In an earlier article, I wrote about why Surface mattered to Microsoft (NASDAQ:MSFT) and should matter to you, setting out the thesis that the move into hardware offered an avenue for growth with the likelihood of substantial profits, and allowed Microsoft to integrate its enterprise offering from desktop to phone based on Windows 8's cross platform interface.
Today, Microsoft released its Q1 numbers, and despite a decline in worldwide PC shipments as reported by IDC and Gartner only last week, Microsoft enjoyed a 23% gain in sales and increased profits in its Windows division. Some might question how this is possible, given the steep drop in PC sales reported by IDC and Gartner.
The answer is simple and confirms the growth opportunity for Microsoft. Touch enabled Windows 8 devices were barely in evidence in 2012 and only began to emerge during Q1 2013, with launches by Samsung, HP, Lenovo, Dell, Acer, Asus, Sony and Toshiba to name a few, and only a handful of Windows 8 or Windows RT Tablets. The Windows 8 tablets and hybrids are not all listed in the PC category by either IDC or Gartner, so a portion of the "decline" represented omitted sales of Windows 8 devices not categorized as PCs. Surface RT and Surface Pro alone probably made up 1 to 2 million of these.
PC World issued a recent article essentially making the same point. The IDC data did not include the Windows 8 hybrids or Windows 8 tablets. It is too bad IDC is not held to account for not making that crystal clear when it issued a negatively framed report that cost Microsoft shareholders some $10 billion in market capitalization in the day it released the data.
Today, Best Buy lists 104 Windows 8 touch screen laptops; 40 Windows 8 touch screen desktops and all-in-one PCs; and, 55 Windows 8 and Windows RT Tablets. With almost 200 varieties of Windows 8 touch screen devices to choose from, the Windows 8 touch screen category now offers a rich selection of computers and tablets. Computers that do not have touch screens run well under Windows 8, but miss out on many of the benefits of the OS.
Intel recently released its first Haswell chip to manufacturers for testing according to internet sources.
In parallel, Intel published a design prototype called North Cape for Haswell-based ultra books and hybrids.
The new devices based on the Haswell chip and reference design will be thinner, lighter and enjoy much longer battery lives than previous Intel-based devices, without sacrifice of power. This advance will make such devices much more competitive with ARM-based devices, and may tip the scale towards substantially more growth for Windows 8 computers and tablets. In parallel, Microsoft has been working on an update to Windows 8 code named Windows Blue, for release later this year.
This update is likely to improve the Windows 8 experience since it will incorporate changes made in response to thousands of Windows 8 users since its launch, and could include full integration of PC and phone versions of the OS, upgrades to Skydrive, improved Snap Views, the next version of the Internet Explorer browser, and a higher degree of personalization. It may also bring back the Start button for those users who did not have the 30 minutes needed to become familiar with the Metro interface.
In my last Microsoft article I estimated Surface devices to have 40% margin. One or two readers challenged my assumption of a 40% margin on Microsoft Surface devices, and I have to admit my estimate was more guesswork than science. I have gone back to the drawing board and have done a more detailed bill of materials relying on many sources and, of course, guesswork, and come up with the table below, which tends to confirm the 40% margin estimate is in the right range.
Surface RT and Surface Pro Margin Analysis
NAND Flash Memory
User Interface & sensors & Combination modules (WiLAN, Bluetooth, FM)
Margin - $
Prices for such components tend to decline over time, so actual margins may be higher unless, of course, I am widely off the mark with these guesses or have missed something major in the bill of materials (both are certainly possible).
In addition to Surface, there have been numerous product innovations from several suppliers in thin, powerful, lightweight hybrids, detachables and ultrabooks. Intel's CFO Stacy Smith commented on the growth in these devices in its Q&A Tuesday night.
"And then we see some of the new form factors of computing are growing significantly. Gartner would call those ultramobile devices, so things like ultrabooks, detachables, and convertibles. We're seeing robust growth there. And then we're now participating across a broad range of tablets between Windows 8 and Android. And with Bay Trail coming out and Merrifield behind that, we start to participate in a much broader set of screen sizes and price points than we are today."
Growth in these devices will be positive for Microsoft in the second half of 2013 and thereafter since many of them will be based on Windows 8 and its successors.
Longer term, I am putting my money on Windows based on my opinion as to the strategic strength of the IOS, Android and Windows franchises, my assessment of which is set out below.
Apple is an extraordinary company with a powerful brand and beautifully designed products, particularly for non-technical users. The legacy of Steve Jobs is the attention to detail and user-centric nature of the interface, making it a joy to use Apple products for their design purpose. The trade-off is that it becomes difficult if not impossible for users to extend the functions of their devices to uses not contemplated by their designers.
Apple controls applications tightly and takes a margin on their sales, making the Apple store a very profitable distribution mechanism as well as a quality control centre. iOS itself evolved from OS X, which in turn has its roots in UNIX, a robust but dated operating system with many variants.
Apple products are targeted primarily at individual consumers. Apple's entrance into enterprise markets has arisen primarily from the Bring Your Own Device ("BYOD") trend where employees urge enterprise IT departments to allow them to use their personal devices on enterprise networks.
With almost a cult-like following, Apple users have displayed more loyalty to the brand than common sense, lining up overnight for example to buy an updated version of a device where the improvement is little more than modest increases in processor speed, display resolution or storage capacity. Their disappointment when the new device looks, feels and runs just like the one they discarded has caused Apple to lose some of its "cool" factor, and it is becoming more of a run-of-the-mill company valued for its cash hoard, dividend, and the hope of the "next big thing," as I see it.
With the stock off 40% from its 2012 high, it is a solid but unexciting investment today. That may change if and when it introduces new and exciting products.
Rooted in UNIX like IOS, Android is an "open" open operating system available for free and customizable by device designers to differentiate their products. Samsung, HTC, LG, Ztel, Amazon, Asus, ACER, Fujitsu, Toshiba, and recently HP have all released devices with Android OS installed.
Google relies on the extensive use of Android-powered devices and its Google Chrome browser to generate advertising revenue from its world-leading search capability to make Android a profit contributor. Android's free distribution allows device manufacturers to meet lower price points than they would not otherwise.
Android has the largest share of the world market for tablets and smartphones and is likely to enjoy share gains for a while yet as the demand for fully functional lower priced devices remains unsatisfied in the developing world.
Sooner or later, however, consumers will wake up to the fact that they are prostituting their personal data to be used to create targeted spam disguised as "advertising" while putting their privacy at risk. As internet fraud grows and predators increasingly use online attacks, consumers will eventually put the safety of their homes, finances and children ahead of the savings of a few hundred dollars on a phone or tablet, in my opinion. In addition, the novelty of Android will wear off for enterprise users who will increasingly find it inconvenient to use a Windows or iOS-based device at work and an Android one away from work, when the cross platform features of Windows 8 and iOS make it possible to use devices with a single OS and user interface regardless of form factor without loss of function or available applications.
Google stock has generated strong returns for its investors and continues to set new highs. I would not hold the shares and, at some point, will have the courage to short it.
Long the dominant personal computer operating system, Windows has a pervasive presence in well over 1 billion devices worldwide. Microsoft Windows-based software such as Azure, Exchange, Outlook, Dynamics, SharePoint, Lync, SQL Server, and its client server and security software are in widespread use throughout major corporations world wide.
Windows 8 is a bold advance of the windows operating system designed to bring a common interface and platform to devices from servers through desktops and laptops to tablets and phones. Its introduction is not a trivial task and will encounter setbacks and resistance at many points. In particular, those consumers who carry the brand of their cell phone as a badge of honour and devoutly decry Windows software in favour of Apple, Android or BlackBerry create waves of misinformation about the real importance of what Microsoft is doing and why it will affect each of us.
At the consumer level, the new Windows 8 OS and devices offer full integration into familiar software virtually every consumer uses or has used, while concurrently building a rich and powerful library of new applications that already rival many of those available on iOS or Android. Windows 8 devices are not only exciting for personal applications in social media, news, entertainment, family living, fitness, finance and the gamut content available for online shopping and viewing, but also for the traditional Windows applications suite and their seamless integration into the workplace environment.
In parallel, Microsoft device makers' key supplier, Intel, has turned its attention from servers to mobile and is in the early stages of developing powerful, low power usage processors that promise thinner, lighter and more powerful devices with much longer battery lives than any in existence today. The advantages enjoyed by ARM, Qualcomm and Nvidia are being met by a world class player with the time, skills and resources to truly compete with them.
As an ex-boxer, I know that the best lightweights have no real chance against a heavyweight. For that reason, I am willing to gamble that Intel will be successful in mobile processors and its success will propel the success of Windows 8 (and its successors') devices and make real inroads that turn the contest with Apple and Google into a war worth watching.
It may also be a war worth winning by investors who place their money on the right players. To date, those players have been Apple, Google and ARM. In the future, they will include Intel and Microsoft, in my view.
Disclosure: I am long MSFT. 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 long calls on Microsoft