Inside Microsoft’s earnings: A sweeping reorganization points Microsoft in the right direction, but obstacles in its PC and mobile businesses will remain through 2014, writes Jack Narcotta, an analyst with Technology Business Research. He takes a look at the company which disclosed its latest earnings report on Tuesday.

HAMPTON, N.H. - Microsoft (Nasdaq: MSFT) has been on a course of substantial change to its business models, organizational structure and culture since Satya Nadella was appointed CEO in February 2014, even prior to Microsoft announcing its largest-ever layoffs in 2Q14 – a total of 18,000 employees, with an estimated 12,500 coming from Nokia.

With Nadella’s message that the company he leads is primed to further evolve into a platform and productivity company,

it is clear that the primary focus for Microsoft has shifted back to increasing user engagement with Windows software, regardless of the device. TBR believes this will aid in triaging Microsoft’s relationships with its largest OEM partners – Dell, HP and Lenovo – who found themselves competing head-to-head with a partner as Microsoft made its push into the devices market with its range of Surface tablets.

Revenue of $23.4 billion for calendar 2Q14, up nearly 18% year-to-year, illustrates that Windows 8 is gaining traction, and increased proliferation of Windows 8 in the enterprise – as evidenced by upticks in the commercial PC businesses of Dell, HP and Lenovo – highlights the strong grip Microsoft has on the business market.

However, TBR believes the substantial changes ahead for the company will have negative effects on its and its OEMs’ consumer market share and relevance in the mobile device market.

Consumer-facing businesses such as Xbox and Windows Phone are facing uncertain futures

With Microsoft shifting from focusing on devices and services to providing productivity tools and platforms, TBR believes that the Windows Phone platform is becoming non-competitive in the consumer market, even as Microsoft assumed full control of its $7.2 billion acquisition of Nokia’s handset business in 2Q14.

Nokia remains one of the world’s largest handset vendors, but its product mix – 84% of Nokia’s handset shipments in 2Q14 were feature phones – is out of sync in a market where smartphones are the dominant device. Nokia continues to aggressively market its newly expanded range of Lumia devices into emerging markets, but lukewarm sales of Lumia smartphones compelled Nokia to rely on a rapidly shrinking feature phone customer base for its handset revenue and profits.

However, with Microsoft’s announcement in July 2014 that it is exiting the feature phone business – and aims to replace them with budget-priced, entry-level Windows Phone smartphones – and that Microsoft is ending Nokia’s Android development, TBR believes the Lumia consumer brand is at risk of fading completely from the market. Lumia devices may evolve into business tools, a la BlackBerry at the height of its success, but Nokia’s sustained operating losses combined with declining revenue threaten to dent Microsoft’s cash reserves, hampering the company’s ability to make investments or acquisitions necessary to reach its “mobile-first, cloud-first” goal.

Additionally, while the Xbox One and continued sales of the Xbox 360 are positive signs that Microsoft is well-established in the “connected device” market, the re-emergence of Sony’s PlayStation as the de facto gaming console and the continued rise of casual, mobile gaming – as well as a hosted of HD television ready, lower-priced devices from Roku, Apple, and Google – are undermining the value proposition of Microsoft’s media hub. Shipments of the Xbox console in 2Q14 climbed just 100,000 units from the prior year to 1.1 million. A 14% revenue gain year-to-year in Xbox platform revenue was driven largely an increased mix of higher-priced Xbox One console, helping offset slowing unit shipments.

Surface is set to take on a supporting role in the Windows ecosystem, but Windows OEMs are more focused on lower-priced 2-in-1 PCs and Chromebooks

Part of Nadella’s manifest included staunch support for Microsoft remaining a first-party hardware manufacturer of devices like Surface Pro 3, but the go-to-market strategy will be revised to stoke demand for Windows devices as productivity tools. Nadella stated he expects Microsoft to continue to forge ahead and, at times, develop new product categories.

TBR believes that Microsoft will reduce the degree to which it directly competes with PC OEMs like HP, changing Surface’s value proposition from hardware reference design to an example of how Windows can adapt on demand for meet the productivity (or entertainment) demands of a PC user. Surface is not a threat to compete with traditional clamshell or 2-in-1 PCs, but TBR believes it represents opportunities for OEMs to collaborate with Microsoft to produce devices that amplify Nadella’s message of Windows as the tool to “get stuff done”. Even without mainstream vendor and comparatively limited marketing support, Surface revenue eclipsed $409 million, helped by price discounts applied to Surface 2 and Surface Pro 2 ahead of the launch of the Surface Pro 3 in June 2014.

However, Chromebooks, smartphones, tablets and a growing number of sub $400 2-in-1 PCs are beginning to exert greater influence on the computing device market. New, sub $200 Windows 8 devices are due out in 4Q14, and part of PC vendors’ strategies will need to include capitalizing on budget-priced devices. However, save for Lenovo and, to a lesser extent, HP, PC gross and operating margins are already below those of Windows OEMs’ other business lines.

With even lower-priced PCs on the horizon that threaten to generate even smaller profits, TBR believes the shrinking margins will compel Windows OEMs that lack enterprise market share, such as Asus and Acer, to focus exclusively on Chromebooks and budget-priced 2-in-1 PCs. However, TBR expects consumer PC markets to enter into a prolonged period dominated by customer attrition from one vendor to another, stunting overall consumer market growth.

(C) TBR