A recent Digitimes article raised eyebrows in regards to Microsoft's (NASDAQ:MSFT) beleaguered Surface tablet. According to upstream supply chain sources, the Surface tablet line has created US losses of about $1.7 billion. However, the biggest takeaway was related to its heavily marketed Surface Pro 3:
With the factors above, the sources believe sales of the Surface Pro 3 are unlikely to surpass one million units, adding that Microsoft is also not very aggressive about development of a next-generation Surface and is likely to terminate the product line.
Microsoft quickly pushed back on the rumor with a blog post from Brian Hall, the General Manager of Surface. Under the ending subhead, "Businesses can buy with confidence. We are here to stay," Mr. Hall quotes Microsoft CEO Satya Nadella's strong support for the device: "Microsoft is putting its full and sustained support behind the ongoing Surface program as one of a number of great hardware choices for businesses large and small." It is apparent that Microsoft is committed to the Surface line, but should they be?
Microsoft's Surface struggles
After two years – and three iterations -- with no meaningful results from the product, the question for investors is should Microsoft abandon the product. And on the surface (pun shamelessly intended), it seems like the Surface abandoning crowd has a point. If the numbers provided by Digitimes are correct (Microsoft doesn't release specific product results, so third-party results are the only source of estimates), then Microsoft can enrich shareholders simply by exiting the business (after the costs of winding down the business are expensed).
Recently, CEO Satya Nadella appeared to distance himself from the Surface line by calling Microsoft's hardware a "supporting" business. Analysts and observers have closely followed Nadella's comments about the Surface, partly because the tablet line was former-CEO Steve Ballmer's idea and mostly because poor sales results for the Surface RT were widely considered the "final straw," leading to Ballmer's exit. Nadella hedged on Ballmer's characterization of a "devices and services" company instead choosing to refer to Microsoft as a "mobile first, cloud first" company.
Devices are flashy, but not essential to Microsoft
Lost in the discussion of whether or not Microsoft should keep the Surface tablet lies a rather important fact: Microsoft isn't dependent upon devices for revenue or earnings. Unlike fellow device-makers Samsung and Apple(NASDAQ:AAPL), Microsoft isn't dependent upon gadgets. Last fiscal year, Microsoft’s "Devices and Consumer Hardware" segment only provided 13.4% of total revenue. For perspective, Apple’s iPhone along provides over 50% of its revenue.
So while the news covers the struggles its devices face – Windows Phone's distant third place in worldwide smartphone operating systems, Xbox One's losing battle against Sony's PlayStation 4, and the aforementioned Surface's woes — shareholders continue to benefit from Microsoft's strong overall performance.
As a matter of fact, since the beginning of 2012, Microsoft's stock holds up extremely well against Apple although their devices since then have had two widely differing paths:
As you can see, Apple's provided a negligibly better return since then by capital appreciation of nearly 68% versus 65% for Microsoft. However, when compared to the greater market (as indicated by the S&P 500), both are doing well for shareholders. So as you can see, although devices are flashy and interesting to discuss, Microsoft doesn't need to be a device leader to enrich shareholders.
Microsoft continues to struggle with its devices, but that's not what investors should focus on. In its "Commercial Other" division, the company reported $7.5 billion in sales last fiscal year -- that's where Microsoft books its cloud-based revenue. And although currently that's only 9% of revenue, it grew 33.3% on a year-over-year basis. Satya Nadella wisely described Microsoft as a "cloud first" company, investors would be wise to pay more attention to Microsoft's moves in the cloud than in devices.