First up on the new year’s earnings calendar is Microsoft, which reported its fiscal 2023 second quarter results last week.
Results were mixed in the holiday period for the software giant and its Xbox business, mostly expected coming off last year’s all-time highs. Just last quarter, gaming had its best Q1 ever.
That’s not the case for Q2, where normalization towards pre-pandemic levels has started in earnest. Even so, it was still one of the best quarters in Xbox history, which is important to keep in mind as headlines are often gloomier than reality.
In the three months ending December, Microsoft’s gaming revenue showed a double digit decline for the first time in three years. Mainly due to a sparse exclusive game slate, lower third-party monetization and ongoing hardware challenges. From a dollar standpoint, it was still the third best Q2 ever for Xbox, as I’ll illustrate soon. The sky isn’t anywhere near falling.
Executives tried to paint a picture around engagement and Xbox Game Pass while not providing any updated subscription numbers for its flagship service. On the bright side, they did share an updated figure for Monthly Active Users (MAUs) across the Xbox ecosystem as it passed a major milestone by year-end.
“In gaming, we continue to pursue our ambition to give players more choice to play great games wherever, whenever, and however they want,” said CEO Satya Nadella. “We saw new highs for Game Pass subscriptions, game streaming hours, and monthly active devices.”
I’ll now move into the underlying numbers for the latest quarter, then provide a look ahead to the back half of Microsoft’s fiscal year.
Between October and December, Xbox generated $4.76 billion in revenue which is 13% lower than the same time last year. That was in-line with guidance. While this number is the lowest it’s been in three years, it’s the third best Q2 in history only behind the latest two.
This historical context really illustrates the sort of impact quarantine spending had on the industry, as just last year Xbox recorded an all-time second quarter revenue high of $5.44 billion.
Executives pointed to this strong comparable as the main reason Xbox suffered declines across first and third-party content plus lower hardware sales output. I wouldn’t necessarily call it an outright disappointing holiday season; it’s just not nearly as good as last year.
One caveat is currency impact on this figure. You’ll see in the above slides that total gaming sales were down 9% in “constant currency.” This implies a 4% impact from exchange rate movement. I tend to report the overall figure because global companies must navigate these shifts, while also noting this particular point when fluctuations are especially drastic.
Taking into account the latest quarter, current annual gaming revenue stands at $15.56 billion. As shown in my chart, Xbox segment sales have been slowing lately after peaking around a year ago. It was bolstered by last holiday’s record quarter until now. This chart also keeps quarterly movement in context as it smooths out the results, displaying how well gaming has been faring versus the Xbox One generation.
Within these articles I like to run a quick comparison to industry peers, even this early in the season. Tencent currently has the most annual revenue from gaming, at upwards of $25.8 billion. Sony reached $20 billion. Here is where Microsoft’s $15.56 billion slots in, while Nintendo rounds out the list at $13 billion. If accounting for Activision Blizzard’s latest $7.4 billion in annual sales and assuming roughly $2 billion in redundancies and overlap, the combined entity could have between $20 billion to $21 billion in annual gaming output, potentially matching PlayStation depending on where exchange rates go.
Now, revenue isn’t the sole metric by which a division’s health is measured. Microsoft doesn’t share specifics on Xbox’s profitability, so we’re left to infer here based on its More Personal Computing (MPC) business segment results. Gross margin dollars reduced by 29%, driven by a mix towards lower margin businesses that include gaming. Expenses rose 6%, thus segment operating income dropped 47% to $3.32 billion. All of this implies profitability dropped in the quarter for Xbox, consistent with its lower sales output.
Moving over to category mix to show the underlying dynamics. Within the Xbox business, both sub-segments of Xbox Content & Services and Xbox Hardware experienced comparable double-digit declines as the business cooled.
The larger contributor Content & Services, which includes software and subscriptions, lowered 13% in the quarter. Right at company guidance. It accounted for $3.38 billion in sales, or 71% of Xbox’s total. Nearly the same contribution as last year, and lower than recent quarters since its hardware counterpart has been inconsistent.
During the last 12 months, Content & Services has generated $12 billion in revenue, making up 77% of annual gaming sales. It’s been at that same exact percentage for the last six consecutive quarters.
As has been tradition, Microsoft yet again didn’t share an update on Xbox Game Pass subscription figures. The latest of 25 million is way outdated, from back around September 2021. I often say that we learn just as much, if not more, from what a company doesn’t share. This is one of those cases. I assumed Microsoft would boast when it passed 30 million subscribers, so I assume it’s below that right now. In my predictions piece for 2023, I said it could reach that threshold by Microsoft’s fiscal year-end in June and move higher in the back half on the strength of new releases. I just hope Microsoft is more transparent, at some point.
Thankfully executives did provide another engagement stat: MAUs for the Xbox network overall. Finally. Two years ago, this figure crossed the 100 million user threshold. Now, according to Nadella, it’s at a record 120 million. Thus recently averaging 10 million per year in user growth and nearly double the 65 million achieved back in fiscal 2019. It makes sense that management would point to this within its strategy that emphasizes ecosystem over hardware, expanding its offering to more devices than ever and making a play that stacks up accounts as opposed to unit sales.
Rounding out the category mix with Xbox Hardware, this segment declined 13% to $1.38 billion. The slides cited both a lower average price and number of units sold compared to last holiday, which I’d call somewhat of a concern at this early life cycle stage. Also concerning is the dollar output, which is less than the second quarter in both 2018 and 2019 during the middle of last generation. It shows a few things: hardware is less important to the overall Xbox business than ever before, the lower-priced Xbox Series S is contributing a substantial share plus supply constraints continued into the quarter as competitors were able to better navigate the cost environment.
On an annualized basis, Xbox Hardware is tracking at $3.6 billion in sales right now. The lowest in six quarters. It bucks the trend of a traditional console cycle, where sales should be increasing in the early years. Note that the Xbox Series X|S family of devices launched in November 2020.
It begs the question: How many Xbox Series X|S consoles have shipped to date? Last quarter, I estimated between 17.5 million and 18 million. Given the revenue indicators and supply situation, I guess it’s approaching 21.5 to 22 million at this point, implying around 4 million shipped in the holiday quarter. This would be virtually in-line with Xbox One at this point in the life cycle (22.1 million). My estimate is partially because I notice Nadella is no longer boasting the family as the fast-selling in Xbox history. And it’s nowhere near its current generation counterpart. Sony’s PlayStation 5 recently passed 30 million sold-thru to consumers, and was already at 25 million lifetime shipped in September, showing strength in availability towards the latter parts of calendar 2022.
Fitting the general themes of macro pressure on tech in particular, Microsoft overall had its slowest quarterly growth in six years and missed analyst estimates. Top-line sales rose 2% to $52.7 billion, while analysts thought it would be above $53 billion. Microsoft Cloud alone increased 22% to $27.1 billion in sale, which met expectations. MPC was the only segment to decline, moving down almost 20% to $14.2 billion on PC market weakness and high output last year.
On the profit side, operating income declined 8% to $20.4 billion. Profitability was impacted by a $1.2 billion charge related to laying off 10,000 employees, or 4.5% of its workforce, which the company announced earlier this month. That’s a lot of talented people losing their jobs, notably in a shift towards artificial intelligence businesses, and I hope they are able to find success elsewhere.
General slowdowns hit both Microsoft and its Xbox division during the holiday period, even if it was still one of Xbox’s best quarters when compared to recent history. Higher Xbox Game Pass subscriptions propped up weakness elsewhere, especially the first-party game lineup, and hardware results reveal that the Xbox Series X|S family needs to ramp up supply as soon as possible.
I’ll finish up here with guidance for the next quarter, ending this March, according to Chief Financial Office (CFO) Amy Hood.
Management expects gaming revenue to decline in the “high-single digits.” Assuming it’s down 8%, that implies quarterly Xbox revenue of $3.44 billion. Its lowest in three years.
Xbox Content & Services revenue will decline in the “low-single digits.” Hood claims Xbox Game Pass user growth will outpace “lower monetization per hour” in both first and third-party games. It’s a corporate way to say subscriptions will rise while active engagement, and thus spending, will be down. Let’s assume the decline is 5%, implying Q3 sales of $2.86 billion from Xbox Content & Services.
Microsoft didn’t actually provide an outlook for Xbox Hardware. Based on the above, signals are pointing to another double-digit drop that might be upwards of 20%. The current quarter is a continuation of last year, where first-party output is light and the supply of Xbox Series X in particular will be hamstrung.
Still, the calendar will pick up soon as Xbox Game Studios will publish Minecraft Legends in April then Redfall in May. Thing is, I’m not expecting either of these to move the needle in a major way on the financial side. Certainly not as much as something like Starfield or Forza Motorsport, both of which are slated for this year without a concrete window. Personally I’d be surprised if Starfield makes it out by the fiscal year-end in June.
Speaking of June, Microsoft management reiterated on the conference call that, while its guidance doesn’t include any impact, they continue to anticipate the $69 billion Activision Blizzard deal will close by then. I’m way more skeptical on that front, as displayed in my aforementioned predictions article.
Thus ends my first big recap of 2023, in what will be a shaky quarter for many public companies across the games industry and related sectors. Check back soon for more analysis and a full rundown of results for platform holders Sony and Nintendo. Thanks for reading! Be well, all.
Note: Comparisons are year-over-year unless otherwise noted.
Sources: Company Investor Relations Websites.
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