Can Microsoft Rebound From Surface Flop?

Jul 31, 2013 (08:07 AM EDT)

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Tablet Buying Demystified: 10 Tips
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Tablet Buying Demystified: 10 Tips
Like an overmatched but determined boxer, Microsoft's Surface line has been absorbing abuse for months -- and on Tuesday, the devices took a punch straight to the chin.

In its annual 10-K report to the SEC, Microsoft revealed that its Surface products are hemorrhaging even more cash than previously thought. CEO Steve Ballmer's reorganized company now faces a tough question: Can it increase adoption before its Surface line -- particularly the RT model -- is down for the count?

Tuesday's report added new dimension to the scope of Microsoft's problem. The company evidently took in only $853 million in Surface-related revenue in all of its fiscal 2013, which started in July 2012. That's almost $50 million less than the $900 million write-down Microsoft recently took to accommodate a $150 Surface RT price reduction.

What's more, Microsoft increased its marketing budget by almost $1 billion during the reported period, mostly to advertise Windows 8 and the Surface products. Because Windows 8 and the Surface RT didn't hit the market until late October, Microsoft's tablet revenue represents only two-thirds of the fiscal year, which means that in only 8 months, the company spent a gargantuan amount of money attempting -- and failing -- to attract consumers.

[ Windows 8.1 Enterprise includes a lot to assuage business users, but plenty of questions remain. Read Microsoft Releases Windows 8.1 Enterprise Preview. ]

To be fair, there are only a few tech companies that can casually absorb billion-dollar losses, and Microsoft is one of them. Still, the situation is bleak for several reasons.

The $853 million in revenue includes both the Surface Pro and the Surface RT. In May, IDC estimated that Microsoft sold about 900,000 combined Surface units in the first three months of the year. This is a relatively paltry sum (IDC estimated that Apple sold 19 million iPads over the same period), but some had speculated that the Surface Pro, which arrived months after the RT model and was initially subject to stock shortages, was selling better than its sibling. Microsoft's disclosure suggests that both tablets have struggled, however.

The SEC report is also just the latest in a two-week barrage of negative Windows RT news. Other examples include Steve Ballmer's uncharacteristically direct admission that the device has underperformed, as well as Asus's decision to abandon development of Win RT products. Asus chairman Jonny Shih told All Things D that the OS is "not very promising," and virtually all of Microsoft's OEM partners have now dumped their Windows RT plans.

With the PC market in disarray and Windows 8 still struggling, Microsoft's Surface woes are only one facet of the company's larger challenges. The company hopes to improve sales of both PCs and tablets with Windows 8.1, however, and Ballmer confirmed in July that new Surface models are in development. The OS update should help Windows 8 overall -- but the question still remains: How is Microsoft going to reverse the Surface's dreadful performance?

At some point, Microsoft will presumably release a version of the Surface Pro equipped with Intel's Haswell chip, which should address one of the device's primary flaws -- poor battery life. The refreshed device could face trouble if it maintains the current Surface Pro's $899 base price, especially with cheaper Win 8.1 models expected from other OEMs.

Even so, the next Surface Pro could still attract attention from businesses, many of which will begin device refreshes over the next year. The Pro is vastly outnumbered by iPads in the enterprise, but that ratio could owe partly to timing. Businesses don't generally invest in a new OS until an update – such as Windows 8.1 – is released, and with many businesses still embroiled in Windows XP upgrades, this tendency has arguably been exaggerated.

It remains to be seen if consumers will ever embrace a high-end Surface tablet, but with businesses, there's obvious value in the device's ability to run both mobile apps and desktop software. The Surface Pro could still factor into a write-down of its own at some point, but potential enterprise sales at least give Microsoft reason to be hopeful.

The next Surface RT model will face a tougher path, however. Rumors indicate that the forthcoming device will rely on Qualcomm's Snapdragon 800 chip, which not only handily outclasses the Nvidia processor in the today's model, but also suggests LTE support -- one of the current version's more crippling omissions. The new device is also expected to be smaller, with a 7- or 8-inch screen. Between an updated OS, improved components and an attractive form factor, the next Surface RT could be substantially more compelling to consumers.

Then again, the current model has barely registered a pulse with the mass market, so "substantially more compelling" might not mean much in context, especially given that competing models are growing more persuasive as well. New iPad Mini models could be on the market by the time the new device hits, for example, and unless you truly need Office on a tablet, the new Nexus 7 Android tablet trumps the current Surface RT in nearly every way. Throw in the fact that devices that run the full version of Windows 8 might cost as little as $300, and there's not a lot of room in the market for a Windows RT device.

A truly competitive price could help Microsoft's efforts. The company will no doubt be sensitive to profit margins, especially since the lack of Win RT support means Microsoft is almost singlehandedly bearing the cost of promoting and supporting the OS. Nonetheless, with Surface pricing, Microsoft has already been stung by its own hubris.

Apple has sold more than 57 million iPads since the Surface RT went on sale, for example, which means that if each of the iPads were priced at a mere $20, they still would have produced 33% more revenue than the entire Surface line. Such a low price isn't viable, of course -- but it demonstrates a point: By keeping prices high, Microsoft is losing money.

If the next Surface's price is dramatically lower, Microsoft might still lose money -- but with higher sales volumes, the losses could be less substantial. At the same time, the increase in sales would boost user investment in the Modern UI, which would in turn compel more developers to create Windows Store apps. If short-term hardware profits are unlikely, in other words, Microsoft needs to concede as much and price the devices such that the larger Windows ecosystem benefits.

Data about the discounted Surface RT isn't yet available, so it's unclear how low Microsoft will need to drop prices in order to guarantee a market response. But with its first effort, the company aimed too high on cost and too low on user experience. This time, Microsoft needs to learn from its mistakes.