Microsoft (NASDAQ:MSFT), not traditionally a hardware vendor, has switched tack and intends to become a devices and services company. Its first major launch in this new direction was the Surface line of tablets. Microsoft, unusually, was able to sneak this launch upon the tech world virtually unnoticed; there were very few leaks -- a rarity indeed. The launch consisted of two tablet computers with an innovative design including a kickstand and touch cover as notable features. Unfortunately, these tablets have not been very successful and Microsoft took a $900 million charge related to tablets in its last quarter.
Don't give up - Most companies will not take a $900 million write down lightly and may reconsider this particular line of business, not Microsoft, it shrugged off this loss and has just recently launched new versions of both of its tablets.
The new tablets, like the originals, consist of two models: Surface Pro 2 -- the more powerful version running full Windows; and Surface 2 -- running Windows RT. These are iterations over the previous models with more powerful hardware, longer battery life, two stage kickstand, and the RT version is slightly thinner and lighter; but overall they don't look that different from the originals. Along with the tablets there are more accessories this time around comprising a total of 8 accessories ranging from new touch covers to an Arc Touch Mouse Surface Edition.
The question is what, if anything, has changed to make the tablets a success this time around after the disaster of the initial launch? To answer this question we have to look at why Microsoft lost so much money the first time around. The main reasons were over-ambition, a new product line, limited sales channels, and pricing.
Over Ambitious - With the original Surface, Microsoft had an excellent product on its hands: beautiful, well designed and with innovative features; add to this the tablet market is white hot and it seemed like a winning formula. Microsoft simply overestimated the demand, producing too many tablets that didn't sell at a premium price along with an unproven operating system, RT. This time around it must learn from those mistake and come to market with more modest expectations, keeping the initial run to a smaller number.
New Product Line - RT has been a difficult sell, compared to its competitors it's a nice product that competes well but more often than not it's compared to full Windows where it comes up short, and without x86 apps the App Store is not as extensive as Apple's (NASDAQ:AAPL) App Store.
Limited Sales Channels - Originally Surface tablets were only available online and at Microsoft stores of which there are a limited number, and the rollout outside of the U.S. has been slow. This time around it will be available in the aforementioned channels plus Best Buy (NYSE:BBY) and additional brick and mortar stores. The Best Buy deal is very important, it provides 500+ additional retail establishments where the public can get hands on with the hardware, and knowledgeable staff will be on hand to provide assistance. At this price point customers need to play with the hardware before paying the sticker price.
Pricing - With the Surface pricing Microsoft is going after the same customers as Apple's iPad -- a premium product for a premium price. On the other end of the scale there are many low budget Android tablets on cheap and powerful hardware selling at very low profit margins. Microsoft has kept the pricing very close to the initial launch, so there is demand at this price point but more work is required to explain the difference between the two tablets and the extra features that are included over the competition such as bundled Office, two stage kickstand and the keyboard cover. To compete at the lower price point Microsoft is continuing to sell the original Surface RT at $350, and may get to shift a lot of the unsold stock at this price.
The Surface 2 sells for $449 and the Surface Pro 2 sells for $899, this is without a keyboard which is an additional $119. According to isuppli the original Surface RT had a 53% margin and the Pro had a 35% margin; margins should be similar to slightly lower with the new models. As for actual sales figures Microsoft is not sharing, the only clue is the huge write-down demonstrating sales were nowhere near where they needed to be. For this launch Microsoft will have much more information to work with, it knows the numbers it's currently selling so will not make the same inventory mistakes and with improved distribution and the new version of Windows, 8.1, the current sales rate should be considered as a base to build upon.
Are these tablets going to be profit drivers and add to the bottom line in Quarter1 and 2? This is difficult to predict. The more powerful of the two, The Surface Pro, is the easiest sell. It is the most powerful tablet on the market and it is flexible enough to be used as a tablet, laptop, or desktop with the addition of an external monitor. The Surface 2, on the other hand, is still in search of a market. With a slightly lower price point, more capable hardware, and 8.1; perhaps, it will start to turn the corner.
With scaled back ambitions Microsoft's line of tablets can be much more successful; Windows 8 is gaining ground and these tablets are launching with the new improved version, 8.1. RT is still trying to find a place in the market, and may be a harder sell, but it is unlikely to see further write-downs, and with a little more momentum these tablets can start adding to the bottom line. You should be cautiously optimistic but it may take an additional price cut and the launch of the rumored 8inch model with LTE in the New Year to really ignite sales.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.