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Microsoft gets hardware foothold as Surface, Lumia sales jump

In its latest financial snapshot, the software giant is demonstrating that its hardware business is not just a sideshow after all.

Nate Ralph/CNET

Microsoft's consumer devices are starting to show signs of life.

The company's fiscal second-quarter earnings posted Monday indicate that its consumer businesses are consistently growing. Its Lumia phones are selling better than ever and Surface, its tablet line, is officially a billion-dollar business. Though these divisions are still nowhere near as large as Microsoft's software, servers and Internet services divisions, the numbers represent a promising start.

Though those core software businesses are still the company's bread and butter, Microsoft is very much still in a significant transition period. CEO Satya Nadella, who took over nearly a year ago, now has a twofold mission: to have Microsoft's newest operating system, Windows 10, run across as many devices and screens as possible, and to make consumers love Windows again, not just use it out of necessity. For Nadella, that means pushing Windows as aggressively into the hands of consumers as it has in the corporate realm.

Helping the cause, the software giant is positioning its next operating system as the Swiss Army Knife of computing, with executives explaining at a Windows 10 event last week at its Redmond, Wash., headquarters that the company can both evolve its OS while appeasing longtime users who felt put off by the missteps of Windows 8. But Microsoft is still far behind on mobile with its software running on about 3 percent of phones worldwide. Surface, too, has much ground to cover to compete with both Apple's iPad tablet and the scores of low-cost laptops with which it also competes.

"Each day we're reminded of the enormity of the responsibility we have to move the innovation of Windows forward," Nadella said last week. "Our universal platform is what runs across the phone, the PC and now the TV. Developers can target applications to the largest amount of Windows devices."

Microsoft's biggest challenge is not necessarily selling these consumer devices, which it's doing now at a faster clip. Rather, the company needs -- as Nadella points out -- to get developers to care in a world increasingly swallowed up by Apple's iOS and Google's Android platforms.

It took Microsoft about two years to turn its Surface tablet into a billion-dollar business, though it has serious work to do if it's to compete with Apple and laptop makers. Sarah Tew/CNET

For the three months ended December 31, 2014, Microsoft said its profit was $5.86 billion, or 71 cents a share, compared with $6.56 billion, or 78 cents a share, a year ago. Sales were $26.47 billion, up 8 percent from $24.52 billion a year ago.

That roughly matches the average estimate of analysts surveyed by Thomson Reuters, which forecast earnings of 71 cents a share for the period and $26.32 billion in sales.

The drop in expectations and in Microsoft's earnings is a result of the company's continued costs from acquiring Nokia's handset division in April 2014 for $7.2 billion. Microsoft brought Nokia's Lumia brand into the Windows Phone fold, hoping to boost its mobile division in the face of a struggling global market share. Its phone division now contributes more than $2 billion in quarterly sales.

Microsoft bore a bigger brunt of that financial blow last quarter, swallowing $1.14 billion in restructuring costs like severance packages and other expenses that resulted in a 13 percent drop in year-over-year profit. Executives stressed that Microsoft would incur $500 million more before the end of the year, following a road map outlined in July when the company first announced it would be laying off 18,000 employees, many former Nokia employees.

Microsoft ended up spending only $243 million on those restructuring expenses, incurring a 2 cent per share negative impact to the company's profit. The company said it expects to incur $100 million per quarter for the remainder of the fiscal year, keeping its costs in line with its July projection.

Sales of Nokia smartphones are at a record high of 10.5 million units this past quarter, but Microsoft still struggles with a paltry 3 percent global market share on mobile. CNET

This quarter, Microsoft sold a record 10.5 million Nokia Lumia smartphones, up 28 percent from a year ago and bringing in $2.3 billion in sales driven by demand in the budget smartphone category. And for the first time ever, the company's Surface tablet division pulled in more than $1 billion in sales, a 24 percent jump from a year ago. Overall, the company's Devices and Consumer division increased 8 percent from a year ago to $12.9 billion.

It's worth noting that in swallowing up Nokia's handset division, Microsoft lost its largest licensee, cutting into its Windows Phone revenue figures.

A more pressing issue for the company is how it can convince investors that the future of Windows software, both on mobile and across the many other devices that will run Windows 10 -- is a secure financial bet. Terry Myerson, Microsoft's executive vice president of operating systems, announced last week that the next version of Windows will be free to any PC and mobile users running Windows 7, Windows 8.1 and Windows Phone 8 for the first year of its release.

The company has already ditched licensing fees on mobile by letting other handset and tablet makers run its mobile Windows software for free if the device is under 9 inches, as well as allowing iOS users to use Office applications on iPad and iPhone at no extra cost. The play has yet to reflect positively in the company's mobile market share.

On a call with investors, Microsoft's Chief Financial Officer Amy Hood said the company's OEM model and paid-up-front Windows sales will stay in place, easing some of the tension around how Microsoft will make money off the software.

Many of Microsoft's other divisions, which include servers, PC software and video games, continue to do well, as expected. Sales of its Xbox 360 and Xbox One game console totaled 6.6 million units, a 214 percent increase from last quarter attributed to price cuts and bundling of free games with the device.

Those maneuvers, along with a general drop off in sales of its older Xbox 360, resulted in a 20 percent year-over-year drop in revenue for the division. Microsoft hopes the sacrifice will help the Xbox One compete against Sony's better-performing PlayStation 4, which the Xbox outsold for the first time all year in the months of November and December.

Microsoft's cloud services business, which includes Office 365 and its Azure platform, is still the shining star of the company's enterprise efforts. In its last quarter, Microsoft reported a 128 percent year-over-year growth. This time around, Microsoft notched 114 percent growth in its cloud business, which is now on track to pull in $5.5 billion annually. Overall performance of its Commercial division is up 5 percent to $13.3 billion.

Microsoft offered guidance for its next quarter and for the fiscal year. While the company expects growth in its core businesses, it projected drops in revenue for its gaming and phone hardware units -- down to $1.5 billion and $1.4 billion respectively -- due to springtime trends and continued changes in its smartphone business due to Nokia. For the fiscal year, Microsoft expects revenue growth to be around 4 to 5 percent year-over-year.

Though the company is showing signs of progress, investors were not pleased with the 10 percent drop in profit. Microsoft stock is down 4.3 percent in after-hours trading.

Overall, the company's shares have risen more than 27 percent so far this year. In November, Microsoft stock hit a 14-year-high of $49.58 a share, and has since overcome Exxon Mobil for the title of No. 2 most-valuable company in the world behind Apple.

Update at 3:10 p.m. PT: Added further details from Microsoft's call with investors.