Why Microsoft Is in it for the Long Haul With Surface

When Microsoft first announced its Surface tablet last June, it claimed it had cracked the code on the category.

Weighing in at roughly the same size as the industry-leading iPad, the Surface had improved upon Apple's design, Microsoft claimed. The Surface was "designed to seamlessly transition between consumption and creation, without compromise" according to a press release at the time. The product was also based on "extensive investment in industrial design" which was manifest in its built-in keyboard and kickstand.

Speaking prior to the launch, CEO Steve Ballmer charged that the Surface would rejuvenate the company.

It did not. In July, Microsoft announced a $900 million write-down related to the Surface RT. By August, Ballmer announced that he would be leaving. Now, the company is readying a sequel, which is scheduled to be announced next week.

For Microsoft watchers, the looming question is whether the company will cut its losses with Surface or soldier on. In the past few years, Microsoft has bailed on some loser products, like Kin, a teen-targeted phone that saw daylight for two months in 2010. But it has also stuck for a long time with products that weren't immediate hits, like its iPod competitor, Zune, and Xbox. The latter presents a best-case scenario for Surface. Though Xbox had a decent start in the U.S. in 2001, it suffered weaker sales in Europe and Japan and took years to establish itself. The company stuck with it anyway. It became Microsoft's biggest hit of the decade.

High Stakes

For Microsoft in 2001, Xbox was an attempt to annex a business outside of its bread-and-butter, PC software. However, in 2013, the stakes are higher. The PC business is no longer an oasis. Tablets offer lower margins, but they also represent the future. Carolina Milanesi, an analyst with Gartner, dubs the category a "necessary evil" for Microsoft. The lower margins also explain why Microsoft saw fit to create its own hardware for the device rather than merely act as a software provider as it has in the PC business for more than 30 years. "There is more upside for selling hardware and software," says Wes Miller, an analyst with Directions on Microsoft.

That said, it's uncertain how long Microsoft can withstand losses that hover near the $1 billion range. With pretty much everything riding on Surface, the likely prospect is that Microsoft will bear that burden for years if it has to.

One wild card in the mix is Microsoft's recent $7.2 billion purchase of Nokia's hardware business. The marriage of convenience — between a software maker that can't get any traction with its platform and a hardware manufacturer that has lost its luster — is Microsoft's last, best hope, as we've argued before. With access to Nokia's expertise in hardware design and its teams of developers, Microsoft has more tools at its disposal to work out Surface's considerable kinks in coming years.

End Game

Even if Surface gets vastly better, outshining Apple and Google's Android is unlikely. The best that Microsoft can hope for in the near future is to be a strong No. 3 in tablets. "It's still going to be tough," says Milanesi, "though the market is growing. If they do more things right, we should see an incremental sales volume increase." Miller says one way to carve out more of a niche is to continue to play up Surface's business productivity credentials. "It's really about making a device that consumers like but that they can take to work and get business done," Miller says.

It's unclear whether consumers will be more open to the pitch this year. It's also hard to tell at what point Microsoft can declare victory. Would 10% of the market do it? Fifteen? At the moment, Microsoft has the luxury of waiting things out. Microsoft chief operating officer Kevin Turner disclosed this week that 55% of the company's revenues come from enterprise vs. 20% for the consumer market. Despite the hoopla about Apple vs. Microsoft, the two companies are very different businesses. Apple is almost completely focused on the consumer market. For Microsoft, it's a sideline and a gateway to future business customers.

At least that's traditionally been the way things have gone. Frank Gillett, an analyst with Forrester Research, says that the enterprise market as we have previously understood it is dying. "In hte long run, there is no enterprise market," he says. "There is stuff for individuals bought by companies and stuff for individuals bought by themselves." (Gillett by the way, says that the Surface RT is the only real tablet that Microsoft offers. The Surface Pro is "an ultrabook with touch.") Gillett estimates that Microsoft has two to three years to fix Surface and the redefinition of Windows as a mobile-friendly OS. After that, "the world will have moved on."

If that's true, then Microsoft is in a tight spot. While Apple strives for perfection, Microsoft has always been content to release adequate versions of products and then improve them over time. By all indications, Microsoft still has some time to do that with Surface, but time is running out.

Image: Getty/Timothy A. Clary