If Bill Gates and Paul Allen were founding Microsoft (MSFT) today, it probably wouldn’t look the way it does now.
The tech giant is a confusing mish-mash of businesses that seemingly have little to do with one another. What does Windows have to do with Skype? Is a parent who buys an Xbox for her kid’s birthday going to be inspired to use the company’s cloud computing services at work? Probably not. And that’s a problem.
Rick Sherlund, the veteran Microsoft analyst at Nomura, came out with a blockbuster note that adds more fuel to the growing movement to break up the company. In particular, the Xbox and Bing segments seem particularly ripe to be spun off — though for entirely different reasons.
Among Sherlund’s more salient points is that Microsoft probably loses an astounding $2.5 billion on Skype, Xbox, and Windows Phone. Most of the red ink, as Business Insider notes, comes from Xbox, which is why Sherlund rightly argues that it should be spun out.
Nix the Xbox
The timing of Sherlund’s call comes as Wall Street awaits the U.S. launch of the Xbox One — the newest model — on Nov. 22. Unfortunately, rival Sony (SNE), another misconfigured company, is set to start sales of the rival PlayStation 4 on Nov. 15. The PlayStation 4 also is priced at $499 — $100 cheaper than the Xbox One.
When the December holiday shopping season starts to get in gear, it’s possible that retailers will discount the consoles and the games, which will squeeze the margins of both companies. Shareholders shouldn’t be happy.
Sherlund’s other stunning insight was that Microsoft earns $2 billion annually from Android patent royalties. This cash can help hide all manner of sins such as the weakness in Xbox and the poor sales of other products like Surface tablets.
In the latest quarter, revenue at the company’s Devices and Consumer businesses fell 7% to $4.34 billion. That was actually better than analysts expected, thanks to an increase of Surface revenue of $400 million. Unfortunately, gross margins in the business fell 54% to $242 million, as the cost of revenue jumped 101%.
The question is, why use that $2 billion to bail out a leaky ship? The better idea would be to spin off Xbox, which is basically its own brand, and let it sink or float on its own. Then use that $2 billion toward improving operations in the core business.
Microsoft also has some decent businesses hidden within its unwieldy structure. The company’s Bing search engine has roughly a 17% market share, according to the latest data from comScore ranking — second only to Google (GOOG).
The exact success of Bing is difficult to ascertain because it’s hidden in a category the company has dubbed “D&C Other.” Revenue in this bucket of money rose 17% to $235 million, helped by an increase in search advertising. Its gross margin, though, fell 24% to $245 million as display advertising revenue fell.
The company has been cutting costs in this business, so its performance should improve over time. That makes it another excellent candidate to be spun off.
Companies who tried to be all things to all people have changed their tune in recent years. General Electric (GE) wisely unloaded its NBCUniversal media business to Comcast (CMCSA) because it had absolutely nothing to do with jet engines, power plants and the rest of the GE business. IBM (IBM) slimmed down a few years ago, getting rid of its personal computer business, which had become commoditized, to focus on more lucrative business customers. Dell (DELL) is pursuing a similar strategy, and it certainly makes sense for Microsoft to follow suit.
In the most recent quarter, demand for business products is helping offset declines in PCs and other consumer business. Revenue in Microsoft’s commercial division — which includes SharePoint and Exchange for email — beat estimates and rose 7.3% to $9.59 billion as sales from commercial cloud products doubled. Wall Street has high hopes for these operations going forward … unlike the company’s flashier consumer businesses.
The question isn’t if Microsoft should be cut but how it should be done. Spinning off the Xbox and Bing divisions seem like the logical first steps. But as it stands now, the company is just too complicated.
Jonathan Berr writes for MSN, a Microsoft site. As of this writing, he did not hold a position in any of the aforementioned securities.