Why Surface Matters To Microsoft And Should Matter To You

| About: Microsoft Corporation (MSFT)
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Microsoft's (NASDAQ:MSFT) introduction of the Surface RT Tablet in October 2012 was greeted with a yawn on Wall Street and not much more enthusiasm by consumers. Microsoft reportedly sold fewer than 1 million of the tablets between the October 26, 2012, launch and year end.

The January launch of the Surface Pro tablet received a warmer response from consumers, with immediate stock outs. Many observers alleged the stock outs resulted from deliberate supply shortages created by Microsoft to give the impression the device was a hot seller. It seems there are skeptics as to the bona fides of just about every launch.

There is no doubt that both devices are interesting and functional. I bought one of each. The RT version is an excellent tablet and the inclusion of MS Office RT makes it highly useful not only for viewing content and running some of the excellent applications in the Microsoft store, but also for its connectivity, long battery life, integration with Sky Drive and excellent keyboard. It is highly portable and generates a lot of interest when I take it to the coffee shop to browse my investments while enjoying a coffee among friends. It was well worth the $599 price.

The Surface Pro is even more interesting. Powerful with an Intel Core processor, sporting a true 1080 Screen, and equipped with a stylus, the Surface Pro runs every Windows application I own flawlessly and swiftly. It shares the same application library as the Surface RT, and has similarly high connectivity with full USB and mini-HDMI ports. I use the Bluetooth Microsoft Wedge mouse with it, and the Type keyboard, and I find it more than replaces my relatively heavy laptop without much sacrifice. At over $1,000 including my Office 365 subscription and Wedge mouse, it cost about the same as an Ultrabook. For me, it was good value.

From an investment point of view, the question is whether it will make a difference to Microsoft. My answer is a decisive yes, and the fact that Wall Street is somewhat negative on Microsoft as an investment based on the recent downgrades by Bank America (NYSE:BAC) and Morgan Stanley (NYSE:MS), make it a compelling short term and long term investment.

We are all familiar with the bear case. Desktops and laptops are being superseded by tablets and mobile devices and in a secular decline; Android and IOS devices are replacing Windows based devices at an alarming speed; and, the lack of a true mobile processor from Intel dooms Microsoft to a long term decline that justifies its 10 times earnings multiple. The bears suggest it will just wither away over the coming years, victim of insular and weak management protected from competition for many years by the dominance of the Windows platform.

I believe this is not only far from the truth but also that we are on the verge of rejuvenation of Microsoft and with it Intel that will alter the shape of the mobile world and establish Microsoft as one of the key players in the mobile space. Surface devices are part of that rejuvenation, and in this article I am going to confine myself to the importance of Surface and its impact on Microsoft growth in sales and earnings.

On average, Microsoft will realize revenues of approximately $550 for every Surface RT device and $850 for every Surface Pro device it sells. By selling them directly for the most part, with limited sales through distribution, I anticipate Microsoft margins on these devices to be roughly 40%.

For 2013, my forecast is for Microsoft to sell 3 million Surface RT units and 10 million Surface Pro units worldwide. Revenues from the Surface family should be close to $1.7 billion for RT and $8.5 billion for the Pro version. Together, these devices could add over $10 billion to Microsoft sales this year, and at a 40% margin rate, add $4 billion to operating income. More importantly, I expect Microsoft to grow in the tablet space for several reasons. The initial units are impressive. Integration into the Cloud with Skydrive works very well. The device is highly portable, with the RT version less than 1.5 pounds and the Pro version only 2 pounds with keyboard attached. The keyboards are excellent, particularly the "Type" keyboard.

Critics point to short battery life and the 2 pound weight of the Pro version as limitations in comparison to the Android and iPad tablets. I have found the battery life more than satisfactory and the weight an insignificant issue. Notwithstanding, Intel is planning to introduce Haswell based chips this summer and improved versions of its Atom line. Both can be expected to offer longer battery life and thinner form factors without sacrifice of power. If this proves to be the case, Surface devices will become more compelling.

Despite the success of iOS and Android, the number of Windows users worldwide is a multiple of either competing platform. Enterprises run on Windows. The ability to provide employees with a Surface tablet that integrates into the Enterprise software so elegantly can only serve to defend or enhance the Windows environment.

Many critics point to the number of applications as a limiting factor. This claim may be good advertising, but the fact that there are hundreds of thousands of iOS and Android applications is lost on me. I don't use hundreds of thousands of applications, only a few. The size of application library for iOS makes it almost impossible to navigate, and is as much a barrier as a benefit. The library of Windows 8 applications is rich and growing. I believe the applications library comparisons will wane into obscurity as users begin to compare the speed, power, versatility and battery life of their devices and the ability to integrate those devices into the environments they are used to both at work and at home.

In any event, from an investment point of view, sales and profits from Surface tablets will be measurable and meaningful in 2013 for Microsoft, and increasingly so over time. Each Surface tablet sold tends to pull through a raft of accessories - keyboards, wedge mice, Office 365 subscriptions, etc.

In parallel, Windows 8 is integrating the desktop, laptop, tablet and phone with a common interface and a high degree of applications integration. You only have to try a demo Windows 8 phone to be impressed with the way it manages Office applications like Excel, PowerPoint and Word - I did and I was blown away by the elegance of these desktop applications on a tiny screen. I would not have believed it possible had I not tried out the Nokia Lumia at the Microsoft Store.

The foregoing integration appears part of a long term strategy that has implied elements:

  1. Common user interface agnostic as to device
  2. Cloud based software and storage
  3. Subscription based revenue
  4. Integrated into enterprise
  5. Exciting and fun to use
  6. Powerful and functional at all levels.

In conclusion, my investment thesis for Microsoft comes back to the numbers. The core businesses without Surface in my view deserve a multiple of 10 times earnings of $2.80 more or less, and justify the $28.00 current share price. The addition of the Surface RT and Surface Pro devices adds net income after taxes of approximately $3 billion to 2013, with growth on the order of 15 to 20% annually (in my view). At 15 times earnings for this growth element, Microsoft is undervalued by $45 billion or about $4.00 to $5.00 per share today.

Microsoft reports earnings April 16, 2013. The quarterly report will provide some evidence as to whether my analysis holds water.

Disclosure: I am long calls on several hundred thousand shares of Microsoft at strikes of $29, $30 and $31; short in-the-money puts on 5,000 shares; and short 15,000 shares at $28.00, the latter two positions intended to hedge my long call position. I am also long INTC. 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.