Microsoft’s Q2 earnings take $900 million hit due to millions of unsold Surface RT tablets

Microsoft (MSFT) has announced its fourth-quarter (Q2 calendar) and full-year earnings, and the news isn’t fantastic. While its enterprise offerings continue to do well (the Server and Tools division grew 9% this year), the company continues to be hampered by the shrinking PC market — the Windows division, despite the release of Windows 8, saw its profits drop 18% year-over-year. For the complete financial year, Microsoft’s revenue was up 6% to $77.849 billion, from $73.723 billion — but, if we remove last year’s massive $6.2 billion write-down of aQuantive, Microsoft’s revenue (and profits) are essentially flat or slightly down. More importantly, though, Microsoft’s financial report also shows that it took a $900 million charge for “Surface RT inventory adjustments.” Dividing that by the recent $150 price cut suggests that Microsoft could be sitting on as many as six million unsold Surface RTs.

If Microsoft really has six million Surface RT tablets lying around, it’ll be one of the most gloriously magnificent misjudgments in technological history. Early reports from the supply chain suggested that Microsoft had ordered around three million ARM-powered tablets, and industry analysts estimated that between 1 and 1.5 million of them had been sold. There is a possibility that the $900 million charge also includes Surface accessories, but we’re still looking at a huge number of stockpiled Surface RTs — probably between five and six million. Accounting for the ones that have already sold, this means that Microsoft originally expected to sell up to seven million Surface RTs. A highfalutin target for a sluggish tablet with limited functionality, especially when there are Android and iOS tablets in the same price range.

With a new Surface RT tablet expected alongside Windows 8.1 in the fall, it’ll be interesting to see how much of its existing stockpile it can shift. During the earnings call, Microsoft’s CFO Amy Hood said, “We believe this price decrease will accelerate surface RT adoption and position us for better success.” At $350 the Surface RT is certainly more tempting than it was before, but I still don’t know if I would recommend it over an iPad Mini or Nexus 10. We wouldn’t be surprised if, come Microsoft’s Q4 calendar earnings, there’s another huge charge for unsold inventory.

Zooming out, the financial results from Microsoft’s other divisions are a mixed bag. The Online Services division (Bing) continues to make a loss, but this year it made its smallest loss ever (just $1.28 billion). Entertainment and Devices, which includes the Xbox 360 and Windows Phone, saw full-year revenue growth of 6% to $10.165 billion, and a doubling of profits to $848 million this year. Microsoft’s Business division (Office, SharePoint, Lync) had a fantastic quarter (revenue up 14%; profits up 18%), but fairly flat over the full year. Consumer revenues dropped precipitously (27%) due to the tardiness of the PC market, but this was buoyed up by strong business revenues.

CFO Amy Hood said, in response to Microsoft’s generally weak earnings, “We know we have to do better and this is one reason we made the strategic and organizational changes last week. We are confident we are moving in the right direction.” Looking forward, Microsoft issued guidance saying that next quarter will probably be much of the same: Windows will continue to struggle, Entertainment and Devices will decline slightly (until the release of the Xbox One presumably), and Server and Tools and Business will continue to grow steadily. Online Services will grow by double digits, but that’s not saying much.