Surface Pro 2

Microsoft to turn Surface fortunes around with new devices

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Microsoft Surface Pro 2

19 May 2014

Microsoft has lost more than $1.2 billion so far on its Surface tablet business, an expensive experiment that makes the announcement of new hardware an important milestone for the devices side of its corporate-refashioning strategy.

Tomorrow, CEO Satya Nadella is expected to step on a New York stage and unveil one or more new Surface tablets, and outline his direction for the in-house hardware project birthed by his predecessor, Steve Ballmer.

While analysts and observers have split on Surface’s future – some see Tuesday as a last-chance for Microsoft to tweak its tablet strategy, others believe the company will press forward regardless of the reception pundits give the new devices.

Although Microsoft has been parsimonious in the details it declares of the Surface’s financial performance, the business has clearly been a money pit. In the last two quarters the tablet line lost $84 million.

But that was small potatoes compared to the September 2013 quarter. According to its most recent 10-Q filed with the US Securities and Exchange Commission (SEC) – and some simple arithmetic – Microsoft generated $413 million of Surface revenue that quarter, but spent $629 million to produce the revenue, posting a loss of $216 million.

Combine that $216 million (Q3 2013) with the $84 million (Q4 2013 and Q1 2014), and the total nine-month loss for Surface comes out at an even $300 million, as Microsoft admitted in the 10-Q.

The bleeding does not stop there, however.

Microsoft was forced to take a $900 million write-down in mid-2013 to account for the glut of Surface RT tablets it couldn’t sell. That adjustment was above and beyond whatever cost of revenue Microsoft incurred to build and sell the Surface tablets it did unload between the October 2012 (Surface RT) and February 2013 (Surface Pro) debuts, and 30 June 2013.

The company never divulged the cost of revenue for those three quarters – Q4 2012 and Q1 and Q2 2013 – saying only that revenue had been $853 million. But it would be foolish to assume that the cost of revenue was less than the revenue, what with Microsoft’s inability to turn a profit in later quarters.

Billion-dollar baby
So even without factoring in the three-quarter cost of revenue, Microsoft has lost $1.2 billion on Surface: The $900 million write-down + the $300 million loss from Q3 2013 on. How much more than $1.2 billion? Only Microsoft knows.

The loss, although not an existential threat – Microsoft recorded $5.7 billion in net income in the March quarter and has $88 billion in its cash and short-term investment horde – puts Tuesday’s unveiling in a harsh spotlight. Can Nadella turn tablets around, from money losers to money makers? Analysts aren’t optimistic.

“I expect premium price points,” said Patrick Moorhead, principal analyst with Moor Insights & Strategy, in an interview last week.

He explained why by citing rivals’ business models. “Both Google and Amazon have models for their tablets where they make it up on the back end,” Moorhead said, referring to the advertising and product sales that the two rely on to offset their lower-priced tablets. “But I don’t feel like Microsoft has achieved scale in their tablet content to offset [lower prices].”

Higher prices means lower sales volume. “You have to have scale to buy cheaper components. Microsoft doesn’t have the scale to be profitable or to hit interesting price points,” Moorhead argued.

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