Microsoft Addresses Flagshipgate and the Future of Windows Phones

In a post-earnings conference call on Tuesday, Microsoft CEO Satya Nadella spoke at length about Microsoft’s disastrous phone business and reiterated that the firm planned to address Flagshipgate with Windows 10 and finally, belatedly, ship new flagship handsets again.

I wrote about this issue—for which I’ve coined the term Flagshipgate—a lot recently, but Assessing the Current State of Windows Phones lays out the central issue nicely: despite spamming the market with a silly number of nearly identical low-end phones over the past year, Microsoft has never launched a Lumia flagship. And its predecessor, Nokia, hadn’t launched a true Windows Phone flagship since July 2014, a full year ago. But that model wasn’t even sold in the US: the most recent US-based Lumia flagship was the Lumia Icon, which shipped only on Verizon in February 2014, a year and a half ago.

Mr. Nadella discussed phone a lot during his post-earnings conference call last night, which makes sense: Microsoft just posted a $2.1 billion operating loss for the most recent quarter courtesy of its disastrous purchase of Nokia’s devices and services businesses, which required over $8 billion in write-downs and other charges.

Nadella didn’t actually say anything new, but he did reiterate comments he made in a recent memo to employees explaining the phone business implosion and in a more recent interview. More to the point, he addressed Flagshipgate. (Again.)

“We’re going to have great flagship phones for Windows fans,” he said. “That’s actually a segment we don’t today have good devices and we hope to change that with Windows 10.”

So no news. Indeed, even before the recent drama, we knew this to be the case: the reason Microsoft didn’t release any new flagships—actually, any flagships—over the past is that they were waiting on Windows 10. They said this repeatedly when asked. Which they were. Repeatedly.

So what do we know about these flagships?

We know there will be two, one phone and one phablet, and that both will include 20 megapixel cameras similar to, if not identical to, the units in the Lumia 1520, Icon and 930. We know that both will be essentially identical internally, otherwise, and that they will be marketed similarly to the Lumia 640 and 640 XL, and so might have name like Lumia 940/950 and Lumia 940 XL/950 XL. Or whatever. That obviously doesn’t matter too much.

Windows Central’s Daniel Rubino, who probably knows more about these upcoming flagships than anyone outside Microsoft, has provided more detail based on a third-party report he appears to be implicitly confirming:

Talkman

5.2 inch QHD display
Qualcomm-based 6-core processor
3GB of RAM
32GB of internal storage with a microSD card slot
20MP rear camera
5MP front facing camera
3000 mAh removable battery

Cityman

5.7 inch QHD display
Qualcomm-based 8-core processor
3GB of RAM
32GB of internal storage with a microSD card slot
20MP rear camera
5MP front facing camera
3300 mAh removable battery

I expect these phones to be announced in September and made available in October/November. Given Microsoft’s plans to reduce the number of markets and carriers for Windows Phone, I am hoping they will be made available in global unlocked versions immediately, but we’ll see.

So what else did Nadella—and other Microsoft executives—say about Windows Phone during that call? A lot, but again, nothing truly new.

(I’ve added the emphasis below. –Paul)

Speaking generally about the previous quarter, he noted that Microsoft “restructured [its] phone portfolio so that [it] can operate more efficiently near-term while driving reinvention long term.”

He said that Microsoft would ” generate new growth through gross margin on [its] own differentiated first-party premium device portfolio [and] also significantly reduce losses on phone by operating more effectively and efficiently with a more focused portfolio.” Two bits of interest there. Don’t get excited by “growth,” as he appears to mean with regards to margins only. And he admitted that phone loses money. (Microsoft doesn’t reveal profits for this and many other businesses for a reason.)

Microsoft CFO Amy Hood said that Microsoft “sold 8.4 million Lumias [in the previous quarter], an increase over last year’s full quarter sales. [Average selling price per phone] however have continued to decline. Gross margin declined this quarter driven by lower per unit margins on Lumia devices …  As announced on July 8th, we are changing our approach in this business, and are focused on delivering differentiated experiences for our targeted customer segments while improving our operating results.”

That sounds promising. But then she added:

“With the recently announced changes in Phone, there will be significant revenue declines year-over-year in the phone segment each quarter [in the current fiscal year]. With the proactive measures we’ve taken to reduce our cost structure, overall losses will also decline for the fiscal year.  We would expect the majority of that improvement in the second half of the year once the restructuring efforts are materially complete.”

In other words, phone losses will continue throughout the next year. Microsoft plans for those losses to be less in a year. But this business will still lose money.

When asked about the “strategy around the phone business” and what it would really look like in a year—this is something I openly wondered myself, in Analysis: Microsoft is Scaling Back on Windows Phone Dramatically—Nadella offered the following:

(Again, I’ve added the emphasis below. –Paul)

“The big shift that we are making when it comes to phones is to not think about phones in isolation.  That’s perhaps the biggest shift, because I think about Windows 10 in its entirety, the Windows ecosystem in its entirety.”

“We clearly are going to have a premium first party portfolio.  And you’ve seen some of the numbers, some of the progress we have made in Surface. I feel that we have a formula there that I would like to apply more broadly in terms of growing just delivering innovation, growing our own economic return for it, stimulating demand, creating categories, all of that is what I want to do broadly and it applies to phones, it applies to Surface Hub, it applies to HoloLens.  And that’s how I view it.”

You may recall that I called on Microsoft to emulate the Surface strategy with Windows phones in This is How Microsoft Can Find Its Smart Phone Niche.

“I believe our participation in the phone segment by itself, so Windows phones and Lumia phones being there is important and that’s why we picked the three areas where we have differentiation and we’re going to focus on it [Nadella’s flagship quote was here. –Paul] … We have, in fact, good traction in the business segment. So this is business customers who are actually buying phone devices, which is basically a radio with essentially a smart phone to be able to deploy their line of business applications.  That’s where we have pretty unparalleled value, which is we have the Visual Studio Online and some of the tools I talked about.  So you can generate these apps at a low cost of ownership, manage them, secure them, and deploy them to our phone endpoints, and then of course management and security.  So that’s the place where we want to continue to focus.”

And in the value smart phones, that’s the place where I want us to be much more efficient.  We clearly have some value to add there, because of the uniqueness of Office and Skype and our services.  But, at the same time I think we want to be smart about how many of these phones do we want to generate, how many — which price points we want to participate, that’s where you will see the most significant operational changes form how we operated last year to the coming year.”

That’s a lot of talking. But again, nothing truly new. Ms. Hood added the following:

“The significant revenue declines, quarter-over-quarter for the year are a reflection of the focused approach we’re going to take in phone. It’s an approach that we’ve executed in other hardware segments that I feel is a proven model for us. Our profitability will also improve.”

She previously said that the phone business is losing money. So, arguably, profitability can only improve.

“More of that comes in the second half of the year, structurally as we complete some of the restructuring efforts and those costs come out of our operating expense run rates. But, I think that’s probably the way to more appropriately think about over time you would expect to see gross margin improvement and operating profit improvement as opposed to focusing on the revenue line.”

It would be interesting if Microsoft could emerge with a smaller (by revenue) phone business that is in fact profitable. Does Microsoft expect that to happen by a year from now? That was the question, and she didn’t really answer it. But that appears to be the goal, if not the date.

The executives were also asked if “challenges with the phone business” led to Microsoft missing its gross margins predictions for the quarter. The answer was essentially that “Xbox and Surface … out-performed [Microsoft’s guidance] significantly” in the quarter, whereas phone fell quite a ways short, leading to a “hardware mix shift” and better than expected hardware margins overall.

And I believe that is everything relevant to phone from the call.