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On Tuesday afternoon, Microsoft (NASDAQ:MSFT) announced that it is increasing production of its recently launched Surface RT tablet, and will begin distributing the Surface through third party retailers in the U.S. and Australia. This wider distribution will apparently begin immediately, with Staples (NASDAQ:SPLS) quickly announcing that it would begin selling the Surface on Wednesday, December 12. As recently as two weeks ago, the story on Wall Street was that underwhelming sales had forced Microsoft to cut Q4 production by half (from 4 million units to 2 million units). One of the explanations for the Surface's poor sales was limited distribution: to date, it has only been available online and through Microsoft's retail stores (which are still few and far between, at least compared to the Apple (NASDAQ:AAPL) Store).

Making the Surface available for sale at mainstream retail outlets will almost certainly drive substantial incremental sales for Microsoft. The Surface concept is a good one, but most people will want to try one before buying, and the Microsoft Store does not have a wide enough footprint to serve that purpose. Analysts still only expect around 1 million sales in the current quarter, due to the late retail launch. However, I expect sales to show a counter-seasonal gain in Q1, because it will be the first full quarter of sales, and there will be wider distribution. Microsoft also plans to launch the Intel (NASDAQ:INTC) powered Surface Pro in January, which should help draw attention to the franchise.

Nevertheless, quarterly sales of a few million tablets will not have a meaningful effect on Microsoft's bottom line: adding at most $1 billion next year, compared to annual profits of $23 billion recently. Surface sales will almost certainly cannibalize low-end PC sales, since the devices run a version of Windows (Windows RT for the current version; Windows 8 for the Pro version arriving next month) and have an optional cover that serves as a keyboard (making them better as laptop replacements than the iPad). For every lost PC sale, Microsoft sells one less Windows license. In many cases, Microsoft will also be losing an Office license sale. Those software sales are essentially 100% gross margin, making it very difficult to make up the lost profit through hardware sales.

By contrast, the retailers carrying the Surface, particularly Best Buy (NYSE:BBY), should be beneficiaries. Profit margins are likely to be somewhat better than for the rival iPad, and so retailers will be glad to have another option to sell. Moreover, the Surface could be helpful for generating traffic: while sales have been modest thus far, Microsoft Stores have been seeing substantial foot traffic as people come by to try out the Surface. I happened to walk past a Microsoft Store on Black Friday, and it was packed inside (but it was hard to tell how many people were buying and not just looking).

Struggling electronics retailers like Best Buy could use a draw of that variety. Best Buy's sales have flatlined in recent years due to heavy competition from online retailers like Amazon.com (NASDAQ:AMZN). With the Surface, Best Buy (and similarly-positioned retailers) can try to serve as a hands-on "experiential" store, like the Apple Store. The Windows 8/Windows RT distinction is somewhat confusing to consumers, and that creates an opportunity for retailers to deliver good customer service by explaining the differences and helping customers choose the right product for their purposes. (The Microsoft Store does not have a large enough footprint at this point to provide that service for most people.) This customer service opportunity should be helpful for retailers looking to differentiate themselves from Amazon, and if executed properly, should encourage customers to come back to the store. Furthermore, once customers are in the store, they may make impulse purchases. Lastly, the Surface would provide a good cross-selling opportunity for customers who use Best Buy (and similar stores) to buy PCs.

Nvidia (NASDAQ:NVDA), which sells the Tegra chip that powers the Surface RT, also stands to benefit significantly from wider distribution. The Tegra product line is on pace to lose $300 million or more this year, due to heavy investments in R&D that cannot be supported at current sales levels. CEO Jen-Hsun Huang recently stated, "Consumers are also now starting to realize that a great tablet is better than a cheap PC. Because of Tegra, Android and Windows RT, the entry-level PC market is now a new opportunity for us." Nvidia has not previously had a foothold in the entry-level PC market, so it would be a big beneficiary if consumers decide to purchase Surface tablets rather than traditional PCs. The big criticism of the Surface RT (and other Windows RT devices) has been the lack of compatibility with "legacy" Windows applications. However, most people in the market for a cheap PC are looking to use it for e-mail, internet access, and Microsoft Word (and perhaps Excel or PowerPoint). All of these are well within the capabilities of a Windows RT tablet like the Surface. I therefore think that the Tegra-powered Surface will sell far more units than the much pricier Surface Pro (over $1000 including the keyboard/cover), and will be a worthy competitor to entry-level PCs. While the Surface RT's price point is not quite as attractive as the cheapest laptops, the build quality is much better, and the Surface is much more versatile given its "hybrid" nature.

The biggest losers are traditional PC manufacturers such as HP (NYSE:HPQ) and Dell (NASDAQ:DELL). While they are also targeting the Windows tablet market, they have much more to lose as the Surface goes head-to-head with their PCs in retail stores. Both companies have already suffered from cannibalization caused by the iPad, and the optional keyboard cover for the Surface makes it much more effective as a PC replacement. Consumers may come into Best Buy, Staples, and other outlets intending to buy a laptop, and walk out with a Surface. This is the biggest opportunity for Microsoft to deliver incremental sales (though the incremental profit is much smaller, as explained above). But it is also the biggest nightmare for the PC makers.

Investors should therefore keep an eye out for Surface sales trends over the next quarter or two. If wide retail distribution leads would-be PC buyers to purchase a Surface instead, HP and Dell could suffer, while Nvidia would be a big winner. On the other hand, consumer electronics retailers that carry the Surface should benefit from increased traffic, regardless of whether or not consumers actually decide to purchase the Surface.

Disclosure: I am long AAPL, HPQ, NVDA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also short AMZN.

Source: Microsoft To Increase Surface Distribution: Who Benefits?