A closer look at Microsoft’s Q3 results: Hiding away tepid Xbox One sales

Microsoft's quarterly sales figures are in and they point to a company in flux – as well as tepid sales for the Xbox One. This was CEO Satya Nadella's first time at bat for an earnings call, the first quarter for full Xbox One availability, and (theoretically) the quarter when business buyers, faced with Windows XP's final farewell, might start buying Windows 8 PCs to refresh ancient desktops. The big-picture earnings for Microsoft were largely flat year-on-year ($20.4 billion or £12.15 billion in revenue this quarter versus $20.5 billion or £12.2 billion in 2013), but that fact obscures some of the more interesting shifts within revenue categories.

Since consoles are a favourite topic of discussion, we'll start there.

Console sales and shipments

Microsoft reports that it "sold in" two million Xbox consoles this quarter, including 1.2 million Xbox One consoles. That's surprisingly strong performance... from the Xbox 360. The strong sales may be partly due to Microsoft's pledge to continue supporting the Xbox 360 for years to come and there's historical precedent – Sony only killed off the PS2 in Japan last year and sold more than five million systems globally as recently as 2010. Microsoft may have a similar long goodbye in mind for the Xbox 360.

As for the Xbox One, shifting 1.2 million consoles this quarter and five million to-date is reasonably good, but there are a lot of questions about what "sold in" means versus "sold through." The term "sell in" is used when a manufacturer sells parts into the channel. "Sell through" is used when a company sells products directly to the end customer.

When Microsoft sells an Xbox console to a retailer, in other words, it classifies that as sell in. When it sells you a Surface tablet directly from its own website, that's sell through. This has led to charges that Microsoft is only recognising the impact of consoles it has "shipped," with accompanying squabbles over what the real figures are. Sony, in contrast, has specifically reported a sell through of seven million PS4s as of 6 April.

That means the gap between the Xbox One and the PS4 is going to be somewhat larger than two million units because the two companies are reporting two different figures. Charges that Microsoft is deliberately hiding some catastrophic weakness in Xbox One sales, however, are probably overblown. While it's true that Redmond could probably stuff the channel with consoles in the short term to hide low uptake, its retail partners have financial reporting obligations of their own – and that very much includes inventory. There are plenty of accounting tricks to hide an inventory bulge in the short term, but as quarters slip by, those consoles have to be accounted for. The best way to check a console's health over several quarters is to watch inventory levels at both retail partners and Microsoft itself.

Right now, the PS4 is unquestionably outselling the Xbox One, and by a significant margin, but drawing conclusions at this early date would be foolish.

In 2008 – a full year after the PS3 had launched, the Xbox 360 was crushing its rival, with 1.44 million consoles shipped that year compared to just 726,000 PS3s. The PS3 was dead last in game attach rates, it had fewer titles, and it was significantly more expensive. Sony was still losing hundreds on every console sold. Microsoft had a huge early lead on its rival, even if both were dwarfed by the Wii's meteoric success. Today, things look a little different.

For all the vitriol slung, the PS3 and Xbox 360 ended their runs in more or less the same place, even if Sony took billions more in losses thanks to those early costs. In short, it's too early to call a winner on the Xbox One versus PS4 battle.

Microsoft's other business categories showed a number of shifts that managed to cancel each other out in aggregate. Revenue from consumer operating system licenses was up 4 per cent while OEM license revenue rose 19 per cent on replacement cycle business. Revenue from Office 365 grew 15 per cent, Xbox One sales drove a 41 per cent gain in revenue from that segment, but drove gross margin down 34 per cent – in other words Microsoft sold a great deal more hardware, but made much less money in doing so.

Surface revenue grew to $494 million (£294 million), but Surface cost Microsoft $539 million (£320 million), which makes the entire segment something of a drag. Microsoft barely acknowledged Surface, save to note that its mixture had shifted to second-generation units, implying it had cleared inventory of the old first-gen systems that didn't sell particularly well. There was no mention of whether or not a third-generation Surface was in the works, or what the split was between Surface 2 and Surface 2 Pro.

During the call, Nadella chose to emphasise Microsoft's growth in search (Bing's market share is up to 18.6 per cent in the US), the surge in search revenue (up 38 per cent) and the recent launch of Cortana, Microsoft's Siri competitor. Cloud services, Office 365, and Nokia were the primary topics, with little said about expectations for Xbox One sales through the end of the year or future Windows products. The focus on mobile and cloud could align with some of the company's cross-platform goals for the Xbox One, but that's going to depend on how these plans are implemented.

Image Credits: Ars Technica, VGChartz