Pressure Remains on Microsoft Despite Strong Surface Growth

While almost every part of Microsoft's business faces huge pressure from disruptive technology and competitors, the software that put the company on the map -- Windows -- continues to show it's not going to go quietly into the night. Given Microsoft's surprise report that Surface sales have surged and the company promising new capabilities in the forthcoming release of Windows 10, expectations of the operating system's demise are at least premature and potentially postponed indefinitely.

Despite the debacle with its first Surface rollout two years ago, this year's release of the Surface Pro 3 and the resulting impressive performance shows that Windows still has a chance to remain relevant despite the overwhelming popularity of iOS and Android among consumers and enterprises. Granted, we now live in a multiplatform world, which is a good thing that's not going to change. The only question still to play out is where Windows will fit in the coming years and this will be determined by Microsoft making the right moves. Missteps by Apple and Google going forward will play a role as well of course, but the ball is in Microsoft's court to get Windows right.

Amid yesterday's impressive results for the first quarter of Microsoft's 2015 fiscal year were increases along key lines including Office 365, enterprise software and cloud business and the disclosure of $908 million in revenues for its Surface business. That's more than double of what Surface devices received last year. This report includes the first full quarter that the new Surface Pro 3 has been on the market. Presuming there wasn't significant channel stuffing, this is promising news for the future of Windows overall.

Indeed while showing hope, the latest report on Surface sales doesn't mean Windows is out of the woods. Despite the surge in revenues, Microsoft didn't reveal Surface unit sales. And while the company said its Surface business is now showing "positive gross margins" -- a notable milestone given the $900 million charge the company took five quarters ago due to poor device sales -- Microsoft didn't say how profitable they are, said Patrick Moorhead, principal analyst with Moor Insights & Strategy.

Marketing and the cost of implementing Microsoft's much improved global channel and distribution reach neutralized or negated much of the overall negative margin. Moorhead predicted, "I can say with 99 percent confidence they are losing money on Surface still. That may not be bad for two reasons. They need to demonstrate Windows 8 can provide a good experience and second of all it puts additional pressure on traditional OEMs that they need to be doing a better job than what they do."

Also worth noting, the $908 million in Surface revenues were about 17 percent of the $5.3 million Apple took in for iPads during the same period (revenues for Macintoshes, which are in many ways more comparable to the Surface Pro 3, were $6.6 million, Apple said). Apple's iPads, which often displace PCs for many tasks, are also hugely profitable though ironically sales of the tablets have declined for the past three quarters amid the sudden surge in Surface sales. Naturally they also have different capabilities but the point is to underscore the positive signs the growth of Surface portend for the future of Windows.

Morehead said the current quarter and notably holiday sales of all Windows devices, led by an expected onslaught of dirt-cheap Windows tablets (possibly as low as $99) could be an inflexion point, though he warned that Microsoft will need to execute. "If Microsoft continues to operate the way they are operating, they will continue to lose considerable consumer relevance," he said. "If during the holidays, they make news and sell big volumes, I would start to think otherwise."

Key to the quarter's turnaround was the company's expanded global distribution and extended sales of corporations through its channel partners, though that effort is still at a formative stage. Despite his skeptical warning, Moorhead believes Google's failure to displace Windows PCs with large Android devices and Chromebooks gives Microsoft a strong shot at keeping Windows relevant.

"Google had this huge opportunity to bring the pain on Microsoft with larger devices and eat into notebooks," he said. "They never did it. They really blew their opportunity when they had it. While Android may have cleaned up with phones, when you think about it what they did was just blocking Microsoft as opposed to going after Microsoft, which would be in larger form factor devices in the form of Android notebooks and Chromebooks. The apps are designed for 4-inch displays, not a 15-inch display or 17-inch display. And with Chrome, its offline capabilities just came in too slowly and there really aren't a lot of apps. They just added the capability to add real apps."

Meanwhile, Moorhead pointed out that Apple this month has delivered on what Microsoft is aiming to do: provide an experience that lets a user begin a task on say an iPhone and resume that task on an iPad or Mac.

Hence keeping Windows relevant, among other thing, may rest on Microsoft's ability to deliver a Windows 10 that can do that and improve on a general lack of apps on the OS, which in the long run would incent developers to come back. The promising part of that is the renewed focus on the desktop, Moorhead said. "When they converge the bits in a meaningful way, I think they can hit the long tail because of the way they're doing Windows 10 with Windows apps and the ability to leverage those 300 million units to a 7-inch tablet and a 4-inch phone. I think that is an enticing value proposition for developers."

Given the target audience of business users for the Surface Pro 3, it also is a promising signal for the prospects of Windows holding its own in the enterprise. Do you find the new surge in Surface sales coupled with design goal of Windows 10 to be encouraging signs for the future Windows or do you see it more as one last burst of energy?

Posted by Jeffrey Schwartz on 10/24/2014 at 12:48 PM