Putting Microsoft's Surface-Related Losses Into Perspective

Aug.12.14 | About: Microsoft Corporation (MSFT)

Summary

Microsoft Surface Pro lost $1.7 billion, with most of it driven by inventory-related charges.

These problems aren't insurmountable, and while the Surface is losing money currently, the device is necessary in order for Microsoft to offer a complete product ecosystem.

Going forward, a better managed supply chain paired with falling variable costs will allow Microsoft to at least break-even or even earn profit.

News over Microsoft's (NASDAQ:MSFT) $1.7 billion in losses pertaining to the Surface Tablet went viral.

The Verge:

If the Surface Pro 3 isn't successful in turning Microsoft's Surface losses around, then it makes its existence a lot harder to justify, especially when Microsoft is no longer a "devices and services" company.

So when Microsoft makes a lot of money from certain product categories, the tech experts torch the company for symbolizing corporate greed. But when Microsoft loses money on certain projects, the same tech community says that it's time to close up shop on these lines of business.

Gregg Keizer from Computer World reiterates Dawson's opinion on the Surface lineup:

In an analysis published last week, Dawson put the Surface debit into context. "Continued losses will make it harder and harder for Microsoft to keep the Surface project going, so a good performance in the next quarter or two will be critical to justifying its continued existence," he wrote. "But if the Surface is one, not growing sales; two, losing money; and three, not creating a market, what's the point ultimately?" Dawson wondered. Exactly.

Mashable reiterates poor financial performance of the Surface tablet:

Microsoft continues to sell the Surface tablets at a loss. As the Microsoft rep notes, Surface posted $409 million in revenues in its most-recent quarter, but Computerworld estimates that the cost of revenue for Surface was $772 million for the quarter, meaning it lost $363 million for the quarter. As Alex Wilhelm at TechCrunch points out, the real figure may be even higher, since advertising and marketing expenses may not be included.

I'm starting to think the tech crowd is a really fickle bunch. Sure, not all of Microsoft's projects are profitable right out the door. But, why bring up the topic of profitability now? This is a re-hash of the same headlines we were reading back in 2013, over mounting inventory and lack of demand.

Strategically the Surface still makes sense

Going forward, I think this story will definitely play out in Microsoft's favor, as Windows 9 is expected to bridge the gap between Microsoft's mobile, tablet, PC and laptop. Unlike Apple (NASDAQ:AAPL), Microsoft still has a partial product ecosystem. The Windows ecosystem is nowhere near as refined, and in many instances, Microsoft sends out confusing messages to OEM partners.

Microsoft's tablet has to compete with other OEMs within its respective space. Also, Microsoft hasn't transitioned successfully to ARM, as the Windows RT operating system failed to generate much excitement from the application development community. The lack of support for Windows RT created massive problems for Microsoft, which it plans to address with product execution.

So to address application developers, applications designed for Windows 9 will be compatible with both ARM and x86 instruction set, according to various media sources. In this case scenario, Microsoft will be able to address the deficiencies of its current software ecosystem, and assuming Microsoft wants to keep the lion's share of profit for itself, the company can more vertically integrate software and hardware, but in the process decide against extending software licenses to other OEMs. In this process, Microsoft is no longer competing against itself, and instead redirects the consumer division to compete with Apple and Google (NASDAQ:GOOG) (NASDAQ:GOOGL).

Factors that may lead to Microsoft breaking even, or even earning profit

The bulk of what's making the Surface lineup un-profitable was the over-production of Surface tablets. Assuming Microsoft is able to manage its supply chain more effectively, and go for product shortage rather than product abundance, it can create an "Apple-like" effect with consumers. Forcing consumers to stand in line is way more effective than always communicating to consumers that there will never be a shortage.

Counter-acting write-offs is a matter of inducing scarcity, which has more to do with supply chain execution. This type of problem is easy to fix, and I see no reason for anyone to overly exaggerate the impact Surface will have to Microsoft's bottom line financial performance. Also, Surface sales grew by 50% on a year-over-year basis in Q2. Assuming Microsoft addresses key deficiencies in its ecosystem, and produces an adequate quantity, there's no reason to believe Microsoft won't earn profit from this emerging product category. Also, revenue growth of that scale is typically unprecedented in many sectors of the economy, and I have no issues with categorizing the surface as a high-growth business with potential to become a highly profitable venture. All it would require is effective cost controls that would cut back on over-production, along with effective resource allocation toward R&D and SG&A.

Source: Gartner

In 2013, Microsoft's OS market share in the tablet space was 2.1% since it primarily captured the high-end of the market, those are pretty solid results. Assuming Microsoft is on track to grow unit sales by 50% year-over-year, using a back of the envelop calculation, Microsoft will generate 6 million in unit sales in calendar year 2014 (maybe more). I'm going to assume that the Microsoft Surface ASP is $500 by averaging the Windows RT price point with the Windows Surface Pro price point. Obviously, the relative sales mix for the two devices may be different, which will render this estimate inaccurate, but for the sake of brevity, I'm using a $500 ASP.

So if we multiply 6 million units by the average price point of $500 that totals $3 billion in annual revenue from the Surface product category. Assuming Microsoft can generate net profit margins in the 10%-20% range (perfectly attainable at a $500 ASP), Microsoft may actually earn $300 million to $600 million in profit, assuming Microsoft doesn't experience further write downs in future accounting periods from over production.

The original Surface Pro had a gross margin range of 25-30%, whereas RT had a gross margin of 23%. I think Microsoft can drive higher gross margins in future generations as component sourcing will cost significantly less in future models, and efficiencies at higher scale will eventually lower manufacturing costs, and on a per-unit basis the R&D and SG&A will become incrementally smaller.

Conclusion

I think Microsoft Surface sales may have scaled to a point in which the whole entire operation can be optimized for profitability. It's doubtful that further write-downs will appear in future accounting periods, as excessive supply overhang is a symptom of over-estimating demand. I think Microsoft will be far more careful, and will produce only an adequate quantity to avoid further charges on inventory.

Also, the strategic implication of the Surface Pro is far more important to Microsoft than simply earning a couple hundred million in profit. Consumers in emerging markets are making their entry level PC purchase a tablet, therefore Microsoft cannot ignore this part of the market, even if it's absorbing losses in the early stages.

Therefore, going forward, Microsoft's product road map will be inclusive of the tablet, and I think that the Microsoft Surface Pro will become a profitable venture over the next year or two. In other words, no one should anticipate Satya Nadella to end the Surface line-up, no matter how tempting it may sound.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.