On October 26, 2012, Microsoft (NASDAQ:MSFT) released Windows 8, as the first major software update out of Redmond in three years. The Windows 8 movement introduced the Metro concept, where typical smartphone, tablet, and desktop interfaces were fused together beneath one operating system. One year later, on October 17, 2013, Microsoft launched a Windows 8.1 upgrade that Brad Chacos and PC World promptly referred to as "The Great Compromise." Windows 8.1 balanced the competing demands of PC traditionalists against Redmond's drive towards a universal Metro concept. Windows 8.1 restored the Start button and eased transitions between tile-based commands.
The Microsoft Surface, of course, will forever be linked to the Windows 8 and 8.1 operating systems. The Surface was engineered to bridge technical gaps between standard laptop and tablet machines. Following its October 26, 2012 launch, the Surface line ultimately expanded into RT and Pro iterations. In any event, the Windows 8 and Surface movements have been thoroughly dismissed as outright busts. Greg Keizer and Computerworld went so far as to make the claim that Steve Ballmer was "forced out" following the $900 million RT inventory charge "debacle." According to Keizer, Microsoft brass wheeled out new CEO Satya Nadella simply to "save face." Satya Nadella, however, will be routed in his first major battle. The Surface Pro 3 will not replace my laptop.
Surface Pro 3 Versus Apple
Microsoft Surface Pro 3 tablets are now available for pre-order and will ship by August 31. The 64GB Surface Pro 3 with Intel (NASDAQ:INTC) i3 chip technology begins at $799.00. The premium 512GB Surface Pro 3 powered by the Intel Core i7 processor retails for $1,949.00. Surface Pro 3 covers that double as functional keyboards are sold separately for $129.99. Consumers must therefore remain willing to shell out $2,078.99 for a fully-loaded Microsoft Surface Pro 3 machine. Again, the Surface Pro 3 is a hybrid device between the tablet and laptop technical spectrum. For its part, Microsoft has already billed the Surface Pro 3 as "the tablet that can replace your laptop."
Microsoft and the technology commentariat, of course, have made no secret of the fact that the Surface Pro 3 was engineered to compete directly against Apple (NASDAQ:AAPL) products. Be advised that Apple iPad prices range between $299.00 and $929.00. Meanwhile, MacBook Pro computers do start at $1,299.00. The 2.3GHz Intel Core i7 MacBook Pro retails for $2,599.00. At these price points, the Surface Pro 3 would be largely matched up head-to-head against the MacBook Pro. The 12-inch screen Surface Pro 3 weighs in at a mere 1.76 pounds, while also standing 11.5 inches tall by 7.93 inches wide. For the sake of comparison, the 15.4-inch screen MacBook Pro weighs in at 4.46 pounds, while also standing 9.73 inches tall by 14.13 inches wide. The Surface Pro 3 is a much thinner machine relative to the MacBook Pro - at 0.3-inch to 0.71-inch depth.
Beyond its svelte profile and 9-hour battery life, the Microsoft Surface Pro 3 is technically inferior to the MacBook Pro. The MacBook Pro features larger screens, crisper resolutions, and more powerful Intel Core i-series chips at comparable price points to the Surface Pro 3. The MacBook Pro, of course, is another gateway to the popular Apple ecosystem that includes the iPhone, iTunes, and hundreds of thousands of third-party applications for customizing the user experience.
On March 27, 2014, Microsoft was to finally make its Office software available to iPad owners. Free versions of Office may be downloaded in three separate Word, Excel, and PowerPoint applications via the App Store. Apple iPad owners, however, must purchase Office 365 subscriptions to create new documents and complete what Microsoft has referred to as "robust editing" and "rich formatting." Apple now stands to collect 30% commissions off Office 365 subscriptions sold through its App Store. In any event, this Office offer may have literally destroyed any selling point advantage that the Surface line held over the iPad tablet.
Surface Pro 3 Versus Google Android
Prospective Microsoft investors should prepare to confront the idea that the Surface Pro 3 movement may serve as further evidence that Microsoft is fighting a losing war on multiple fronts. Any mobile ecosystem discussion, of course, will likely begin and end at the Apple iOS - Google Android duopoly.
A recent report out of research firm comScore (NASDAQ:SCOR) estimated that Android (52.2%) and iOS (41.4%) combined to control 93.6% of the U.S. smartphone subscriber market through calendar Q1 2014. During this same time frame, Microsoft did expand its share by 200 basis points to 3.3% of this market segment. The International Data Corporation also identified Apple and Samsung (OTC:SSNLF) as the leading tablet vendors - with a respective 16.4 million and 11.2 million units sold through this latest quarter. For its efforts, fifth ranked Amazon shipped 1 million units of its Kindle tablet through this very same time frame. Microsoft, despite its wealth of cash, has failed to crack this top-five list.
Google has built its imposing empire largely through bait and switch business practices. Google effectively gives product away at cost, in order to drive traffic towards its higher-margin search and online advertising businesses. In mobile computing, Google appears therefore willing to accept minimal return on investment, in exchange for building out market share. As such, the Microsoft Surface Pro 3 will remain thoroughly shut out of the low-end, yet critical mobile market segment. For example, a struggling student would most likely opt for a $429.00 Samsung Galaxy Tab, before upping the ante to purchase the entry-level $799.00 Surface Pro 3.
Microsoft, again, made the claim that the Surface Pro 3 would inevitably replace the laptop. Unfortunately for Microsoft, the oft-maligned Windows supply chain has already joined forces with Google to undercut Redmond. Intel Celeron chips power an HP (NYSE:HPQ) Chromebook laptop line that requires its users to sign in through Google Accounts. Google has been aggressively promoting the HP Chromebook 11, which retails for $279.00. The 16GB Chromebook may be more so ideal for consumers in the market for basic word processing, web browsing, and gaming capabilities. Limited hard drive storage may be of little consequence for more sophisticated users who may prefer to access files via Google Cloud. Certainly, these value conscious consumers would snicker at the idea of paying $2,000 for a Surface. A recent report out of research firm NPD has made the claim that Chromebooks now lay claim to roughly one quarter of the U.S. low-cost laptop market.
The Bottom Line
For 2014, Microsoft reorganized its business units. The new business units then branched off into somewhat awkward Consumer Devices and Commercial classifications. The Commercial grouping was to include server products alongside enterprise Windows operating system Office software sales. The Devices and Consumer unit broke down further into Licensing, Hardware, and "Other" operating segments. Devices and Consumer Licensing now includes what Microsoft has defined as "non-volume" Windows operating system and Office software sales. Be advised that Microsoft has included popular Xbox gaming console sales alongside Surface revenue beneath Devices and Consumer Hardware. By all measures, Microsoft has remained a software company reliant upon the PC.
Taken together, Commercial and Devices and Consumer Licensing accounted for $16.6 billion out of $20.4 billion in total Q2 2014 sales at Microsoft. Commercial and Devices and Consumer Licensing also accounted for a respective $9.9 billion and $3.9 billion in gross margins. Microsoft did close out the latest quarter with $14.5 billion in gross margins. For the sake of comparison, Devices and Consumer Hardware generated a mere $258 million in gross margins off $2 billion in Q2 2014 revenue. On a year-over-year basis, Microsoft Devices and Consumer Hardware actually declined by 34.3%, despite a 40.2% increase in operating segment revenue between Q2 2013 and Q2 2014. Going forward, the Surface Pro 3 rollout will do little to reverse this trend. If anything, Microsoft is throwing good many after bad, which may result in another $1 billion in asset write offs.
Microsoft is a beta stock. Long-term investors may expect Microsoft shares to simply track the Standard & Poor's 500 Equity Index, while the corporation returns larger amounts of capital back to shareholders through stock buybacks and dividends. Investors in the market for alpha returns may consider buying into Apple, instead of Microsoft. The Surface Pro 3 machine will not replace the Apple iPad, let alone anybody's laptop.
Disclosure: I am long AAPL. 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.
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