Huge Price Cuts for Windows Phones and Tablets Coming Soon

Microsoft (MSFT 0.69%) vice president of OEM partners Nick Parker has promised to make huge price cuts for Windows phones and tablets this year. Mr. Parker said that the company aims to make the prices of devices with screen sizes of 7 inches, 8 inches, and 10 inches, ''very industry competitive.'' According to him, devices that were selling in the $300-$500 range will now sport new price points in the $100-$300 range. Some Windows Phone smartphones could see prices drop below $200.

Falling prices
The average selling price (ASP) for both smartphones and tablets has been declining sharply over the years. According to the IDC, the tablet ASP fell 18.3% in 2012 and 14.6% in 2013. This year, however, tablet ASP is expected to fall just 3.6%. Tablet sales have been falling for most tablet vendors, with worldwide shipments falling 5% to 56.3 million units in the last-quarter.

Microsoft does not usually reveal how many tablet units it sells. Surface tablet revenue grew 50% year-over-year to $500 million, but dropped 44% sequentially compared to the fourth-quarter of 2013 when it recorded a revenue of $893 million.

The leading tablet vendor Apple (AAPL -1.20%), with 36% tablet market share, recorded a huge 16.1% year-over-year tablet sales slump to 56.3 million units. Samsung, another large tablet vendor with 19% market share, recorded a small 2% year-over-year growth in tablet sales to 9.9 million units.

Puzzling decision
Microsoft's decision to lower the prices of its tablets looks puzzling when you consider that the company has been losing quite a lot of money on tablet sales. The Surface tablet generated $1.8 billion in revenue in the first nine months of the current fiscal year, while its cost of revenue ran into $2.1 billion. This equates to losing $300 million for the company.

Data: Microsoft, SEC Filings

Source: PC World

Microsoft sells a variety of Surface tablet models with prices ranging from $299 to more than $1,000. The ASP of a Surface Tablet is therefore around $600. This in turn means that the company sold approximately 830,000 Surface tablets in the third quarter of the current fiscal year. Full-year sales might therefore come in the $3 million-$3.5 million range.

The $300 million loss in three quarters of the year gives an annual run rate of $400 million loss for the full year. If Microsoft decides to lower the average selling price of its Surface tablets by about $100, the annual loss from tablet sales could escalate by another $350-$450 million, or about double the current loss.

The ASP of all smartphones has been coming down over the years. Currently Windows Phone smartphones sport an ASP of around $300, slightly above the ASP of Android smartphones which sits at $270.

Source: Gartner

It's important to note that Mr. Parker said that Microsoft intends to introduce highly industry-competitive price points for Windows devices with a screen size above 7 inches, whereas the Windows Phone model with the largest screen size is the Nokia Lumia 1520 with a 6-inch screen. This might mean that prices for Windows Phones won't come down by much. In any case, the ASP of Windows smartphones is already very competitive, and a slight drop would place it in line with Android smartphones.

According to the IDC, shipments of Windows Phones are expected to grow at a CAGR of 29.5% through 2018.

Shipment Volumes in Millions

Source: IDC Mobile Tracker, Feb, 2014

Microsoft is expected to ship 47 million Windows Phone units in 2014, about 3.9% of total global smartphone shipments. Nokia devices (the company's phone and device unit is now fully owned by Microsoft) accounted 82% of all Windows Phones sold last year. If this ratio still holds going forward, that could translate to 38.4 million phones shipped in fiscal 2015, bringing in a revenue of $10.37 billion.

Microsoft charges anywhere from $5 to $30 as Windows Phone license fees. The company should therefore earn approximately $68 million in Windows Phone license fees next year.

Driving growth in cloud
There is only one possible explanation for the planned huge price cuts, especially for Surface tablets. Microsoft is already losing quite a lot money on its tablets, which makes it highly likely that its main objective of selling Surface tablets cheaply is to enable as many people as possible to connect to its cloud.

Microsoft's new policy is that its cloud comes first, and it's doing everything within its means to grow it. By introducing highly competitive price points for its tablets and smartphones, Microsoft will accelerate growth in its cloud by getting more people to connect to Microsoft experiences such as SkyDrive, Skype, and Bing Search.

Microsoft is now ranked as the second-largest cloud services provider after Amazon Web Services (AWS). Its cloud grew 154% last year, the fastest among all clouds.

Foolish bottom line
Microsoft has a new policy where its cloud comes first. The move to drastically lower the price of Window Phone devices and tablets appears calculated to drive even more growth in its cloud by getting more people to connect to it.