Microsoft (NASDAQ: MSFT) late last week impressed investors with solid numbers for its fourth quarter. Its revenue and adjusted earnings rose 12% and 21%, respectively, buoyed by the growth of its commercial cloud business, which grew its revenue 39% annually and accounted for nearly a third of its top line.
However, Microsoft's gaming business was a soft spot in the earnings report. It posted a 10% annual decline in revenue and missed its own expectations. Xbox hardware sales plunged 48% annually, while sales of Xbox software and services -- a bright spot in previous quarters -- slid 3%.
Image source: Epic Games.
Soft demand for Xbox consoles isn't surprising since the Xbox One is nearly six years old and gamers anticipate new consoles next year. Soft sales of video games were also expected due to a lack of major game releases during the quarter. However, Microsoft also noted that it faced a "tough comparable" from lower sales of an unnamed third-party title.
Niko Partners analyst Daniel Ahmad claimed that title was Epic Games' Fortnite and that gamers are spending significantly less cash in the free-to-play game. Let's see how Fortnite's decline is affecting Microsoft, and whether or not it will weigh down its gaming revenue in fiscal 2020.
Are gamers losing interest in Fortnite?
Fortnite launched two years ago and is currently available on Windows, macOS, iOS, Android, the PS4, Xbox One, and the Nintendo Switch. The game has three main modes: a shooter-survival mode, a battle royale mode, and a creative mode for building worlds and battle arenas.
Fortnite generates revenue by selling V-bucks, an in-game currency that can be spent on cosmetic skins, dances, and pre-released game modes for certain characters. It generated $2.4 billion in revenue in 2018 according to SuperData, making it the year's highest-grossing free-to-play game with over 200 million players worldwide.
But 2019 was a much tougher year for Fortnite. Revenue fell 48% month-over-month across all platforms in January, according to SuperData. The firm also recently claimed Fortnite generated $203 million in revenue in May, marking a 38% drop from a year earlier.
Newzoo also recently reported that Fortnite continues to lose viewers on Twitch. As a result, Tencent's (NASDAQOTH: TCEHY) Riot Games, the publisher of League of Legends, overtook Epic (which Tencent also holds a stake in) as the most-watched publisher on Twitch in the second quarter.
Newzoo still ranks Fortnite as the fifth most popular core PC game worldwide, but it clearly peaked as it faced tougher competition from similar games like Electronic Arts' Apex Legends and Activision Blizzard's Call of Duty: Black Ops 4. It also faces fierce competition on mobile devices from games like PUBG Mobile and NetEase's Knives Out.
Image source: Epic Games.
What does Fortnite's decline mean for Microsoft?
Microsoft and other platform operators typically retain a cut (usually about 30%) of Fortnite's revenue, with a few major exceptions.
Epic avoided paying Alphabet's Google that cut by directing Android users to download the app from its website instead of Google Play, and applied the same strategy on Windows and Mac by launching its Epic Games Store last December.
Microsoft still controls its Xbox gaming ecosystem as a walled garden, so it's likely still generating a full slice of Fortnite's revenue on Xbox consoles. We can't quantify the exact value of Fortnite for Microsoft without knowing the exact number of Fortnite gamers on Microsoft, their spending patterns, and its cut of the game's revenue -- but its earnings report and Ahmad's comments indicate that the game's decline was significant enough to dent Microsoft's gaming business.
On the bright side, Microsoft noted that it partly offset its weaker software sales with higher sales of Xbox Live and Game Pass subscriptions, which indicates that its gaming ecosystem remains healthy.
The bottom line
We won't know how much revenue Microsoft's gaming unit generated in 2019 until it files its 10-K report (and it releases it in early August), but it generated 9% of the tech giant's revenue in 2018. The gaming business was weak over the past few quarters, but Microsoft easily offset that softness with the growth of its commercial cloud business -- which is firing on all cylinders with the growth of Azure, Office 365, and Dynamics 365.
Microsoft expects the gaming business to warm up in the second half of fiscal 2020 as it works through the tough year-over-year comparisons. It also has several long-term catalysts on the horizon, including its new Xbox and xCloud cloud gaming service, which could both turn the gaming unit into a roaring growth engine again.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Tencent Holdings. The Motley Fool owns shares of and recommends Activision Blizzard, Alphabet (A shares), Alphabet (C shares), Microsoft, NetEase, and Tencent Holdings. The Motley Fool has the following options: long January 2021 $85 calls on Microsoft. The Motley Fool recommends Electronic Arts and Nintendo. The Motley Fool has a disclosure policy.