Is the Surface a Problem for Microsoft?

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

Microsoft (NASDAQ: MSFT) has put together a few wins recently, even in the face of a declining PC market. The Surface was supposed to be the company's big break into the tablet space, but unfortunately it seems to have fallen short.

Despite being an impressive demonstration of the company’s innovation capabilities, its lack of sales forced the company to take a $900 million inventory write-down. In addition to taking the write-down, Microsoft lowered the price of the Surface RT by $150 per unit. On top of that, the Surface Pro is now being discounted by $100 through the end of August. Sounds like a fire sale to me, but does it mean that the Surface is a complete failure?

The Surface hasn’t led Microsoft to market domination, but the company’s presence in the tablet market has grown significantly. According to IDC, Apple (NASDAQ: AAPL) is losing market share as Microsoft and other competitors are gaining ground. It is clear that Microsoft thinks that design is important, and the device serves as a very complete reference design for its manufacturing partners.

<table> <tbody> <tr> <td> <p><span><strong>Vendor</strong></span></p> </td> <td> <p><span><strong>2Q13 Unit Shipments (in millions)</strong></span></p> </td> <td> <p><span><strong>2Q13 Market Share</strong></span></p> </td> <td> <p><span><strong>2Q12 Unit Shipments (in millions)</strong></span></p> </td> <td> <p><span><strong>2Q12 Market Share</strong></span></p> </td> <td> <p><span><strong>Year-over-Year Growth</strong></span></p> </td> </tr> <tr> <td> <p><span><strong>Android</strong></span></p> </td> <td> <p><span>28.2</span></p> </td> <td> <p><span>62.60%</span></p> </td> <td> <p><span>10.7</span></p> </td> <td> <p><span>38.00%</span></p> </td> <td> <p><span>162.90%</span></p> </td> </tr> <tr> <td> <p><span><strong>iOS</strong></span></p> </td> <td> <p><span>14.6</span></p> </td> <td> <p><span>32.50%</span></p> </td> <td> <p><span>17.0</span></p> </td> <td> <p><span>60.30%</span></p> </td> <td> <p><span>-14.10%</span></p> </td> </tr> <tr> <td> <p><span><strong>Windows & Windows RT</strong></span></p> </td> <td> <p><span>2.0</span></p> </td> <td> <p><span>4.50%</span></p> </td> <td> <p><span>0.3</span></p> </td> <td> <p><span>1.00%</span></p> </td> <td> <p><span>527% (excludes RT)</span></p> </td> </tr> <tr> <td> <p><span><strong>Blackberry OS</strong></span></p> </td> <td> <p><span>0.1</span></p> </td> <td> <p><span>0.30%</span></p> </td> <td> <p><span>0.2</span></p> </td> <td> <p><span>0.70%</span></p> </td> <td> <p><span>-32.80%</span></p> </td> </tr> <tr> <td> <p><span><strong>Other</strong></span></p> </td> <td> <p><span>0.1</span></p> </td> <td> <p><span>0.20%</span></p> </td> <td> <p><span>N/A</span></p> </td> <td> <p><span>N/A</span></p> </td> <td> <p><span>N/A</span></p> </td> </tr> </tbody> </table>

One thing is certain: the tablet market is still rapidly growing, while it seems that the PC market is saturated and growth has stalled. That’s bad news for Microsoft, Intel (NASDAQ: INTC), and every other company that depends heavily on the PC industry.

While Intel has managed to do reasonably well in spite of strong headwinds, it’s clear that the chip giant is feeling the pressure. In its most recent reported quarter, the company experience a 5% decline in revenue and a 29% decline in profit. The company’s new CEO, Brian Krzanich, has even made it a point to discuss the fact the Intel was behind on the ultra mobile trend; Krzanich specifically called out the company's lack of presence in the tablet space.

There is other evidence that the tablet market is rapidly becoming mission critical. Apple, which still leads in tablet shipments with 32.4% in the most recent quarter, makes just over 18% of its net sales in the tablet market. For comparison's sake, the portion of revenue driven by Windows was 22% in the last quarter. Factor in that the Windows market seems to be stalling while the tablet market is still growing, and it seems like Microsoft has a real problem.

Though it missed the initial mobile wave, Microsoft has already made significant moves to catch up. The first of these was the company’s deal with Finnish phone giant Nokia (NYSE: NOK) to revamp its line of smartphones. Total shipments for Windows Phone-based smartphones more than doubled for the first quarter on a year-over-year basis, jumping from 3 million units in the first quarter of 2012 to 7 million units in the first quarter of this year. The Nokia deal has played a major role in Windows Phone’s growth, as the company was responsible for 79% of all Windows Phone smartphones shipped for the quarter.

Microsoft also completely overhauled one of its core products, Windows, designing it for touchscreen use from the start. While Windows 8 hasn’t been warmly welcomed it shows that no product is sacred, even one with a legacy like Windows. That’s a positive indicator for the company, because history tells us that those stuck in the past become a thing of the past.

Apple’s success with the iPad does show that a strong performance in the tablet market can have a dramatic effect on revenue, but it doesn’t necessarily mean that Microsoft is doomed in the mobile space. While the tablet space is experiencing rapid growth, the smartphone segment is arguably the more important part of the mobile space.

Both Apple’s iOS and Google’s (NASDAQ: GOOG) Android OS dominate the tablet and smartphone fields, helped in part by the ecosystem that unifies both platforms. Additionally, the primary Internet connection in many developing countries is the cellular network. In countries where cellular is the primary connection, tablets are secondary devices.

There’s also the question of relative price. Tablets are generally more expensive than their smartphone counterparts, and we’ve seen the effect pricing has on devices in unsubsidized markets. Is it that much of a leap to think that tablets will continue to take a backseat to smartphones, at least in the near term? I do not think so.

Ultimately, I think that the Surface line provided valuable experience for the company that can be used to improve its mobile strategy. I also wouldn’t count the software giant out just because its latest venture didn’t resonate like the successes of its competitors. The company is making inroads both in the tablet and smartphone markets, and that is more than some of its competitors have managed.

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Chris Moore owns shares of Intel. The Motley Fool recommends Apple, Google, and Intel. The Motley Fool owns shares of Apple, Google, Intel, 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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