Microsoft's weakest link in 3rd quarter: Xbox and phone division

While many are focusing on Microsoft's strong Windows client performance, let's not overlook the not-so-great quarter turned in by the company's Entertainment and Devices unit.

Microsoft's third-quarter earnings for its fiscal 2012 year are in, and most of the stories I'm reading are focusing on the strong Windows client performance -- compared to the year-ago quarter.

Fewer stories are focused on the not-so-great quarter turned in by Microsoft's Entertainment and Devices unit, which is home of the Xbox and Windows Phone (and where the Skype division's numbers are reported).

First, a bit of context on both counts. Yes, the Windows division's performance was better in the third quarter of fiscal 2012 -- an impressive feat given the ongoing concerns about the growth and viability of the PC market. But Windows/Windows Live revenues ($4.62 billion) were down compared to those from the second quarter of this fiscal year ($4.74 billion). The second quarter was the usually robust holiday quarter for Microsoft, during which the company tends to earn a lot of revenues from new PCs sold to consumers. In the third quarter, according to Microsoft officials, Windows sales were strong due to corporate demand for Windows 7.

Regarding the Entertainment and Devices unit's performance, some will be quick to claim it must be Windows Phone dragging down the rest of the division. However, the overall video game market has been sluggish. Xbox console sales are down 48 percent for the quarter, according to Microsoft. So even though Xbox is leading the console market with 42 percent share, according to Microsoft's latest numbers, the video game console market overall is very soft.

Now it's easier to understand why Microsoft is increasingly pushing to reposition the Xbox as not just a video game console, but more of an entertainment hub with TV/entertainment channels. And it's also more apparent why the Softies are playing up Xbox and Kinect stories over what's still really making the company money -- namely those "boring" enterprise products like CRM, SharePoint. and Lync.

Microsoft still isn't breaking out Windows Phone sales (and don't expect it to any time soon, even if Wall Street analysts ask). But even the Softies have been forthright about the fact that Windows Phone hasn't yet taken the market by storm -- to put it mildly. Microsoft is spending millions to increase advertising and sales incentives/retailer education on Windows Phone to attempt to boost its share, which is currently estimated to be around 1.5 percent worldwide.

But don't think it's all Windows Phone to blame for the decline in Entertainment and Devices revenues this quarter. From Microsoft's 10Q report dated today:

EDD revenue decreased primarily reflecting lower Xbox 360 platform revenue, offset in part by Skype revenue and Windows Phone software license revenue from Nokia. Xbox 360 platform revenue decreased $584 million or 33%, due mainly to decreased volumes of Xbox 360 consoles and standalone Kinect sensors sold, offset in part by higher Xbox LIVE revenue. We shipped 1.4 million Xbox 360 consoles during the third quarter of fiscal year 2012, compared with 2.7 million Xbox 360 consoles during the third quarter of fiscal year 2011.

On the operating income side, Entertainment and Devices took a hit from lower revenue, payments made to Nokia, and higher R&D and sales and marketing expenses, the 10Q said. Nokia officials have said Microsoft agreed to pay the Finnish phone maker more than $1 billion when the pair formed their Windows Phone partnership a year ago.

Microsoft is planning to deliver Halo 4, the first non-Bungie-produced version of its popular Halo game for the Xbox, on November 6 this year. But Microsoft isn't expected to roll out the next version of its Xbox (said to be codenamed "Durango") until calendar year 2013. In the interim, Microsoft is counting on Kinect sales, Xbox Live subscriptions, and game sales to propel its Xbox business, officials said during today's earnings call.

Microsoft reported third-quarter earnings of $5.11 billion, or 60 cents a share, on revenue of $17.41 billion. Wall Street was expecting Microsoft to report earnings of 57 cents a share on revenue of $17.18 billion.

Entertainment and Devices isn't the smallest or worst performing of Microsoft's five business units. That distinction still belongs to Online Services, the division behind Microsoft's Bing search engine and its online advertising division. Online Services earned $707 million with an operating loss of $479 million in the third fiscal quarter. Entertainment and Devices brought in $1.6 billion and an operating loss of $229 million.

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