Microsoft’s Surface numbers don’t add up

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.
• “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.”

How is it possible that Microsoft doubled the number of units sold between Q2 and Q3, and raked in $400 million in the three months between July and September 2013, after writing off $900 million in June 2013 — and having sold just $853 million in the eight months between October 2012 and June 2013? Sales were so bad that Microsoft dropped 30 percent off the price of Surface RT tablets in July.

Keep in mind that all Q3 Surface retail sales were of the old models — the much-maligned Surface RT and Surface Pro — and the Surface 2 and Surface Pro 2 didn’t go on sale until last week. Perhaps everybody and his great-grandfather suddenly decided over the summer to buy a Surface, knowing that the new models were coming out shortly?

Frankly, I think that Microsoft’s leading us all down a merry path once again, and that the back-of-the-envelope guesstimates of 1 million Surfaces sold in Q3 (that’s $400 million divided by a $400 average price) are all hot air. It sure looks to me like Microsoft is repeating its old — and perfectly legal — method of reporting shipments, not sales, and letting the trade press stumble all over itself sending out inaccurate messages.

We saw that happen with the report that Microsoft had sold 900,000 Surface RT tablets in the fourth quarter of 2012. Balderdash. The same kind of shenanigans happened back in December 2010, when Microsoft announced it had “sold” 1.5 million copies of Windows Phone 7 in its first six weeks. Pshaw. Not even close.

Taking these make-believe numbers seriously, you might be tempted to conclude that Microsoft “sold” 900,000 Surface RTs in Q4 2012 and 1 million Surfaces (of all types) in Q3 2013. Counting back, based on Hood’s comment, that would mean 500,000 sold in Q2 2013 and an unknown number — IDC says 900,000 — in Q1 2013. The total would be 3.4 million Surfaces.

Apple just happens to publish its sales figures, and we know that Apple has sold 170 million iPads to date. If Microsoft’s fantasy tally was correct, Surfaces would account for roughly 2 percent of tablet usage. In fact, Surfaces run about half that rate, based on data gathered by Chitika Insights.

So where did the $400 million and doubling in unit shipments come from?

In August Microsoft announced “the first international channel availability of the Surface RT and Surface Pro … in 17 new markets.” Only Microsoft knows how many Surface tablets were shipped to all the stores in all those markets, but it was certainly considerable. If my conjecture holds true, there are lots of unsold Surfaces sitting in retail store warehouses all over the world — Surfaces that shipped in the third calendar quarter, no doubt at full price.

I also have to wonder if Surfaces shipped to Microsoft’s brick-and-mortar stores also count in the “shipped” tally, adding to both the unit count and the dollar amount. Perhaps you’ve been to a Microsoft store that has an extra unsold Surface or two sitting around.

Microsoft’s reluctance to withdraw the Surface RT from retail outlets — announced with the renaming of “Surface RT” into just “Surface” — certainly adds to the inventory.

Finally, nobody knows how many of the new Surface 2 and Surface Pro 2 tablets shipped to retailers in the third calendar quarter. If there were any, those too would contribute to the $400 million and the doubling of unit volume.

Perhaps paying customers opened their wallets and spent $400 million on Surface tablets last quarter, and bought twice as many as the preceding quarter. If you want to believe those numbers, there’s nothing to trip you up: Microsoft’s much too good at this kind of doubletalk. Somehow, though, I doubt we got the straight story — and given Microsoft’s accounting, it’s unlikely we’ll ever know the truth.

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