2014 Overview: Mobile a Disaster for Microsoft

Source: Thinkstock

In recent years, Microsoft (NASDAQ:MSFT) — as the world’s largest software company — has somehow been associated with the terms “disaster,” “debacle,” “embarrassment,” and “failure.” Last September, Mark Hachman of PC World dismissed the Microsoft and Nokia combination as “fail plus fail equals more fail.” Web 2.0 and its 24/7/365 news cycle of hyperbole have largely left behind Microsoft. For now, Web 2.0 begins and ends with the smartphone, as even Facebook (NASDAQ:FB) has already declared itself a “mobile company.” Unfortunately for Microsoft shareholders, however, Microsoft will still remain stonewalled on the outside looking in by the end of 2014. The Apple (NASDAQ:AAPL) iOS-Google (NASDAQ:GOOG) Android duopoly will be ever more entrenched above the mobile market over the course of the next year.

The Apple iPhone Pace Setter

2009

2010

2011

2012

2013

Q1 2013

Q1 2014

Apple Revenue

$42.9B

$65.2B

$108.2B

$156.5B

$170.9B

$54.5B

$57.6B

iPhone Revenue

$13.0B

$25.2B

$46.0B

$78.7B

$91.3B

$30.7B

$32.5B

iPhone Unit Sales

20.7M

40.0M

72.3M

125.0M

150.3M

47.8M

51.0M

iPhone Revenue Per Unit Sold

$628.00

$630.00

$636.24

$629.60

$607.45

$642.26

$636.90

iPhone % of Apple Revenue

30.3%

38.7%

42.5%

50.3%

53.4%

56.3%

56.4%

Source: Apple Earnings Releases and SEC Filings

Ironically, a haughty Steve Ballmer once incredulously jeered Steve Jobs’ iPhone as simply a “$500 phone” upon its 2007 launch. At that time, Ballmer dismissed an iPhone that “does not appeal to business customers.” Ballmer also went on to opine that Microsoft was selling “millions upon millions” of phones per year, while Apple was obviously starting off from ground zero. On August 23, 2013, Steve Ballmer announced that he would be stepping down from his CEO post within the next twelve months. Microsoft shares gapped up to $34.49, for a 7.3 percent gain, immediately upon Ballmer’s resignation announcement. Going forward, Ballmer’s awkward and hysterical laughter directed at the original iPhone will always haunt Microsoft shareholders.

On January 28, 2014, Apple filed its first quarterly report of 2014 with the U.S. Securities and Exchange Commission. This latest report summarized Apple’s financial information for the quarterly period ended December 28, 2013, which largely coincided with the critical holiday season. Apple generated $32.5 billion in revenue off a record 51 million Q1 2014 iPhone unit sales. This performance broke down further to $636.90 in iPhone revenue per unit sold. On average, Apple consumers were purchasing the equivalent of the 16GB iPhone 5S, which retailed for $649.00 last quarter. Research firm IHS iSuppli recently performed a teardown of the 16GB iPhone 5S and estimated bill of materials and manufacturing costs of $198.70 for the handset. In all, Apple is likely generating roughly 70 percent gross margins off its smartphone portfolio.

For the sake of making comparisons, be advised that Nokia fiscal years parallel calendar time, while Microsoft ends its fiscal years on June 30. The IRS’ 0.783 euros-to-dollar ($1.28 dollars-to-euro) 2013 average exchange rate will be used to convert Nokia financials into dollar amounts. Nokia has suggested that it will complete the sale of “substantially all” of its Devices and Services operating segment to Microsoft by the end Q1 2014.

Nokia categorized its Devices and Services division as Discontinued Operations within its latest 2013 annual report. Nokia Discontinued Operations racked up $753.5 million in losses upon $13.7 billion in segment revenue for 2013. Nokia Discontinued Operations also burned through $1.4 billion in operational cash flow through this same time frame. Year-over-year segment revenue actually deteriorated sharply from $19.4 billion to $13.7 billion between 2012 and 2013. Interestingly, Nokia operating losses declined alongside the contraction in revenue. Going forward, Microsoft may be poised to take over a unit that bleeds additional cash upon each marginal handset sold. Nokia blamed the collapse in Discontinued Operations sales upon “competitive industry dynamics” and “intense competition at the low end of [the] product portfolio.”

For 2014, both Samsung and Apple are likely to further push the boundaries of phablet technologies for their premium handsets. The year 2014 phablets may be known for their larger screens and fingerprint sensory, as they advance to fuse together traditional smartphone and tablet interfaces. Apple may also expand upon its 64-bit A7 chip with a more powerful and efficient A8 engine. Microsoft would then find itself shut out of the profitable high-end handset market, before attempting to hawk cheap and near obsolete phones throughout the Third World at a loss.

Shutting Down Windows Tablets

Nokia Discontinued Operations, of course, included results for the Lumia 2520 tablet, which was packaged with Windows RT software. The Lumia 2520 tablet therefore directly competed against Microsoft’s Surface, Surface 2, and Surface Pro tablets. Last summer, Microsoft wrote off $900 million in inventory charges related to the Surface RT. Going forward, the terms and specifications related to the Windows 8, Windows 8.1, Surface, and Lumia tablet brands will only confuse the marketplace further. Obviously, there is not enough room within the Town of Redmond for both tablet lines. Most likely, Microsoft will quietly abandon the Lumia 2520, and take yet another $500 million in asset write-downs.

The Microsoft Surface has remained as an unceremonious standby upon all flop lists created over the past two years. Mobile consumers have thoroughly rejected the Windows 8 concept that attempted to meld personal computer, smartphone, and tablet capabilities beneath one umbrella. Fans of the Personal Computer have appeared to be at war with Microsoft over apparently minor Start Menu details. Microsoft will not be able to recover from what Woody Leonhard of Info World thoroughly ripped as a “multibillion-dollar” boondoggle by the end of 2014.

Microsoft will remain trapped within a destructive cycle where developers refuse to build out applications for this ecosystem due to weak sales and usage rates. Meanwhile, prospective consumers will refuse to buy into the Windows ecosystem due to its lack of applications. Loyalists, or fan boys, are becoming more locked into the Android-iOS duopoly with every passing day. Apple iTunes sales have risen sharply in recent years, which may serve as further evidence that consumers have refused to exit this iOS ecosystem. Apple reported $4.4 billion in Q1 2014 iTunes, software, and services sales, which was a 19 percent increase above the year-over-year quarter.

If anything, a return to Microsoft’s bread and butter as a pure play software company would grant Redmond the best opportunities to turn profits within the mobile space. The Silicon Valley and Wall Street rumor mill has speculated that Microsoft will ultimately customize its Office Suite for the Apple iPad. Artist renderings for an iPad Pro show off a larger “two-in-one” workstation out of Apple that takes pages out of both the iPad tablet and MacBook Pro playbooks. An Apple hybrid tablet/laptop machine running Office would literally be the death of the Microsoft Surface.

Apple recently sold 26 million iPads during Q1 2014 — to set yet another sales record. For the sake of comparison, Morgan Stanley analysts had forecast that Microsoft would sell 1.4 million Surface units through the holiday quarter. Microsoft was not identified within the International Data Corporation (IDC) top-five tablet vendor list. IDC estimated that fifth place Lenovo shipped 3.4 million tablets during the fourth calendar quarter of 2013.

The Bottom Line

Silicon Valley denizens may recognize the phrase “merger of two garbage trucks,” as coined by the formerly high-flying Sun Microsystems brass towards the tail end of the dot-com boom. Today, Microsoft is attempting to patch together two failing businesses prior to the inevitable bursting of the Web 2.0 bubble. An ugly culture clash may prove inevitable, as Redmond will now be tasked with selling 32,000 Finnish employees upon the Microsoft Way.

Microsoft has somehow backed itself into a lose-lose situation. Aggregate return on equity and gross margins would deteriorate if Microsoft were to gain real traction in mobile. In 2013, Microsoft leveraged its dominance above the personal computer market to generate $8.9 billion in operating income off $18.7 billion in segment revenue out of its Windows division. Microsoft software has consistently run more than 90 percent of all desktops for the greater part of two decades.

Last year, Microsoft tucked away its mobile sales within its Entertainment and Devices Division. Microsoft Entertainment and Devices did include the popular Xbox gaming console. In any event, the Microsoft Entertainment and Devices division generated a mere $888 million in operating income off $10.2 billion in segment revenue. Most likely, the Entertainment and Devices segment will rack up more than $1 billion in 2014 operating losses after taking on whatever remains of Nokia.

Microsoft has thrown good money after bad. Traders should promptly sell off Microsoft shares, which have literally returned nothing for the greater part of one decade. Microsoft’s stubborn foray into mobile is set to yield disastrous results for 2014.

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