While Surface Pro 3 Is A Great Device, Fast Rate Of Adoption Critical For Microsoft's Success

Summary

• While the Surface Pro holds great potential for business consumers, uptake must increase at a faster pace to allow for greater earnings growth.
• The device has performed well financially, with quarterly gross profit in December 2014 being recorded at $210 million.
• Should uptake of the device stall, then Microsoft risks negative investor sentiment similar to that of the sell-off experienced on January 26.

In November of last year, I had written an article examining whether Microsoft (NASDAQ:MSFT) was overvalued based on both its current and projected earnings. At the time, the company was trading at a price of $49 having since fallen to a price of $43.06 at the time of writing. I had argued that the company needs to deliver significant earnings growth in 2015 or risk negative sentiment on the part of investors. So far, recent events have supported my view. While Microsoft met analyst estimates for Q2 earnings of $0.71 per share on January 26, markets were not satisfied and Microsoft shares took a staggering tumble from $47.01 to $42.66. In this context, Microsoft must deliver high earnings growth to convince investors of its future growth prospects - I had previously commented that a higher P/E ratio of 19.4x was being bid up partly due to investor expectations of future growth.

The Surface Pro tablet, which Microsoft dubs as "the tablet that can replace your laptop," is arguably Microsoft's biggest initiative to appeal to businesses looking to transition from traditional desktops to portable devices, and this represents the company's greatest opportunity to increase earnings going forward. More broadly, the technology represents one of Microsoft's greatest opportunities to capitalize on the portable devices market. Financially, the device has performed well, with quarterly gross profit in December 2014 being recorded at $210 million which is almost double the $122 million achieved in the previous quarter. Revenue from the device itself was recorded at $1.1 billion which was a 24% increase over the same quarter in 2013.

It is important to remember that while the Surface tablet also is being marketed to individual users, the company is by no means trying to win over the die hard Apple (AAPL) fan who will hang on to his/her iPad for eternity. The vast majority of Microsoft's sales has traditionally been to small and large businesses, and this is highly likely to continue into the future. In this regard, a tablet running Windows software is a highly attractive option to companies whose IT infrastructure is already invested in Windows and for which the switching costs to another platform such as Android, OS X or Linux would be too high. The idea of the Surface Pro is to allow users to utilize the device as a tablet while also incorporating the device as part of a broader workstation to resemble the look and feel of a desktop as many users already do with their laptops. For example, I am a Windows 8.1 user and as I type this article, my fingers are not even touching my laptop. Instead, I am using a wireless keyboard connected to the laptop which in turn is connected to an external 22 inch LG screen. For all intents and purposes, my workstation resembles a desktop more than it does a laptop. However, I still have the convenience of unplugging my laptop to take on the move. The same principle applies with the Surface Pro, only the device comes as a tablet which is highly appealing to businesses looking for a device that can function both as a tablet and a desktop without having to purchase the two devices separately.

In my opinion, the Surface Pro 3 tablet has strong potential to succeed. However, in light of the recent earnings performance, I think what's going to make or break Microsoft is the rate of uptake of these devices. For instance, big name businesses such as BMW, Coca Cola and Louis Vuitton, among others, are proclaimed customers for the Surface Pro 3. However, markets are clearly putting pressure on Microsoft to step up its earnings. Should earnings from the Surface Pro device not materialize due to slow uptake of the device, whether due to reticence on the wider part of business customers or simply apathy, then the markets may not be satisfied with low earnings and there's a risk of seeing further deterioration in share price similar to that experienced on January 26.

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.