Microsoft Should Have Left Google Alone

If there's one takeaway from software giant Microsoft's (Nasdaq: MSFT) earnings release last week, it's this: It should have left Google (Nasdaq: GOOG) alone.

Do you see what happens when you compete with Google in advertising? Do you see what happens?
Mr. Softy's fiscal fourth-quarter results were marked by a net loss of $492 million, a rare glimpse of red ink. In fact, this is the first quarterly loss that the company has ever publicly posted since its IPO in 1986. And it's all thanks to the decision to try to tackle Google on its home turf.

There is exactly one reason Microsoft posted a loss this quarter: the previously announced goodwill impairment of $6.2 billion related to the acquisition of aQuantive in 2007. Of that total, $5.3 billion of it was directly tied to aQuantive after Microsoft acquired the company for $6.3 billion at an 85% premium. The non-cash charge was a direct admission that aQuantive failed to "accelerate growth to the degree anticipated." In its press release, Microsoft conceded, "While our search business has been improving, our expectations for future growth and profitability for OSD are lower than our previous estimates."

Bing was launched in 2009, two years after the aQuantive deal, and is part of Microsoft's online services division, or OSD. Thanks to the impairment, the OSD generated an operating loss of $6.67 billion this quarter, bringing cumulative operating losses for the division since the beginning of 2005 to a mind-boggling $16.9 billion. For perspective, that's nearly Yahoo!'s (Nasdaq: YHOO) current market cap of just over $19 billion, although much, much less than the $44.6 billion Microsoft once offered for the purple searcher.

For what it's worth, investors knew this was coming, as the impairment was announced earlier this month, so it was effectively priced in already. Still, it serves as a painful reminder that Microsoft's decision to jump into search advertising has been a painful one for shareholders. Besides, it's not as if the OSD sees operating black ink even on a good quarter, much less a bad one. The last time it turned a profit was back in the second quarter of fiscal 2006, when it generated a measly $58 million in operating income.

The usual suspects
As far as the rest of the report goes, total revenue rose 4% to $18 billion. Microsoft saw strength in its three primary cash cows: Windows, servers, and business. The server division saw record revenues of $5.1 billion, pitching in $2.1 billion in operating income.

Source: Earnings press release. Note that figures may not add up because of rounding and also because unallocated revenue and corporate level expenses are not included.

Windows and business, which includes the almighty Office suite, naturally carried the company, generating the bulk of both sales and operating income. Windows sales fell year over year, mostly because of the deferral of revenue related to a Windows Upgrade Offer announced during the quarter, allowing some users to get a heavily discounted price on Windows 8 Pro once it's released later this year. The offer affects only revenue recognition and has no impact on operating cash flow.

Business as usual
The entertainment and devices division, home to Windows Phone and Xbox, continued to lose money, but sadly that's just business as usual. The company shipped 1.1 million Xbox 360 units during the quarter, less than the 1.7 million shipped a year ago. That's mainly a function of declines in the broader console market, while the Xbox 360 still leads compared with its primary rival, the Sony (NYSE: SNE) PlayStation 3.

That brings Microsoft's cumulative total of Xbox 360 units sold to 68.3 million units, with roughly 40 million Xbox Live members. Software attach rates continue moving higher and now stand at 9.4 software titles sold per console on average. That bodes well for player engagement, especially as many eagerly await the next version of the console, the Xbox "720," which isn't due out until next year.

Windows Phone 8 is due out later this year, hoping to make a dent in Apple's (Nasdaq: AAPL) and Google's dominating smartphone market share. Microsoft will be faced with transitioning to WP8 because it won't be backwards compatible. It may be worth it, though, since the mobile OS will share the same core as Windows 8, which has many long-term benefits if Mr. Softy can pull it off.

Spoiler alert
Overall, there were no big surprises in the results, which is why shares didn't register much action one way or the other. That said, investors can't help wondering how much better off they'd be if Microsoft would just focus in on its core strengths of Windows, servers, and productivity software while jettisoning its financial weaknesses in online services and entertainment.

Spoiler alert: They'd be a lot better off.

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