Twenty years ago, when Microsoft was on the rise, it decided to spend the then princely sum of $100 million on an ad campaign to tell the world about itself. The image spots asked "Where do you want to go today?" While the actual commercials were sometimes a bit weird, Microsoft CEO Satya Nadella might want to dust off the question itself right about now. After the launch of the new Surface Pro 3 this week, the company seems completely lost. And while Microsoft has the financial resources that prevent it from falling into a crisis state anytime soon, it needs to decide what businesses it wants to be in over the next several years and how it plans to keep on making money. The last year has not been encouraging.
Surfacing from the depths
On the plus side, the new Surface is clearly a cut above the old. (This in no way is an attempt to review the Pro 3; I hope to get a unit and do that in the near future). By ditching the ridiculous 16:9 form factor and the too-thick-by-far screen, it's now at least possible to hold the Surface Pro as a tablet in portrait mode. The new variable-angle kickstand similarly increases the Surface's versatility as a laptop, as do the multiple processor options and the larger screen. If there is any hope for the so-called Windows 2-in-1, Surface Pro 3 is probably it.
But therein lies the first problem: This is a product in search of a market. And it's a market Microsoft has been insisting is the next-big-thing since at least 2002. Microsoft seems as unclear as ever on people want tablets and, for that matter, why they want laptops like the Macbook Air -- the product they kept comparing Surface Pro 3 to. Tablets are inherently touch products, held in the hands, used intimately. While keyboards are brought out by a small minority of users for note-taking and document creation, that's the rare case, not the raison d'etre.
Great laptops are built around great keyboards and trackpads (or still for some, the little red eraser head of the ThinkPad). The Macbook Air's most amazing attribute is its bulletproof construction, best exemplified by its remarkable rigidity. Surface Pro 3 is basically a series of compromises to achieve some destination that remains ambiguous -- where does it want to go? "This is the tablet that can replace your laptop,” said Panos Panay, Microsoft's Surface chief. It can, but why? It's not an especially good buy as a laptop, with prices ranging up to $1949 (Surface Pro 3 starts at $799) and it's unlikely to be a great laptop given the kickstand and a keyboard/trackpad combo that no one who touched it felt was best in class.
And more importantly, it's not a laptop that's replacing anyone's tablet. At 1.76 pounds, it's way too heavy. An iPad Air checks in at just 1 pound and personally I returned one for a 3/4 pound Mini after deciding it would get tiresome to hold for long periods. Surface Pro 3 is also far too large to use for any length of time as a handheld device.
Down to business
None of this is to suggest that Surface Pro 3 is dead on arrival, but just how live it is seems a fair question. IDC expects 295 million PCs to be sold this year and Microsoft has to be looking at several million of those being the new hybrid. While it insists it isn't competing with PC OEMs, it's difficult to find a more absurd claim as each of those sales will come out of the hide of Dell, HP, Lenovo, et al. And for every Surface, it won't be booking any Windows license revenue either, since it can't bill any of those OEMs for a machine the company itself is selling.
Microsoft has called its new approach the "devices and services" strategy whereby it sells the physical thing (a smartphone, a tablet) as well as the software and cloud technology (Windows, Office 365) and makes more profit doing this. The theory is to get some of the sauce that has made Apple the most valuable company in the world and layer that on top of the meat and potatoes that once saw Microsoft hold that crown.
The problem here is Microsoft is terrible at this. It has already taken $900 million in writedowns on the Surface RT, its putative iPad competitor. Even if Surface Pro 3 succeeds in selling 5 million units at a 20% margin -- which would be an impressive result given that many will need to pass through the hands of third-party retailers who will get their own markup and also considering Microsoft's relatively low volumes won't allow it the best pricing on components -- it's likely to barely earn that back in gross margin.
But then one has to consider that it will lose out on about $250 million in Windows licensing revenue by taking 5 million sales from its "partners." Further, it will likely spend far in excess of what that 1994 ad campaign cost marketing the Surface Pro 3 -- perhaps another $200 million or more. Suddenly, that potential billion dollars of gross margin has been halved.
Domino principles
Of course, this is just the beginning. Microsoft could eventually find itself selling tens of millions of Surface Pros annually if the product is a big hit. That seems improbable given the compromises, but let's say it does happen. What then of Dell and HP? Neither makes much selling PCs and the competition from Microsoft could drive one or both from the market. While that might seem like good news for Surface, it's more likely that it would simply accelerate the decline of the PC business as a major seller of them exits. That's more lost licensing revenue and more incentive for PC users to examine tablets and smartphones more closely as alternatives.
And here, Microsoft's strategic weakness seems worse than ever. With Surface Pro 3, the company has attempted to shore up the PC, the fount from which all of its riches once flowed and still a critical source of its income. But it said nothing about the other Surface, the less-expensive one that competes with Apple's iOS and Google's Android. The one that it hopes to bring more in line with its smartphone platform. That Surface has no traction to speak of as Apple's iPad dominates the corporate tablet market and Android has captured the low end globally.
Microsoft, in the meantime, is digesting its purchase of Nokia, which it felt was essential to preserve its presence in smartphones. In Nokia's final quarter of stewardship sales there were down 30% year over year and gross margin fell to just 16%. The big problem for Microsoft is that while there has been some growth in the number of Windows Phones sold, it's come entirely at the low end of the price curve. Effectively, Windows Phone is attracting first-time or price-sensitive smartphone buyers and yet remains a distant third behind Android and iOS. The devices there are quite literally losing money and it's not at all clear those customers are buying any services either. While they might grow into something interesting over time, they have no overlap at all with the corporate base Microsoft is targeting with Surface Pro 3.
Which brings us full circle. Microsoft finds itself between everywhere and nowhere. It's essentially entering the declining PC business while attempting to redefine it -- that's tough enough for someone with a strong track record in hardware. Simultaneously, it's sitting out the tablet business, which is undermining that very PC business and could yet cause it to collapse. (Rumors abound that Microsoft will release a Surface Mini when it's ready, but how many tens of millions more iPads will be out in the wild by then?) Finally, it has jumped into the smartphone race with a very strange horse that's running from the back of the pack, yet promising no big payoff. Nadella had better decide where he wants to go sometime soon, because for the moment none of that appears to be going much of anywhere.
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