Microsoft announced their fiscal Q3 (calendar Q1) results last week, and the figures were surprisingly stable given the steep decline in PC shipments this quarter. Microsoft announced Q3 revenue of $20.49 billion and an operating income of $7.61 billion. The Windows division revenue was flat sequentially, at $5.7 billion. However, a deeper look at the numbers show some worrying signs.
Microsoft's Windows revenue in Q4 and Q1 includes deferred revenue from Windows upgrade offers (from Q3), so the numbers themselves may be a tad inflated. However, this in itself is just a minor issue. Practically all of the revenue generated from the Windows division comes from sales of Windows licenses for x86 devices. Windows Phone revenue is practically non-existent as Nokia, the largest Windows Phone manufacturer by far, pays Microsoft just about as much as Microsoft pays Nokia in platform support payments. Windows RT tablets have barely had any impact on the market, so any revenue generated from that segment was probably just a tiny flash in the pan (in Q4).
As the chart above shows, Windows revenue is typically consistent with PC shipments. This is because the largest chunk of Windows revenue comes from licenses purchased by PC OEMs for manufacturing new PCs. However, the PC shipment crash in Q3 (calendar Q1) was not accompanied by a decline in Windows revenue. This suggests that OEMs continued to purchase Windows licenses for new devices, but these devices were not sold. However, Microsoft's explanation in the earnings conference call differed from this line of reasoning:
In the Windows division, revenue was flat this quarter. Within that, OEM revenue performance was in line with the underlying x86 PC market, which continues to be challenged as the PC market evolves beyond the traditional PC to touch and mobile devices. This quarter, inventory levels were drawn down as the channel awaits new Windows 8 devices.
Non-OEM revenue grew 40% this quarter, driven by sales of Surface and continued double digit growth in volume licensing. Businesses continue to value the Windows platform, and volume licensing of Windows is on track to deliver almost $4 billion in revenue this year, and nearly three-quarters of enterprise agreements that we signed this year include Windows.
Microsoft claims that the decline in Windows revenue from OEMs was made up by sales of the Surface and volume licensing. Given the low shipment estimates for the Surface RT & Surface Pro, the proportion of Windows revenue from Surface was probably low. Also, given low consumer interest, Surface shipments should continue to decline until a new product is launched. This leaves Windows volume licensing, which was driven by enterprises continuing the upgrade path from Windows XP to Windows 7 (driven by the closing support "windows" for Windows XP and probably discount offers to enterprises). Therefore, this revenue spike is likely to be a one-time event as upgrade cycles tend to be concentrated around OS launch timelines. In any case, a 40% revenue spike in non-OEM revenue could hardly be considered sustainable.
Microsoft also stated that Windows revenue from OEMs was in line with the drop in PC shipments. PC shipments should continue to decline throughout the year (a minimum 8-10% annual decline as per my most recent forecast), which should pressure Windows revenue over the next few quarters. With negligible revenue from Windows Phone (thanks to Nokia's platform support payments), little consumer & OEM interest in Windows RT and slowing volume licensing revenues as enterprise customers complete their migration cycles to Windows 7, the future of Microsoft and Windows looks murkier than ever.
