Don't Buy Into Microsoft 'Surface' Hype

| About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) recently launched its own Windows 8-based tablet called Surface. This move is an attempt to enter into the competitive tablet industry. The competition is intense with many players including Hewlett-Packard (NYSE:HPQ), Dell (NASDAQ:DELL), Research In Motion (RIMM) and of course, the leader of the pack, Apple (NASDAQ:AAPL). There will be two versions of the tablet. The first is the Windows 8 RT which has a 10.6 inch screen, 9.3 millimeters thick and weighs 1.5 pounds. This seems similar to Apple's iPad, which also has a 9.7 inch screen, 9.4 millimeters thick and weighs 1.44 pounds. There's news that Microsoft is attempting to revive its battle against Apple.

Based on the Gartner report, Microsoft's Surface is expected to ship 4.8 million units this year. This accounts for 4.1% of the total estimated 2012 shipments. The report also predicted that this will increase to 11.8% of total shipments by the end of 2016. The research firm cited that there is opportunity to capture clients who are more familiar with the Windows operating system. It further discussed that Windows 8 is an offering with a strong consumer appeal.

On the other side of the story, there are skeptics who believe that the Windows 8 platform is another Vista. If the skeptics are right, it could be another big blow on the company. The company has been looking for ways to improve its perception on its ability to launch better than expected product lines. I see bad reviews talking about the platform's unfamiliarity and difficult to navigate system. One of its problems is that Windows 8 has two separate and largely incompatible parts. There is radical change on its new interface and old customers familiar will have to relearn how to use the system. This totally negates Gartner's thesis that there will be strong consumer appeal with those familiar with the old Windows operating systems.

Little Impact to Microsoft's Profitability

Despite the highly publicized launch of the Microsoft's Surface, I believe that it will have little impact on the company's profitability. It's difficult to steal market share from Apple and other players given that the company has yet to provide details and pricing on its tablet. Moreover, there are still concerns around its battery life and connectivity. These considerations are definitely important for consumers.

According to Next Web, its sources found that the RT Surface version will be priced at $599 and the Pro version at $999. If this is true, then it doesn't seem like a good idea to beef up its market share. How could someone buy an untested tablet running on an operating system that is unfamiliar to him? Even if you lower the price, it's still a battle difficult to fight. Remember how other company entered into this market. I'm not sure whether CEO Steve Ballmer has taken the lessons of HPQ HP TouchPad and RIMM's Blackberry Playbook. I'm certain it won't be a walk in the park for Microsoft.

Even Microsoft's Partner Acer said that the Surface will be doomed to fail. It said that Microsoft's strategy of copying Apple will not succeed. It reasoned out that one cannot be a hardware player with two products. It will lead to a lack of focus from Microsoft and would shift its resources to building a consumer brand. This is definitely not how the company worked its way as a technology giant. It has to focus on what it does best - as a software company.

Another obstacle to its success is the distribution. Microsoft Surface tablets will be sold through Microsoft stores in the US. It seems that there are only 20 Microsoft stores so far. That's a big disadvantage considering the number of Apple stores. Over time, this raise concerns on how Surface will be distributed.

Licensing is still the best way to go

Acer founder Stan Shih said that Microsoft has no real intention of selling hardware based products. The real objective of this move is to prod device manufacturers to use Windows 8-based tablets. Once Microsoft has accomplished this goal, it will withdraw its own tablets from the market. It will then no longer offer newer models of the products.

This theory from Mr. Shih makes sense. If you look at its performance, the company has really made money from licensing. In fact, I have read positive statements from Dell and other device makers. Dell said that it remains committed to delivering a full slate of Windows 8 tablets. Even Acer said that Microsoft will remain an important partner for them.

Licenses are still profitable venture rather than hardware. Based on the recent quarterly reports, the Windows &Windows Live segment rose by 4% compared to the same period last year. This segment helps offsets the weaker than expected PC demand. Around 75% of these sales come from Windows licensing. If Mr. Shih is right, this segment should continue to perform well in the future and could be a drive to bring back Microsoft's glorious past.

A Back of the Envelope Calculation of Surface's Impact to Valuations

Assuming a best case scenario of 4.8 million units, this translates to sales of $3 billion. I also assumed prices of RT at $599 and Pro at $999. Applying an operating profit margin of 20%, this translates to income of $700 million. At current valuations of 11 times of Microsoft, the impact of Microsoft's Surface will be at least $0.95 per share. Even at best case scenarios, this will not boost Microsoft's valuations. I believe this will be lower as the pricing of its tablets seem high.

If you look at the launches of other tablet makers in the past, there is lukewarm reception from investors. These device makers need to convince investors that they can outsell Apple's iPad. Otherwise, it seems it would not have much impact on their valuations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.