Microsoft's Surface numbers don't add up

How in the world did Microsoft sell $400 million worth of Surface tablets last quarter? My bet: It didn't. Not even close

Last Thursday, Microsoft reported outstanding sales and earnings for the third calendar quarter ending Sept. 30: $18.53 billion in sales (up 16 percent from the same quarter last year) with $5.24 billion in profits and a pro forma $0.63 earnings per share, excluding one-time items.

Those are tremendous numbers, meant to reinforce the idea that Microsoft's transition to a "devices and services" model is spurring the company to new heights. That may well be the case, although I remain skeptical about devices and services outside the cloud.

The number that stuck in my craw? Q3 revenues for the newly minted Devices & Consumer Hardware division -- specifically the revenue for Surface RT and Surface Pro tablets. (Microsoft wants us to call "Surface RT" just "Surface," but I'll minimize the confusion and continue to call the Surface RT just that. After all, last quarter, it wasthe Surface RT.)

Microsoft's press release for its third calendar quarter (officially known as FY14 Q1) contains this startling statement: "Surface revenue grew to $400 million with sequential growth in revenue and units sold over the prior quarter."

That's quite remarkable, considering that in the prior quarter Microsoft took a $900 million write-down for "inventory adjustments" on the Surface RT.

During the earnings call following the announcement, Microsoft CFO Amy Hood said that Surface unit sales had more than doubled between Q2 and Q3 2013. TechCrunch says it has confirmed that assertion with Microsoft.

Of course, we haven't been told how many Surface units were actually "sold" (versus shipped) and how much revenue they generated in any of the preceding quarters. Further confounding matters, Microsoft changed its accounting buckets between the second and third calendar quarters of this year, ostensibly to provide more accurate information on the devices and services drive -- I call it Microsoft Accounting 3.0. Effective with the third calendar quarter, Surface income and expenses are lumped into "Devices & Consumer Hardware," along with the Xbox, video games, Xbox Live subscriptions, and the old-fashioned Microsoft PC accessories, including keyboards and mice. That's more than a mixed bag, that's an undifferentiated pit.

The Accounting 3.0 change came on top of the "Windows deferred income" smoke 'n' mirrors that took place primarily between the last calendar quarter of 2012 and the first quarter of this year. A more cynical person than I might come to the conclusion that Microsoft's trying harder than ever to bury the bodies that matter to Windows folks. They're very, very good at it.

Microsoft's 10-Q filing includes further obfusc ... er, illumination:

  • "[Devices & Consumer] cost of revenue increased $946 million or 23 percent (year-over-year), primarily due to Surface product costs, as well as higher data center and headcount-related expenses." In other words, after taking a $900 million "inventory adjustment" for Surface RT in the second calendar quarter, Microsoft spent an extra $950 million or so in the third quarter (extra, that is, compared to Q3 2012 when Surface RT production was in full swing), primarily for making more Surfaces. I'm sure there's some hidden logic that escapes me.
  • "[Devices & Consumer] sales and marketing expenses increased $359 million or 12 percent, due mainly to increased advertising of Windows Phone 8 and Surface and higher headcount-related expenses, as well as due to higher fees paid to third-party enterprise software advisors." Nobody knows how much Microsft has spent on Surface advertising, but the ads started in 3Q of last year. At the end of calendar 2Q this year, Microsoft disclosed that it had suffered "an $898 million increase in advertising costs associated primarily with Windows 8 and Surface" for the preceding year. So in the past five quarters, Microsoft's spent an extra $1.3 billion on advertising Win8, Windows Phone 8, and Surface.
  • "D&C Hardware revenue increased $401 million or 37 percent, due primarily to Surface revenue of $400 million. The general availability of Surface RT and Surface Pro started October 26, 2012 and February 9, 2013, respectively." That's a very definitive statement, but it's subject to some, uh, interpretation, as you will see.
  • "D&C Hardware gross margin decreased $242 million or 54 percent, due to a $643 million or 101 percent increase in cost of revenue, offset in part by higher revenue. D&C Hardware cost of revenue increased, primarily due to $645 million higher Surface cost of revenue. Surface product costs increased with higher volumes sold, while other costs grew as we ready inventory lines for the Surface 2 launch and the holiday sales cycle." Keep in mind that Microsoft wrote off $900 million in Surface inventory in the preceding quarter -- and it hadn't started selling the new Surface 2 until after the third quarter.
  • "Cost of revenue increased [compared to Q3 2012], primarily due to a $645 million increase in Surface product costs."
  • "Sales and marketing expenses increased, the largest driver of which was a $111 million or 37 percent increase in advertising, largely for Windows Phone 8 and Surface."
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