Tech Giants First Swing In Mobile A Miss

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

Over the last few years, one of the fastest growing industries has been mobile computing. There’s no reason, not to expect that trend to continue next year, and for the foreseeable future. The rise of mobile has certainly been a boon for industry leaders like Apple (NASDAQ: AAPL) and Google (NASDAQ: GOOG) who have seen share prices rise nearly 6 times and 2.5 times respectively since the beginning of 2009 when mobile computing started to take off.

Meanwhile, Microsoft (NASDAQ: MSFT) seems stuck in neutral, continuing to make steady profits off its personal computer software, but missing out on the mobile computing market. That changed in October, when Microsoft launched its Surface tablet computer along with Windows 8. The new touch-screen oriented operating system is quite a change for Microsoft as it’s clearly trying grabbing a piece of the mobile market.

Weak Sales On The Surface

Last week, Microsoft was forced to cut its order of Surface RT tablets for this quarter in half, from 4 million to 2 million, based on weak demand. Other Windows 8 manufacturers, such as Asus, Samsung, and Dell, are experiencing weak demand as well. While this could be chalked up to lower discretionary spending by consumers, I believe its problems run slightly deeper.

The most glaring issue to me is Microsoft’s price position for the Surface RT. Priced at $499, the lowest priced Surface costs the same as a new iPad 4. Faced with the choice between paying the same price for the ever-popular iPad or the new product without much social clout, consumers are choosing the Apple product.

There is room for Microsoft to lower pricing without sacrificing too much margin. iSuppli estimates the touch keyboard cover, a defining feature of the Surface, costs Microsoft $16 - $18 to manufacture. Consumers can currently upgrade to include the keyboard cover for $100, representing a margin of 82% to 84% on the keyboard cover, more if sold separately.

The total margin for the $599 model including the keyboard cover is 53%, much greater than the iPad 4’s gross margin of 43%. Microsoft could lower the bundle to $499, and maintain the same margin as Apple on the newest iPad, and it could even undercut iPad pricing by about $60 on the standalone surface and maintain a 40% margin.

Additionally, Microsoft has further room to reduce margins if they can increase sales of premium priced products for Windows 8 tablets like Office. The draw of the Surface is that it can be used for both media consumption and content creation with its innovative keyboard design. Comparatively, most users buy the iPad for a nice web browser, ebook reader, and casual games – low priced products. Office sales and charging for rounds of Windows upgrades (think Windows 9) could be seen as a bonus for increased tablet sales.

A price reduction ought to boost sales, which can be a bigger driver of profits than gross margin. You can’t make any money if you don’t sell products.

Microsoft’s Bread And Butter Is Going Stale

While Microsoft doesn’t manufacture PC’s it currently has a symbiotic relationship with PC makers. Without PC sales, Microsoft has no one to sell its software. As mobile computer sales grow, PC sales have dwindled. Unfortunately, Windows 8 hasn’t spurred any rejuvenation in the PC industry.

At first blush, initial sales of Windows 8 look good - 40 million licenses sold in the first month of release. That’s well ahead of what Windows 7 did in its first month in 2009. However, there are a couple of caveats. First, Windows 8 retails for just $40, about one-third of the price it cost users to upgrade in 2009 to Windows 7.  Second, the sales of licenses has not yet translated into actual usage.

The latter is what gives me pause. While Microsoft can report that it sold 40 million licenses, it doesn’t break out how many of those licenses were to consumers and how many were to manufacturers. Windows 8 computers that are still sitting on the shelves count toward Microsoft’s sales, but they don’t count toward the manufacturers sales. Low PC inventory turnover will lead to slower Windows 8 sales in the near future.

I don’t think Windows 8 is a complete misstep for Microsoft. It may simply be ahead of its time. Most consumers may not upgrade their PC to Windows 8 because part of its value comes from its touch-screen capabilities that most current PCs do not provide.

As touch capabilities invade more devices, I believe Microsoft has an opportunity to capture that market with Windows 8. Possibilities include television sets (think Google TV and iTV), home appliances, and anything you can dream of that you might interact with on a daily basis. Competition from Google is likely to be fierce, as the company is content with simply giving away its Android software.

Playing Ball

It looks like its first strike in mobile and touch-screen computing might be a swing and a miss. One might say it was caught looking a few years ago as mobile computing started cutting into PC sales, so now it has two strikes. It’s time for Microsoft to get its head in the game. I believe its products have a lot of potential to grab a share of the mobile market as well as spurring innovation to revive the PC market, but it might call for a slight change in how it approaches the plate.

adamlevy has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Google, and Microsoft. Motley Fool newsletter services recommend Apple, 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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