Please ensure Javascript is enabled for purposes of website accessibility

Should Microsoft Kill Off the Surface, Windows Phones, or Xbox One?

By Leo Sun – Jul 25, 2014 at 5:16AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

It’s time for Satya Nadella to make some hard calls about Microsoft’s slumping hardware business. What should he do with the Surface, Windows Phones, and the Xbox One?

Microsoft's (MSFT -1.49%) fourth quarter results revealed that its server and cloud businesses were doing well, posting 11% year-over-year sales growth to $13.48 billion, but its three big hardware bets -- the Surface, Nokia Windows Phones, and Xbox One -- were falling behind.

In times like these, tech investors should look back at Google's (NASDAQ: GOOG) (NASDAQ: GOOGL) sale of Motorola Mobility. Google bought Motorola for $12.5 billion in 2012, took consecutive quarterly losses with the business, then eventually sold its set-top box unit for $2 billion to Arris and the rest of the company for $2.9 billion to Lenovo. That was a huge loss, but Google learned its lesson -- that it's smarter to have other companies, like LG and Samsung, shoulder the risk of manufacturing hardware for its software ecosystem.

That's a concept that Microsoft failed to grasp. Whereas Google has avoided margin-crushing hardware businesses since Motorola, Microsoft embraced hardware under former CEO Steve Ballmer. But now, with Satya Nadella at the helm, is it time for Microsoft to finally kill or spin off these three underperforming hardware businesses?

Killing the Surface
The Surface has run out of steam for a simple reason -- it competes against tablets but it is priced against Ultrabooks. Consumers either see the Surface as an extremely overpriced tablet or a moderately overpriced laptop. Microsoft has also kept Windows RT alive through the Surface 2, although the unpopular ARM-based OS doesn't support older Windows software.

Source: Microsoft.

The Surface division reported $409 million in revenue last quarter -- a sequential drop from $500 million in the third quarter. Perhaps Surface 2 and Surface Pro 2 tablets stalled out because consumers were holding out for the Surface Pro 3, but sales were likely just crushed from both sides by cheaper laptops and tablets. Microsoft also scrapped the previously rumored Surface Mini, possibly out of fear of it cannibalizing Surface 2 sales.

Microsoft did not disclose tablet sales figures or profit and losses from the tablets. However, an SEC filing from the third quarter revealed that Microsoft lost $109 for every $100 gained in Surface sales. The entire business has lost more than $1.2 billion since it launched in October 2012.

For now, the Surface's best-case scenario is to claim a 1% market share by the end of the year if it hits 3 million shipments -- but the more units it ships, the bigger its losses become. This lose-lose situation suggests that Microsoft should scrap the Surface and forge closer ties with leading PC makers instead.

Holding onto the Windows Phone
Microsoft's Windows Phone business, which became a hardware one after the acquisition of Nokia's handset business, is another weak spot. During the quarter, Microsoft reported phone hardware revenue of $1.99 billion from Lumia and first-party non-Lumia phones. The division squeezed out a gross profit of $54 million.

Source: Microsoft.

That seems mildly better than the Surface business, but it's still poor considering that Microsoft bought the division for $7.2 billion. Microsoft expects to break even on the Nokia investment within two years, but that could be a tough call considering how quickly the smartphone industry changes. Nonetheless, research firm IDC expects Windows Phone's global market share to grow from 3% today to around 7% by 2018. During that time, Apple (NASDAQ: AAPL) iOS and Google Android are expected to moderately decline.

Since the division is squeezing out a small gross profit, its market share is expected to rise, and the success of Bing's mobile ecosystem is heavily dependent on Windows Phones, Microsoft should retain the handset business despite the steep challenges ahead.

Spinning off the Xbox
The Xbox One is also in trouble. Microsoft obscures the sales figures of the Xbox One by grouping it with the Xbox 360, but Vgchartz pegs Xbox One unit sales at 5 million. That puts its behind Sony's (NYSE: SNE) PS4 and Nintendo's (NASDAQOTH: NTDOY) Wii U, which have respectively sold 8.7 million and 6.7 million units.

Source: Wikimedia Commons.

Microsoft sold 1.1 million Xbox 360 and Xbox One consoles during the quarter, only 100,000 more than the prior year quarter, when only the 360 was available. Meanwhile, both the PS4 and Wii U continue outselling the Xbox One on a weekly basis. That's bad news considering that Microsoft has already lowered the original $499 price of the Xbox One to $399 by ditching the Kinect and scrapped the Xbox Entertainment Division, which was intended to develop original video programming for the Xbox One.

Without Microsoft's Kinect-centered dream of the Xbox One as an entertainment supercomputer, the console is nothing but a shadow of the PS4, with the same third-party games and a handful of exclusive games. Nadella plans to integrate the Xbox One into "One Windows" -- but gamers generally care more about games than connecting their phones, tablets, and PCs to the Xbox One.

The Xbox division reportedly loses around $2 billion per year, suffers from a lack of long-term vision, and is crippled by Microsoft's attempts to connect it to the Windows ecosystem. Therefore, spinning off the Xbox into its own company, which Bill Gates supports but Nadella opposes, could be a wise move.

The Foolish takeaway
In conclusion, if Nadella is as serious about making bold changes to Microsoft, it's time to start slimming down the hardware divisions. In my opinion, killing the Surface, keeping the Windows Phone, and spinning off the Xbox One are the three key strategies to creating a slimmer, more focused, and more profitable Microsoft.

Leo Sun owns shares of Apple and Google (C shares). The Motley Fool recommends Apple, Google (A shares), and Google (C shares). The Motley Fool owns shares of Apple, Google (A shares), Google (C shares), and Microsoft. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.