Microsoft Ate More Surfaces Than It Sold

"We built a few more devices than we could sell."

-- Steve Ballmer

That was the Microsoft (NASDAQ: MSFT  ) CEO's concession earlier this month at an internal town hall meeting. With the software giant recently filing its 10-K annual report, investors now know just how poorly the Surface business did in Microsoft's fiscal 2013.

For its full fiscal year, Microsoft generated $853 million in Surface revenue, which includes both Surface RT and Surface Pro models. That's less than the $900 million inventory adjustment it just recognized ahead of a $150 price reduction, meaning Microsoft just ate more than it sold. In addition, Microsoft increased its marketing expenses by $898 million to push both Windows 8 and Surface.

Microsoft doesn't disclose unit volumes or product mix, nor does it specify if accessories like the Touch Cover are included in the Surface total or if they're included with other PC accessories. Still, these numbers somehow don't add up.

Bloomberg had reported in March that Surfaces were selling below expectations, with 1.5 million Surface units to date at the time, composed of a little over 1 million Surface RT units and 400,000 Surface Pro units. Let's generously round those Surface RT units up to 1.1 million. At the entry-level price points of $500 and $900 -- an unrealistic expectation that all units were base models -- and ignoring accessory revenue, that adds up to $910 million in sales.

Microsoft's official figure for three fiscal quarters of availability is less than an unrealistically conservative estimate for two quarters.

IDC estimated that Microsoft had shipped 900,000 Surface units (including RT and Pro) in each of the fourth and first quarters, for a total of 1.8 million over two quarters. Estimates for the second quarter haven't been released yet, but it seems inevitable that Microsoft will see a big sequential drop in Surface shipments considering the data.

There is no clear explanation as to how Surface revenue could be so low given the various estimates that have been released. One possibility is that Microsoft in part uses deferred revenue recognition for Surface, likely related to future software updates, which reduces its reported figure. Another is that sell-through is even worse than the reported estimates that are based on channel sell-in, and many of those units are still sitting on retail shelves at Microsoft Stores (Microsoft would recognize revenue from units sold to third-party retailers).

Microsoft had reportedly ordered 3 million Surface units or more (Bloomberg's sources corroborated this figure). That quantity would be on par with Apple's original iPad launch, when it sold 3.3 million tablets. "Built a few more devices than we could sell" is putting it lightly.

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