but I am hopeful that cost cuts should continue to drive EPS expansion.
• These results underpin my view that Microsoft is one of the best ways to gain exposure to the recovery I see coming in PCs.
• Intel is also a good way in but is more exposed to hardware shipments which so far are lagging software.

The Bad

• The Smartphone business, which Microsoft is about to take position of, looks to have had a sudden and very worrying loss of momentum.
• Nokia declined to give specifics at it results but enough was disclosed so that conclusions can be drawn.
• Q4 is the strongest quarter of the year where RFM and Counterpoint Research predict that the market grew by 10% QoQ with smartphones growing 12%.
• Against that backdrop Nokia device revenues fell by 2% QoQ.
• Furthermore with Mobile phone revenues being flat, it looks like all the pain was taken by smart devices.
• RFM analysis suggests that Nokia has had to cut prices again to hold onto share but even that tactic has not worked very well.
• Sell in volumes look to have been around 8.8m units with sell out volumes somewhere around 11m. (Sell-out data from Counterpoint).
• RFM’s research suggests that the channel has warned Nokia of the impending weakness in demand for Lumia smartphones and that most of December’s sell through sales came from inventory being worked down.
• It looks very much like Lumia inventory which stood at around 5.0m units (4-6 weeks) in October was worked down to around 3.3m units in order to account for the difference between the sell in and sell through numbers.
• If demand has unravelled, as appears likely, the new level of inventory would still represent around 4-6 weeks but at a lower level of demand.
• Hence, I suspect that Q1 is going to see sell-through of around 8m units which represents a real loss of momentum that had been nicely built up in H2 2013.
• I see four main problems.
  • First. Android is getting better at the cheaper price points making the Lumia 520 not such great value at $135. Low end Lumia needs to be refreshed to re-extend the gap to Android.
  • Second. Microsoft continues to make a total mess of telling users why they should buy a Lumia device meaning that there is very little pull for the ecosystem from the handset end.
  • Third. The app. store is still woefully inadequate when compared to iOS and Android and this is a major turn off for prospective buyers of the devices.
  • Four. The change in ownership may have distracted the business from pushing the devices to the best of its ability. I am hopeful that this quarter will see this fixed.
• Microsoft needs to rapidly address these problems as a loss of momentum could easily become a tailspin, resulting in Nokia devices becoming just another awful acquisition by Microsoft.
• I still have high hopes for this ecosystem as it has so much going for it but this loss of momentum leaves me deeply worried.