Fixation on Margins: The Surface RT Debacle Edition

I know you’ve been waiting for a comment on the Microsoft Surface impairment charge ever since Microsoft’s earnings report.  Well, I’m going to give my view of the problem and how Microsoft turned what should have been a shining moment in its transition to a Devices and Services company into a debacle.  There will be no dwelling on the Surface RT hardware (and particularly ARM) debates nor on Windows 8 shortfalls, except for limited reference.  Those things play a role, but I believe a fairly minor role in how Microsoft messed this up.  The problem, at its surface (pun intended for a change), is that Microsoft let a desire for Apple-like margins on hardware cloud its judgment on how to enter the PC hardware business.

The other day a friend of mine made two astute comments.  The first was that the only real problem with the Surface RT was that it lacked applications.  The second was that if Microsoft had given away the millions of unsold Surface RT systems implied by the $900 million write-down then the application problem would have been solved.  So why didn’t Microsoft do exactly that?  That is, sell several million Surface RT systems at bargain basement prices to seed the market?  I’ll get into that as I walk through this story.

Before getting into Surface specifics I want to discuss a general point about Microsoft over the last decade and moreover the last few years as it started the transition to a Devices and Services company.  As a (near) pure-play software company Microsoft has had absolutely enviable margins.  The kind of margins that make for business school case studies.  Put simply the Microsoft software business model is very high fixed costs and near-zero variable costs.  So as you drive volumes higher you reach a point where every sale is nearly pure profit.

Software profits have been so high over the years that they allowed Microsoft to invest in many unprofitable products (or even outright failures) while still maintaining profit margins that were the envy of the entire business world.  In the 90s no one even noticed.  In the 00s they noticed, but were more critical of the lack of new successes than of the margin impact of trying to find one.  In the 10s you are seeing more calls to split or drop all the new endeavors and remake Microsoft as an Enterprise-focused software company, thus returning it to historical margins at the risk of the likeliness that the “Consumerization of IT” will eventually render it irrelevant.

The problem for Microsoft today is that if you transition the company away from its primary revenue stream being sales of perpetual software licenses to a Devices and Services revenue stream you stop being able to hide behind the tradition software license sales margins.  So Microsoft, and I’ll put this very much (and very appropriately) at Steve Ballmer’s feet, is extremely focused on maintaining margins as much as possible during the transition.

Take Office 365 as an example.  Without getting into all kinds of details of the dynamics of the Office business and how a services offering changes them, I’ll just point out that Microsoft is adding a lot of variable cost (running the service) to what used to be a purely fixed cost business.  And the fixed costs (e.g., Engineering) don’t go down at all.  So when you look at the complex set of offerings under the Office 365 umbrella what you see is Microsoft trying to address cost-sensitive parts of the market, value for $ parts of the market, and high-end information worker parts of the market and trying to get the mix of subscriptions to end up margin neutral.  Or at least close enough that when the transition is done shareholders will be happy with the resulting margins.  So far they seem to be on a path to success with this one.

Bing is another case of a focus on margins.  While there are very strategic (survival even) reasons for being in the Search space, the business case is that once you achieve a particular market-share the advertising revenue hits the knee of the curve and you quickly get to very high margins.  So, if you have the money, you can pour immense amounts into scratching your way to that magical market-share (whatever it may be) knowing the eventual positive bottom line impact will be enormous.  If, and it remains a big if, Microsoft hits the knee of the curve on advertising revenue then the many billions spent to get there will quickly be forgotten.  For now they are getting close to a break-even run rate while making good use of Bing as a platform technology.

But Surface and future mainstream device offerings are a far more risky venture for Microsoft.  Before Microsoft announced that it was becoming a Devices and Services company you could look at the Surface and declare it a “North Star” product.  That is, it wasn’t really intended to make money but rather to excite customers and show OEMs the way.  But if you are a Devices company then you need to make money selling devices!  And because devices are very high revenue per unit, they can quickly overwhelm your software revenues and have significant margin impact.  You can look at Apple, and to some extent Samsung, and see that it is possible to get high margins from devices.  And that led Microsoft, which has always had a bit of Apple-envy in its DNA, to fall into a trap.

Microsoft, in entering the devices market, could either go for market share or margin.  They went for margin.  According to IHS iSuppli, the gross margins for the Surface RT were (based on original pricing) higher than the Apple iPad.  And they did that at exactly the same time that overall tablet prices were being driven down by the introduction of 7-8″ devices, often with a subsidized price.    If Microsoft had actually been able to sell several million Surface RT’s at its original pricing then this would have looked like a brilliant move and Steve Ballmer would have been a candidate for CEO of the year.  But it turns out the “go for margin” strategy completely failed.

I’d originally expected a competitive, but not aggressive, list price for the Surface RT that, when combined with a service subscription, made the device seem inexpensive.  Microsoft didn’t do that.  I’d also expected a price in the ball park that the Surface RT came out at with a price reduction once supply became plentiful.  Microsoft never lowered the price.  Actually my main expectation was that after the holiday season Microsoft would effectively lower the Surface RT price by package the Touch Cover with it at the same price as the Surface RT-alone had been for the holiday season.  They didn’t do that.  Instead they maintained the effective price at about $100 more than the iPad through FY13, and then took a write-down as a result of a re-pricing for FY14 that did nothing more than take the Surface RT to the price it should have been at introduction!

The write-down, aka impairment charge, is an abomination in my opinion.  Why did Microsoft take it?  Well, we are back to the margin point.  By re-pricing the Surface RT to where it should have been in the first place Microsoft eliminated the possibility that it would ever be a high margin product.  They could have taken the hit in reduced overall margins for the first two quarters of FY14, which would have been a fair representation of the impact becoming a Devices company is likely to have on the business in the short to medium, if not long, terms.  Instead they pulled the entire margin impact into Q4FY13 and took the PR and investor hit all at once.  This will make FY14 look artificially good.  Most likely from Microsoft’s perspective they hope to attain good margins on Devices in the second-half of the fiscal year and just wanted to avoid more margin discussion until then.  But personally I’d rather see a continual true representation of the impact of Devices on the business quarter-to-quarter instead of using accounting tricks to hide it.

Back to the Surface RT debacle itself let’s focus on the weakness of introduction strategy.  The uniqueness of the Surface RT tablet is that it is (a) tablet for running Metro apps, (b) runs Microsoft Office, and (c) has a keyboard and track pad built into a thin cover.  So basically, along with other Windows RT tablets, you have a tablet that will let you run Office and be more productive on content creation tasks than the iPad or Android tablets.  But at introduction it had almost no Metro apps, and nine months later the library is growing fast but is still not compelling.  So effectively you would pay $100 more (than an iPad) for a tablet that can run Microsoft Office, but can’t run any other applications.

Microsoft Office is indeed a compelling capability on a tablet.  So is a keyboard and track pad.  But, Microsoft missed on the tablet version of Maslow’s Hierarchy of Needs.  Near the base of pyramid that represents the hierarchy is “Run the applications I want”.  A few levels up is “Does real work” (which for many people means runs Microsoft Office).  And the way Maslow’s hierarchy works is that you have to satisfy the needs nearer the base before people care about things more towards the top.  A tablet that doesn’t “Run the applications I want” is a non-starter despite the ability to run Microsoft Office.  And one that requires I pay a premium for the privilege of not meeting my base needs is truly DOA.

Microsoft apparently expected that the Metro application library would grow so quickly that Maslow’s tablet hierarchy would be a non-issue.  But they shot themselves in the foot with their strategy to achieve this.  No, I don’t mean that Windows 8 sucks so app vendors are ignoring it.  On the contrary, app vendors offer near universal support for Windows 8.  The mistake Microsoft made was to assume that support for Windows 8 meant the creation of Metro applications while Microsoft made it perfectly acceptable for Windows 8 support to mean desktop Win32 applications and IE10-tuned websites.  Microsoft gave App vendors (and I use the modern term broadly to also include traditional ISVs and website operators) almost no real incentive to create Metro apps rather than continue down the same path they were on for Windows 7.

Think about Microsoft’s initial spiel to developers:  There are already hundreds of millions of PCs installed that will be capable of running Metro applications (because they are upgradeable to Windows 8).  That takes away the disincentive of the market for Metro apps being too small, but does nothing to incent developers to create Metro apps.  So today there are about 100 Million PCs actually running Windows 8, and perhaps 98 Million of them also run Win32 Desktop apps.  So the real market, the one you can’t reach in other ways, for Metro apps is only 2 million systems.

The reason we have 110,000 Metro apps in the Windows Store is because of the business advantages the Store model brings for small developers.  Such as not dealing with installation, uninstallation, payment/billing, automatic updates, etc.  But for medium and larger developers, the incremental market reach of doing a Metro app pales in comparison to the costs associated with maintaining a desktop application (for Win 7 for example, or for power users) in addition to the Metro app.  So the Windows Store is largely populated by apps from small developers, with only a modest subset of apps from larger developers and website front-ends.  This is a speed bump for Windows 8, because users will continue to use the desktop applications.  But it is devastating for the Surface RT and other Windows RT systems as they cannot run Win32 apps.

Think about other examples of confusing messages from Microsoft.  The IE team is on a big push to get websites to support IE10 and be touch friendly.  But a good touch friendly IE10-compatible website reduces the incentive for a front-end Metro application.  Microsoft itself, in tweaking Office for touch and then including it in Windows RT, showed developers how they could avoid creating Metro apps in favor of tweaking their desktop Win32 apps.  So you have developers claiming Windows 8 support and pointing customers to either their website or their Win32 apps.

Now we get to where Microsoft’s desire for high margins and its need to incent developers to create Metro apps crippled each other.  The main incentive for developers would have been a large number of systems that they could only effectively reach with Metro applications.  The best way Microsoft could have made sure this happened would have been to price the Surface RT very aggressively so developers saw a rapidly growing population of Metro-only devices and moved rapidly to jump on the bandwagon.  Banks, newspapers, airlines, social networking companies, Information Worker ISVs, etc. would pay a lot more attention to 10 million devices and growing fast then they are to 2 million devices apparently going nowhere.   Of course, since Microsoft equated Windows 8 unit growth with Metro app library growth they thought they could have their cake and eat it to.  Windows 8 would drive Metro app library growth and they could go for high margins on the Surface RT.  It didn’t work.

Microsoft now finds itself with the worst of all worlds.  They’ve had to write down the Surface inventory.  They will have to be more price competitive (and accept lower margins) on the next generation of devices.  And they still don’t have enough Metro apps to make Windows RT devices successful.  Moreover, the reputation of Windows RT may have been harmed to an irreparable degree.  This is important because, as I’ve pointed out before, Windows RT was supposed to be the future of Windows.

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51 Responses to Fixation on Margins: The Surface RT Debacle Edition

  1. SpragueD says:

    It’s baffling that the company that lives by owning platforms didn’t see their goal — arriving so late to the game — was to claim [market/mind]share by subsidizing price and eating costs (at least in the first generation of devices). Are they not studying the Google playbook (which is merely an updated version of the legacy Microsoft playbook)? With a sufficient user base to develop against, even the motley app strategy could’ve been sorted out.

    • halberenson says:

      In hindsight what they did was wrong and, yes, many people could have seen it was wrong at the time. I suspect Steve’s desire for margin met Steven’s belief that he’d put together such a compelling product that deep financial incentives were not required. But that’s pure speculation.

      My own annoyance with Microsoft on this is how slowly they moved to try to correct the situation once it was clear there was a problem. I was shocked, for example, that there was no price cut to the Surface RT at the time of the Surface Pro launch. They blew a big opportunity to get things back on track.

      • Tom says:

        I don’t understand the fixation on margin. Break out the hardware into a separate division, and report your margins separately for each division.

        So what if your companywide margins go down? If you manage to sell a few million Surfaces, then it doesn’t matter what the margin is (so long as it is positive). Your profits go up. Investors will understand.

        • halberenson says:

          Investors will tolerate it in the short-term, but not in the long term. The pressure for Microsoft to divest low-margin businesses is growing, so the fear would be that allowing margins to drop substantially would lead to a shareholder revolt is real (if overstated).

  2. I am astounded that this wasn’t priced right from the start. But to be honest, it wasn’t even ready at the start. It has taken months of bug fixes (wifi bug), to even get Surface RT to presentable form. Even today, a consumer will walk out of a store with a Surface RT, and not even realize that there are a couple of hours worth of updates to perform in order to make it behave, and a lot of them that I see don’t even know to update the core apps at the app store.

    Those two huge issues have been addressed with 8.1. The apps update automatically, and with 8.1 out of the box there won’t be hours of updates to perform. Well it’s ready now, particularly with 8.1 and the inclusion of Outlook 2013, the new mail app etc. etc. No viruses, malware, or toolbars.

    Has the reputation been irreparably damaged? Remember when HP put the WebOS tablet on a fire sale for $99? It flew off the shelves in record time. I don’t know of a more badly damaged reputation than that one at the time.

    Now is the time for MS to not only lower the price, but throw in the damn keyboard, take the loss, and up the adoption rate. I already have several customers that have bought one at Staples for $310 after a rebate, and they all think its a great device; but that was after I set them up with a Microsoft Account, forwarded their old email, imported their contacts, and performed all the updates for them. That is not a small list of things to do to get it ready..

    Get them to put out Quicken for RT and Minecraft for RT, that would please more than half of my user base overnight.

    Great explanation Hal, there is always so much more at play than what we think.

    • halberenson says:

      With the exception of the WiFi issues, which at my house only showed up when the Surface tried talking to a Linksys Range Extender, I didn’t have any issues with my Surface from day one. And the Surface’s WiFi antenna is so good that I removed the Range Extender and could still use the Surface in every room of the house.

      The update issue can be annoying, and I don’t know why Microsoft doesn’t start pre-installing them whenever update times stretch to something over a specified range. But I still don’t see those as being a real impediment to purchase.

      • “But I still don’t see those as being a real impediment to purchase.”

        It’s not the purchase I worry about, it’s the confusion afterward. Tech savvy users many times have a hard time understanding the trials and tribulations of the average non-tech savvy user. I work with these types of folks every day, and believe me, NONE of them even know that the numbers on the Store tile mean updates are available. It’s not explained anywhere, and no one wants to read about it. The included tutorials in 8.1 will go miles toward educating non-savvy users.

        • halberenson says:

          This is exactly the same as on the iPhone, iPad, etc.

          • And a ton of my customers that have Ipads and phones, don’t even do those updates, they actually think it will screw something up. This auto updating app feature will be really nice on 8.1.

          • Not so exactly any more. iOS7 lets you choose to update your apps in background. (Doing so over cellular is optional, as is whether you also update music, books or the OS that way.)

            No more number badges on my app store icon; and since I don’t need more apps than the 180-odd I already have, I don’t need to give it homescreen space at all.

            I think I’ve seen the claim that Android has had this for a while; I imagine that once Microsoft gets a bit more comfort level with the app/OS updates not bricking the phone or an app, it’ll roll to WPX, too.

    • rkeithhill says:

      Yes, Minecraft as a Windows Store app! My kids would *love* that!

  3. Philip says:

    I never thought they could really price the Surface aggressively and thus price it lower than all OEM products. And I’m not sure they should have.

    When the Surface was announced everyone saw a real danger of alienating the OEMs even before knowing the price. Had they chosen a price point the OEMs couldn’t even reach with their inferior products, one could argue that this might have hurt Microsoft in other ways.

    In the end, alienating the OEMs probably wouldn’t have mattered much, since the OEMs don’t seem to care about tablets running Windows, anyway. They just don’t seem to put as much effort into their Windows offerings as they do on the Android side. Looking at their tablets, it’s easy to see, which ones they really focus on and really want to sell.
    As Charlie Kindel likes to repeat, people don’t buy things, but they are sold things. And the OEMs are selling Android devices. Therefore, I don’t think Windows will stand a chance on tablets no matter what Microsoft does.
    Their focus on making websites IE10 compatible may not be a bad thing, since they won’t get the apps either way.

    • halberenson says:

      I think there were price points, lower price points, that wouldn’t have damaged OEMs. In particular packaging the Touch Cover with the Surface at the original cover-less Surface price would have made no difference in the OEM equation. Moreover, by the time of the Surface Pro announcement it was clear that all OEMs had lost (what little interest they had) in Windows RT. So lowering the price of Surface RT at that point would have had absolutely no impact on OEMs.

      • Brian says:

        I agree that OEM worries probably were important in the early pricing decisions. I’m also curious why the type and touch covers are still priced over $100. Yes, they are somewhat innovative, but the margins on those keyboards must be huge. Microsoft should be throwing a touch-cover in with every Surface and and offer a type-cover upgrade for a nominal charge (say $20).

        The big selling point of the Surface RT is that attached keyboard you see in every commercial and the inclusion of Word (Excel and PowerPoint are nice, but the only Office app I seem to use on my Surface is Word). Make every Surface get a touch or type cover.

        (FWIW, my pet peeve is that the typing experience on the on-screen keyboard is, in some ways, better than on the touch cover – you get a *much* better auto-correct experience. And, according to me, neither of those experiences matches the experience you get with Windows Phone (whose auto-correct behavior I categorize as magical).)

      • Bob - Former DECie says:

        Since I’m not in the market for a tablet, I haven’t been following the Windows RT market closely. Does anyone other than Microsoft make a Windows RT powered tablet? If not, isn’t the Windows RT market pretty much dead? Or would the coming support for a 7″ form factor possibly create a market?

        • There have been a few, such as ASUS (the VivoTab RT is one of the better examples), but most haven’t. The scarcity may be intentional — Microsoft reportedly wanted to have chipset and device makers pair up for the launch — but there’s also an increasing reticence from OEMs. They either don’t see the value (i.e. they want backwards compatibility) or are aware that Windows RT devices don’t really sell.

          I see Microsoft taking a second shot at this, but I’m not counting on a third. Windows RT already has the aura of a struggling Microsoft product (see: Bob or Kin), and there’s been enough of those that many OEMs are reluctant to commit; if there isn’t an obvious turnaround, it’s doubtful RT will get much further.

          • dave says:

            If MSFT really wants to make Windows RT devices popular with the age 30-40 male buying demographic that has thus far bought the lion’s share of tablets, then MSFT needs to make integration with Google services a top priority – be the best Hardware for Google service access. That, and offer hardware at no more than $250.

            Im afraid that the Windows RT reboot price is still too high – and msft will probably not be given a chance for a third reboot.

            Tablets are purchased by 1) males age 30-40 (who are in love with newer fresher Google services), and 2) lower income families (who can’t afford a new laptop), with Netflix, email and social media needs (not excel, ppt, word…) and 3) older 50+ age demographics, for web surfing and email.

            So, given the relatively unsophisticated demands of a tablet that most of the tablet buying audience has of these devices, competition is based on 1) price, 2) device design, 3) delightfulness of the experience for the things that people want to do on a tablet (movies, music, social, games, email). Windows RT doesnt lead on on any of these points. It’s more expensive, bulkier and its Office software integration is not what most people are expecting, want or need from software tablet that costs as much as a laptop.

            • smallmountain says:

              Google services? Seriously? There are 3 tablets in my house, and none of them ever connect to Google services. Microsoft has a fantastic e-mail service in Outlook and a very good search service in Bing. Microsoft has very good cloud services in Azure and the service formerly known as SkyDrive. One day maybe XBox Music will be decent. Microsoft has the XBox tie-in. For the “work” half of “work and play”, Microsoft has enterprise mindshare. I can’t think of a single thing anyone, let alone Microsoft, needs from Google. They just need to quit screwing up the marketing.

              • dave says:

                Yup, I’m serious. If MSFT wants to win in the tablet market, it needs to out compete the competition. Its a given that MSFT hardware should work better with MSFT software and services. But, right now, there are more tablet oriented services that the world loves from google than from MSFT. And everyone expect google services to work beat on android devices. The whole google experience is predicated on the cloud. MSFT does have some great things coming through. But it’s no way as well developed from a consumer point of view. Damn, even their coolest branding names (Metro, Skydrive…) need to be abandoned.

                If MSFT want to carve out a third platform to offer distinguishing features compared to iOS and android tablets, then those feature had better appeal to the tablet buying audience at the expected tablet buying prices. Windows RT is a half-way house that isn’t quite cutting it. Until the entire Office suite is 100% touch enabled Windows RT has little that merits the higher prices, and bigger bulk compared to a new Nexus 7. Indeed, Windows RT needs a bigger screen to be useful with office right now. Not a smaller screen.

                putting it simply, go see what people making $30,000 to $50,000 a year are buying. That’s the mid market.

            • andisimo says:

              Disclosure: I work for Microsoft. The opinions here are my own and do not represent Microsoft.

              Dave, Microsoft’s revenue doesn’t come from hardware. The whole point of having a Surface tablet (in a rational strategy, which might not have been what was originally in place with Surface) is to pull through the things it makes money on – Windows, Office, Skype, Bing, xbox, etc – most of which compete directly with Google. If you’re Microsoft, you don’t make a tablet and integrate it with Google services.

              Making “the best hardware for Google service access” means 1. you think the future of your company is in hardware revenue, and 2. the future of your company is not in things like Office and Skype (which was acquired for $8B). That’s just going to be a losing strategy.

              • dave says:

                Andisimo – maybe I was not clear, or complete, enough with the idea I was trying to communicate.

                What I’m trying to get at is this: let MSFT’s hardware be simply awesome to access services inside MSFT’s OR Google’s ecosystems. Remove barriers to entry for the devices.

                A LOT of people will not use Windows Phones or Tablets because key Google services that they rely on now (or always have relied on, depending on their age) are poorly supported.

                There are a lot of factors that can lead a person to “fall into” an ecosystem. But once in an ecosystem they will stay there, somewhat trapped, until it’s disrupted (as has happened to Windows), or bridges are created.

                Perhaps it’s impossible to do what I am suggesting. Apple’s “mobile lead-dog” status means Google ensures Google services work great on iPhones and iPads. On Windows PC’s, Chrome works great. Looking at the Windows Phone YouTube App battle is an example of where Google presses it’s advantage is in services.

                MSFT has lost almost a decade, and perhaps a generation of users, on the mobile front. Analogies can leads to faulted arguments, but I’ll throw this out there: Windows (PCs) seem to be somewhat like the family Buick. The kids don’t need something like that to get from A to B. A first car might be a cheaper, hipper, and less powerful Scion. But it more than gets the job done. And it runs on the same roads and uses the same type of gas.

                Ultimately, it’s about “an awesome user the experience” – from the user’s perspective. If users can’t get something they want, they will move on.

                A side-note about Skype: Man, I hope Skype can come back to life FAST on mobile phones. It seems like WhatsApp, Viber, Line, et. al. have entered into the game while Skype seemingly has stood still.

                • Eric says:

                  If the ridiculousness of the idea of focusing on Google services was not obvious 2 months ago, Google’s cry-baby behavior over Microsoft trying to build THEIR OWN YouTube app to create a first class YouTube experience on Windows Phone during that time should have driven the point home. Google wants no part whatsoever of a third viable smartphone eco-system, and they have demonstrated their willingness to do whatever they need to do to make Windows Phone fail. Microsoft needs to focus entirely on providing a great UX that doesn’t rely on Google Services. Once Microsoft has 20% market share, Google may relent and decide the revenue from Microsoft platforms is worth having their services Windows mobile devices.

          • Bob - Former DECie says:

            Interesting that you should mention that ASUS model as has the reconditioned ASUS VivoTab RT 32GB for $279 – $329 as its deal of the day.

  4. dave says:

    You always do a great job discussing the many variables and considerations that enter into a msft decision-making. Thank you.

    And now, what to do with Windows RT? My view is the buying public has been confused by the device. Its not a tablet, its not a laptop. It lacks apps. It is natural that MSFT would yry to leverage the windows office franchise strength into its tablet device. But, usage of tablets is more on the “consume” info side of the consume / create side of the equation. So, that didn’t pan out.

    What now for MSFT? My suggestion (as if it will ever happen!) is abandon Windows RT, offer RT owners a trade in program towards the price of current surface pro devices (or for better publicity, next Gen haswell pros) and create tablets with the Windows Phone 8.1 / GR3 platform.

    At no price point will the RT is take off, because it’s differentiation from Android and ios and Windows devices is too thin for what people want in a tablet.

    • halberenson says:

      Sorry, Windows Phone would require considerable work to be suitable for tablets. And then so would the apps. And it isn’t like Windows Phone has a compelling app library either. In fact, Windows 8s library should blow by the Windows Phone library in just a few months.

    • Tim says:

      So if they offered only the Surface Pro, does that mean the need for RT would go away? I can’t imagine that. People would still want, expect and need to interact with the device using touch, which means a need for a touch-based framework and apps designed for it.

      • dave says:

        Surface Pro is touch-based. And will be more so as 8.1 becomes 8.2. MSFT has made an astute bet on touch. It should be commended for that.

        But three touch based OSs is one more than either of its competitors are offering or contemplating, and so far one more than developers or consumers understand and want to invest in.

        Simplify the conversation. Simplify the messaging. Simply the pricing and marketing. Drop one of the OSs. Focus energy. Focus management. Focus the channels. Drop Windows RT.

        • Tim says:

          Sorry, you’re talking WindowsRT as in the brand, right? In that case, I can understand your point (although not sure I agree). I was thinking in terms of WinRT – as in the API, which is the framework that enables the touch experience in Windows. That doesn’t go away.

    • Brian says:

      Windows RT offers much better battery life in a smaller, lighter, fan-free package. Yes, BayTrail and Hazwell will make Windows x64 more competitive, but ARM will be better than Intel in terms of battery and overall “lightness” for the foreseeable future. I don’t really want to carry a Surface Pro around (except as a laptop replacement).

      • Tim says:

        Yes, unless Haswell improves battery life to the point of being equal or close to ARM, many people will want a lightweight device that offers a consistent, single-ecosystem experience. And the RT devices are ideal for that. Even with RT, you can RDP to a desktop and use all the Win32 tools you want.

  5. Pete says:

    My understanding of the accounting rules (and discussed briefly with a CPA) is that the write-down for unsold Surface RTs can only be taken when the price Microsoft is selling them for drops below what Microsoft paid to acquire those units. In addition, once Microsoft takes a write-off for those units, it cannot make a profit on them again. So the profit margin on those units is now zero, or lower if we are to see additional losses in the next quarter.

    Accounting rules are clear that Microsoft cannot take a loss this quarter against expected revenue from next quarter.

    The CPA I spoke to assumed that Microsoft spent $500 on each unsold Surface RT, then the markdown to $350 would absolutely mean a quarterly loss of $150 per unit. But the estimate of $280 per unit that I’ve seen does not mesh with the write-off- as far as the accounting rules go our understanding is that Microsoft can only take a loss on the amount that the public price is below the price they paid to acquire the devices.

    The only way we could make sense of it was that either Microsoft actually paid $500 per unit. It may be possible that the current $350 price is temporary (it has to be) and that the price will soon drop to something like $150, and this is the price that the write-off was calculated against, but this is fudging the numbers from the past quarter by a bit.

    IMHO, Microsoft should have bit the bullet on those unsold RTs and done a proper fire-sale. <$150. They're beyond making a profit on them (now that they've claimed a write-off, they cannot make any profit on them), so may as well use them strategically.

    • halberenson says:

      You’re assuming that the write-down was primarily for finished goods (aka, completed Surface systems) and that is where the numbers you’re using go wrong. And I was too harsh in my comment, because I’m really talking about a subset of what I think the write-down is for.

      The bulk of the write-down is likely for assets that will never be sold or reach end-of-life before originally predicted. For example, assume Microsoft purchased 10 million screens for the Surface RT but now believes it will sell no more than 2 million of those devices. It has 8 million screens which it expects to sell for scrap. The value of that inventory is clearly impaired. Now imagine that it has other parts for millions of Surface RTs sitting around, parts that will never be assembled into completed devices and will likely be sold for scrap. Imagine that it has a few million more 10.6″ Touch Covers than it will ever sell. There may also be cases where it bought machines to be used in the manufacturing process but those machines are now obsolete (because, for example, the bet on the 10.6″ form factor won’t last beyond the first generation of devices). The value of those machines is now impaired. To the extent that this is what the write-down is all about, and it has nothing to do with the recent price reduction, I see the write-down as completely valid.

      My issue has to do with the notion that impairment was caused by the recent price reduction. While I’m sure Microsoft followed the letter of the rules on taking any charge on finished good inventory, I also think they would have looked under every rock to figure out how to take it. I’ve seen this before, at multiple companies. Once you decide to take a charge you go looking for every possible piece of bad news you can throw into it. Investors aren’t going to react any differently to a $500 Million impairment, $700 Million, or $900 Million. So why hold back? So without a lot more details from Microsoft, and based on the association between the price cut and the impairment charge, I make the assumption that finished goods are indeed included in the write down. And unless they literally plan to send those to scrap, I believe any losses should accrue to the quarter in which the sale occurs.

      • Pete says:

        Ah, so they have a bunch of parts reserved which they must pay for, but limited supply of built machines that they are pricing at $350 just to make sure they don’t run out before the next-gen is available?

        I’ve been under the impression that most HW manufacturing pipelines are run quite a bit tighter than this these days- the screens and processors are fairly generic and should not have required significant pre-orders. The magnesium cases and touch covers are special but should not add up to $900m.

        It’s odd that they took a write off on the parts but are still selling the devices for a profit.

      • brent says:

        Makes sense. And they were going to miss earnings badly anyway, with or without the write down. So even more incentive to load up the write off and make it the main focus of the earnings report rather than the operating miss. Not sure it worked out too well as a strategy though. Because Einhorn dumped the stock shortly thereafter – and he’s well regarded. As ValueAct’s hand has to have been strengthened by the combo big miss + big write down.

        It will be interesting to see how the board handles Ballmer’s review. Two major write downs in the past two years. I’m not sure another hand slap will be enough to placate investors.

  6. icing says:

    Steve Balmer is a very good sales man. But sales men do not invent products or create services. They apply products and services to markets to generate sales. That is what he did with Windows and Office. The invention of Windows and Office, the transition from DOS to Windows NT was not driven by him.

    His famous statements about “unicorn tears” or that the iphone will never sell and others lead me to believe that he did not try to belittle the competition, but that he fails to see what makes people love a product. He just knows price.

    So, this discussion about margins is a very Balmeresque way of looking at the world. I don’t buy the argument “…because there are not enough apps for it”. People buy a Porsche, because it’s a Porsche, not because of the cup holders.

    • To me, apps are a huge factor here.

      If you want to continue the car analogies: Microsoft might be trying to sell you a Porsche, but it’s a track-day-only car. It does one thing particularly well (Office) but is less than ideal, or genuinely bad, for many other tasks. iPads and Android tablets, meanwhile, are daily drivers: they may not do any one thing spectacularly well, but they’re so flexible (read: have many quality apps) that they’re the ones you can actually justify owning.

      Ballmer’s main issue, to me, is that he overvalues Windows and Office — he’s utterly convinced that the track day car is also perfect for picking up the kids from school. He sincerely believes that most customers love his software, and that just having Windows and Office automatically makes a product superior. The truth is that many (if not most) people use those products because they have no choice. They can only get Windows on that $400 laptop at Best Buy; they use Office because it’s what their workplace has required for 20 years. Instead of acknowledging that the Surface RT had limited utility (due to a poor initial app base) and had to prove itself in a tough market, Ballmer was expecting Apple-like cachet from the word go.

  7. smallmountain says:

    This entire article could have been one word long: arrogance. Wait, two words: arrogance and stupidity. Attributing what has happened with Windows RT and Surface RT to “fixation on margins” gives it far too large a degree of reason and reflection.

    Every person on planet Earth with a brain knew that Surface was ridiculously overpriced when prices were announced. Pricing is a marketing decision, and this is just another in a series of marketing buffoonery that we have borne witness to in the last two years. The decision to name Windows RT “Windows RT” was more evidence that Microsoft hasn’t the first clue about how to market to consumers. The fact that Steve Ballmer has not recognized that weakness and acted to resolve it is reason enough for him to turn in his badge. (Surface was a good name. That had to have been dumb luck).

    This could have been done so much more intelligently. Sure, make the bust-out-retail list price of Surface be $499, but offer a 25% discount for the first million sold. Depending on how demand was looking at that point, either end the special offer, offer less generous discounts, throw in free keyboards, whatever. And why on Earth did they not allow people buying the 64 GB Surface RT to *choose* whether they wanted the Touch or Type keyboard? No, you were forced to buy the Touch keyboard and then had to pony up another $125 if you wanted the Type keyboard. What a way to give the middle finger to your most enthusiastic purchasers!

    • halberenson says:

      They did not force customers to buy the Touch Cover. The Surface RT device and covers are sold separately. In fact the explanation for why they were separate is exactly the reason you give, that they didn’t want to make the decision for customers.

      They have from time to time offered a Surface RT/Touch Cover bundle that gave you a $20 discount, but that was always a special offer.

      • Brian says:

        Actually, I think at launch, the only way you could buy a 64GB Surface was with a black touch cover. I really didn’t want a black cover so I crossed the 64GB model off my shopping list. Instead, I stopped off at Frys on the way back from the MSFT store and picked up a micro-SD card (which has worked out very well – I stick videos on it before getting on long plane rides).

        • smallmountain says:

          Brian is correct – At launch, you could not buy a 64GB Surface RT without a Touch cover. Believe me, I tried very hard.. Maybe they realized how stupid that was and changed the policy later.

        • smallmountain says:

          Oh, and that’s right, if you wanted the 64GB Surface, not only were you forced to buy the Touch cover, it had to be the black one! Marketing genius!!!!!!!!!!!

  8. Great article, which immediately made me recall this infamous 2006 Ballmer interview:

    Do you have an iPod?

    No, I do not. Nor do my children. My children–in many dimensions they’re as poorly behaved as many other children, but at least on this dimension I’ve got my kids brainwashed: You don’t use Google, and you don’t use an iPod.

  9. Mark says:

    Zune redux, only with far more severe consequences for MS’s future. Knowing how important this one going in, it’s really concerning how badly they blew it subsequently.

  10. Very good and insightful post, as always. I agree the point about margin is key.

    However there are some additional considerations — software margins themselves are under considerable pressure due to open source and the shrinking market for licensing IP (i.e. “secret sauce”). Many software features and functions are reaching a plateau or commoditizing quickly in many areas, especially the traditional Microsoft product areas. For example, does anyone really need a new feature in a word processor or operating system? Enough to justify a new or upgrade license fee?

    I actually give credit to Microsoft for trying to redefine themselves and break through the “innovator’s dilemma.” I’ve seen many posts about Surface and Windows 8 accusing Microsoft of being caught in the dilemma. I don’t think that’s true. I think they tried and more or less failed, as this post is describing.

    I would also question whether a keyboard is a compelling part of a tablet. This is somewhat a minor point, although it is integral to the content authoring vs viewing distinction. I would say a keyboard shows that Surface is not a tablet, at least not in the way the market has defined a tablet. This is another issue for Windows 8 – there is a good debate about whether its visual metaphor and interaction style is superior to iPad and Android tablets, but the problem is that it’s different. Anyone who has learned an iPad easily adapts to an Android and vice versa – Windows 8 may have a superior interface but it’s different. The iPad interface assumes you do not need a keypad – although one is definitely available.

    Finally I’d point out the application compatibility and migration issue for Windows. I can applaud the vision of having the same interface on all devices – phone, tablet, and office – but insisting that the office PC adopt Metro put up a very large and significant barrier to enterprises who only recently completed a costly migration to Windows 7. That Microsoft sent ambiguous messages to those companies is something I can definitely confirm. The struggle to get a coherent story around SIlverlight is a case in point, and did a lot to sew mistrust in investing in the “next new thing” from Microsoft for developing Windows apps.

  11. taylor says:

    Microsoft needs to stop the internal marketing that they do on campus. Not only it is a waste of money, it weakens the competitiveness of the employees to improve the product line.

  12. Albee says:

    They couldn’t price the surface rt lower because they were trying to re-assure OEM’s that they weren’t competing with them. At least 2 OEM’s were very vocal about their core supplier competing with them and stated on the record they were not happy. MS miscalculated (as they have been doing for the last 7 yrs) the downside of signalling this intention to create devices. It had a number of side effects.

    Firstly, OEM’s know they can’t compete with a vertically integrated company on price in the long run. So why help MS get a foot hold in this device market by supporting RT in the first place? So they didn’t. OEM’s like Acer just thought he’ll no, it’s like writing your own death warrant.

    Secondly, MS did this surface thing in secret. Hardly any of their partners knew until the decide was launched that it existed. Can you trust a company that is your main partner when they hold what could be life changing information like this from you? Especially given the OEM game relies on MS and intel playing a straight game (road maps for the next 5 yrs etc…). OEM’s just don’t trust MS anymore. That’s bad..

    Finally, in the time frame that the IPad has been around the first product that truly competed with it was when HP did a fire sale on those web OS tablets at under $200. Smart people took note (google). Google priced the nexus 7 at that price and bingo, they have a competitive product! Had MS either did that or priced RT cheap enough for OEM’s to make a profit at $200 making RT devices themselves, windows 8 would be massive by now.

    For a business man I think Ballmer and his team know how to use lawyers and sales muscle to make lots of dough. However, they have shown they lack a real deep instinct for business that people like Bezo’s, Jobs and Gates have. Their not bold enough, they do take the right risks, they don’t value their partnerships properly and they don’t understand what motivates consumers. I don’t see how MS will survive in the consumer space without addressing these issues. Money doesn’t solve everything, you really just can’t spend your way too success. You must have some innate acumen somewhere for thie game.

  13. R Edwards says:

    I’m surprised no one has done an Xbox compare and contrast here. The console market is adjacent to the tablet (Surface RT) market, and yet Microsoft appears to have taken no lessons from its hard-won position with Xbox.

    I’ve been asked more than once what “RT” stands for. The technology ambivalent consumer seems happy enough with the “Reduced Technology” explanation. Surface RT IS THE DEVICE to replace that (soon to be) unsupported Windows XP PC that’s chugging away in the corner. Turn Windows RT into the every-man computer; link it with Xbox and Windows Phone; and sell it with a subscription to “Home 365” (because some people don’t see an “office” as part of their world).

    The slate market (Surface Pro) is sandwiched in between the tablet and the ultrabook markets, so warrants a different approach and strategy. Surface Pro, as the name suggests, is primarily for business professionals: It’s a slate not a tablet. Explain the difference (digitizing surface with a stylus and handwriting capabilities vs. finger painting) and go head-to-head with Samsung and it’s range of Note devices.

    Microsoft has the resources and the market position to extract itself from this mess, but it might take a change of leadership to bring it about.

  14. WaltFrench says:

    Hal, this is a big, important topic — THE most important for Microsoft in a year or two, I’d say — so I mean no disrespect in saying that your post doesn’t cover some points that seem important. (Obviously, I consider them MORE important, so appreciate your feedback.)

    First, the Maslow discussion itself starts a level or two too high. Why would a person buy a Surface tablet? It’s the #3 entrant and Microsoft’s recent dicking around with customers — officially EOLing WP7 shortly after its introduction, frinstance — was obviously going to have some startup issues (as others mentioned). The brand that is so famous in IT just didn’t have the resonance with individuals who wanted a “just use it” device.

    And when techies needed to take a whole minute to explain RT vs Pro, ARM vs X86 and M*tro vs Legacy, those customers were outta there. Is there a single example of a brand new concept that had so much buyer uncertainty associated with it, let alone any successful ones?

    Now that you’ve cut your potential market in half — and the impulse buyer half has been conceded to Apple, while the fussy, extended approval and custom s/w development types are left in your camp to complain about how you can’t really use Office without a keyboard so it’s not a “tablet” per se, but has a lousier keyboard than an ultrabook so what’s the point, we can look at what’s left.

    The other aspect of “what were they thinking?” is the whole question of whether this was a “North Star” extended concept machine, or intended for volume sales. As the former, a premium price is OK: shoppers and IT buyers can ooh and aah over how great the Win8 concept is on innovative hardware, then buy some crazy Asus or Dell or HP, and everybody’s happy. But methinks the OEM feedback came pretty swiftly: they didn’t hear ANY chorus of demand for high-function touch devices; if Microsoft was going to sell Surface, fine. Now, Microsoft finds itself with no retail system and no OEM support, no way to get the story to the public; it gears up to get Win8 off the ground, showing developers its confidence but painting itself into the corner of looking oblivious to how little the market regards the concept.

    And frankly, that’s why I think those two problems arose: Microsoft was thinking of how to solve THEIR need of a new-gen, modern-seeming OS that would extend their great desktop/Enterprise franchise, rather than identifying a demographic or USER group that had unmet needs, and then defining the product that’d thrill those users. Maybe that’s why the advertising seemed so color-by-the-numbers to me: no matter how hip an accountant is, he does NOT think of himself doing spreadsheets while breakdancing around college campuses, and he will be the LAST person to give up his big dual-monitor desktop and first-class keyboard.

    Surface, as a unique formfactor, has its share of quirks — I haven’t seen a flip-out airline tray that it could be stable on, nor a good way to use it in regular coach when the seat ahead reclines — but those features can be endearing, if the target market is well-served, and Asus is certainly willing to sell you a wildly different form factor with the same Win8 touch software. But the reliance on bridging back to desktops (a now-declining segment) rather than a full-throated attack on new usage models, has doomed Win8/touchscreen to also-ran status, and Surface went down with it.

  15. As always, your posts make for good reading. I shared my thoughts in response the other day:

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