The Moment of Truth Is Coming

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There is plenty of discussion regarding Microsoft´s (NASDAQ: MSFT) new Surface tablet and its performance so far. While some analysts have been painting a dismal picture regarding sales over the last weeks, the company has recently announced increased production, and management´s decision to start selling the product through third party retailers could be an indicator of strong demand. We will likely have more information in the following days, and investors need to watch Surface closely, because there is a lot at stake here.

More than a Product

Surface is more than a product for Microsoft, it can be the company´s last chance to enter the mobile revolution and sustain a healthy degree of profitability after the transition. Mobile is here to stay, and Microsoft needs to succeed with Surface if the company wants to remain a relevant player in the tech industry.

Tablets have been stealing market share from PCs over the last years, and Macs have been gaining ground versus Windows operated PCs too.This is not just about products, it’s a platform war. Apple (NASDAQ: AAPL) has leveraged the success of its iPad and iPhone products to bring customers into its ecosystem and, once they are in, they are more likely to stay with the company in detriment of Microsoft´s sales.

Microsoft could have chosen another path, perhaps simply developing an operating system for tablets as opposed to building both the hardware and the software, but Google (NASDAQ: GOOG) has already won that race. Android is by far the most popular operating system for smartphones on a global scale, and new tablets operated with Android are entering the market in the middle term.

Amazon´s (NASDAQ: AMZN) Kindle owns the low end segment of the market with its aggressively low pricing, and competition is expected to increase in that niche too. Lower priced products benefit enormously from free Android, so there is not much room for Microsoft to sell an operating system for a healthy profit margin in that segment.

A Mathematical Calculation

With a price tag of $500, Microsoft is aiming to compete directly against the iPad with surface. This sounds like a very risky approach considering Apple´s rock solid competitive position in that market, but Microsoft´s management probably decided that it´s their only chance to sustain profit margins in mobile.

And the numbers seem to back that thesis, the economics of operating systems and applications in the tablet business are a big problem for Microsoft, at least in comparison to contributions from the PC industry.

Asymco estimates that Windows “captured” $52 per PC shipment and Office “captured” $67 per PC shipment over the last quarter. Microsoft doesn´t have a big chance in trying to sell operating systems for tablets at more than $50 when Google provides the successful Android free of charge. The company is launching Office for iOS and Android, but most apps are selling for less than $10, so this can hardly compensate the $67 per shipment the company makes in PCs.

So Microsoft decided to go with a relatively expensive tablet, and spread its profit margins on both the software and the hardware. At $500 per tablet, if Microsoft makes around 30% in profit margins – which is roughly what Apple makes in iPads – the company would be making $150 per tablet. Overall profitability will obviously depend on the amount of units sold among other things, but Microsoft will likely attain much better numbers with Surface than by selling just software and apps for mobile devices.

The Big Question

Microsoft seems to be following Apple´s approach by integrating hardware and software, and the company is targeting big profit margins with that business model. The problem is that its price range puts the Surface in direct competition with the iPad, the undisputed leader in the high end segment of the market.

Can Microsoft pull it off? I wouldn’t discard it yet, Microsoft has a big customer base, and the company is very popular in productivity. But I wouldn´t put my money on Microsoft either. Apple is a tremendous competitor with fantastic brand power and an unparalleled ecosystem, so the odds are clearly against Microsoft at this stage.

Bottom Line

Microsoft has a lot at stake currently; Surface could be its last chance to enter the mobile industry while still maintaining its profitability, and the product is facing some seriously tough competition. We will likely have more information regarding Surface sales in the middle term, and this could be determinant for the company´s future, but unless we see some clear evidence of success in Surface, I´m staying away from Microsoft.


acardenal owns shares of Apple, Google and Amazon. The Motley Fool owns shares of Apple, Amazon.com, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Amazon.com, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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