Microsoft's money pit: Surface has lost $1.2B

CEO Nadella will unveil new tablets Tuesday, but can he stop the bleeding?

Microsoft has lost more than $1.2 billion so far on its Surface tablet business, an expensive experiment that makes tomorrow's revelations of new hardware an important milestone for the "devices" side of its corporate-refashioning strategy.

On Tuesday, CEO Satya Nadella is expected to step on a New York stage and unveil one or more new Surface tablets, and outline his direction for the in-house hardware project birthed by his predecessor, Steve Ballmer.

While analysts and observers have split on Surface's future -- some see Tuesday as a last-chance for Microsoft to tweak its tablet strategy, others believe the company will press forward regardless of the reception pundits give the new devices -- it's a no-brainer that eyes will be on Nadella, who will have to explain how he will push, pull and drag the Surface out of its money-losing ways.

For although Microsoft has been parsimonious in the details it declares of the Surface's financial performance, the business has clearly been a money pit. In the last two quarters -- the only ones in which Microsoft has explicitly called out revenue and cost of revenue -- the tablet line lost $84 million.

But that was small potatoes compared to the September 2013 quarter.

According to its most recent 10-Q filed with the U.S. Securities and Exchange Commission (SEC) -- and some simple arithmetic -- Microsoft generated $413 million of Surface revenue that quarter, but spent $629 million to produce the revenue, posting a loss of $216 million.

Combine that $216 million (Q3 2013) with the $84 million (Q4 2013 and Q1 2014), and the total nine-month loss for Surface comes out at an even $300 million, as Microsoft admitted in the 10-Q.

The bleeding does not stop there, however.

Microsoft was forced to take a $900 million write-down in mid-2013 to account for the glut of Surface RT tablets it couldn't sell. That adjustment was above and beyond whatever cost of revenue Microsoft incurred to build and sell the Surface tablets it did unload between the October 2012 (Surface RT) and February 2013 (Surface Pro) debuts, and June 30, 2013.

The company never divulged the cost of revenue for those three quarters -- Q4 2012 and Q1 and Q2 2013 -- saying only that revenue had been $853 million. But it would be foolish to assume that the cost of revenue was less than the revenue, what with Microsoft's inability to turn a profit in later quarters.

So even without factoring in the three-quarter cost of revenue, Microsoft has lost $1.2 billion on Surface: The $900 million write-down + the $300 million loss from Q3 2013 on. How much more than $1.2 billion? Only Microsoft knows.

The loss, although not an existential threat -- Microsoft recorded $5.7 billion in net income in the March quarter and has $88 billion in its cash and short-term investment horde -- puts Tuesday's unveiling in a harsh spotlight. Can Nadella turn tablets around, from money losers to money makers?

Microsoft's tablet strategy has cost the company $300 million in the last nine months, more than $1.2 billion since its debut. Can the new CEO turn that around? (Data: Microsoft, SEC filings.)

Analysts weren't optimistic.

"I expect premium price points," said Patrick Moorhead, principal analyst with Moor Insights & Strategy, in an interview last week.

He explained why by citing rivals' business models. "Both Google and Amazon have models for their tablets where they make it up on the back end," Moorhead said, referring to the advertising and product sales that the two rely on to offset their lower-priced tablets. "But I don't feel like Microsoft has achieved scale in their tablet content to offset [lower prices]."

Higher prices means lower sales volume. And that's a problem. "You have to have scale to buy cheaper components. Microsoft doesn't have the scale to be profitable or to hit interesting price points," Moorhead argued.

In other words, because Microsoft will be forced to stick with premium prices for the Surface, it's unlikely to sell in enough volume to be able to strike bargains with component suppliers. If it was able to make those deals, it could either use the lower costs to turn a profit in the short-term, or more likely, immediately reduce prices, recognizing that would delay profits but expecting the losses to turn into even larger, and more sustainable, gains.

Others also expected the new Surface tablets to retain their high prices. Independent analyst Sameer Singh, for example, pegged the likely price of a "Surface Mini," a 7- or 8-in. tablet, at between $249 and $299. "I don't think Microsoft can afford to compete with low-end Android and 'white box' manufacturers on price," Singh said recently.

Singh's price range was closer to the established first-generation iPad Mini -- which lists for $299 -- than to the current crop of 7-in. tablets from the likes of Amazon and Samsung, priced at less than $200.

Rumored prices of a new slate of Surface Pro tablets -- the models that run legacy Windows applications -- also tilt toward the high end. A report Saturday by Windows Phone Central claimed that the next-generation Surface Pros will start at $799 and run up to $1,949.

Those prices are minus the keyboard that Microsoft virtually mandates in its marketing. A Surface keyboard currently runs between $80 and $140.

Although the $799 base price is $100 less than the lowest-priced 64GB Surface Pro 2 sold today, the combined tablet + keyboard package equals an out-of-pocket expanse around $900, still stratospheric for tablets, and in the realm of premium notebooks and the 2-in-1 hybrids Microsoft aggressively trumpets.

Minus a price-reduction strategy, Microsoft faces an uphill battle against the also-premium-priced iPad and a bewildering array of low-cost Android tablets. The smaller losses in the last two quarters are encouraging signs. But there are some other signals that the Surface is gaining ground, and doing it organically.

"Surface Pro is making some headway in corporate environments," contended Ross Rubin of Reticle Research. "One of the big draws for Surface versus competitors is legacy Windows compatibility, and its pricing is more geared toward corporate customers."

Fidel Deforte, the infrastructure and communications technology manager for the city of Cape Coral, Fla., agreed. In an email last week, Deforte outlined how he has begun replacing some senior managers' hardware -- typically a combination of an iPad and a Windows notebook -- with the Surface Pro. And saving money as he did.

"I replaced [a manager's] HP laptop and iPad (total value $2,600) with the Surface Pro 2 ($1,300) and she not only loves this, but sees that it is more flexible and efficient," Deforte wrote.

All that Nadella needs is millions more stories like Deforte's.

Microsoft will webcast the Surface event Tuesday, starting at 11 a.m. ET (8 a.m. PT).

Gregg Keizer covers Microsoft, security issues, Apple, Web browsers and general technology breaking news for Computerworld. Follow Gregg on Twitter at @gkeizer, on Google+ or subscribe to Gregg's RSS feed. His email address is gkeizer@computerworld.com.

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This story, "Microsoft's money pit: Surface has lost $1.2B" was originally published by Computerworld.

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