Surface Pro 3. Source: Microsoft.
Microsoft (MSFT 0.25%) has had a mixed history with its line of Surface tablets. The company uses a two-pronged platform approach, adding Windows RT for ARM-based devices to the mix, and Microsoft remains the only vendor of Windows RT devices at this point. For a while, Microsoft even considered entering the small-tablet market with a Surface Mini, but cancelled its plans at the last minute.
Well, the software giant's flagship tablet family just hit an encouraging new milestone: profitability.
Sweet black ink
During Microsoft's earnings release last week, CEO Satya Nadella noted that Microsoft has "improved the business economics" of the Surface lineup, adding that "gross margin for Surface was positive this quarter." That's a notable change from prior quarters, as Surface has been losing money up until now. While negative gross margins are common for many companies entering new markets, investors will welcome Surface's newfound profitability.
Surface revenue jumped 127% to $908 million last quarter, thanks primarily to the introduction of Surface Pro 3, which Microsoft is positioning squarely as a laptop replacement.
In the corresponding 10-Q, the company said that Surface's cost of revenue rose by $157 million, or 23%. That translates into $840 million in cost of revenue for Surface, meaning Surface's gross profit was approximately $68 million, or 7.5% of sales.
Here are Surface's results for the past five quarters:
Source: SEC filings. Fiscal quarters shown.
Surface squeezed out some black ink last quarter. Nadella said units for Surface Pro 3 are pacing at twice the rate of Surface Pro 2.
Next stop: operational profit?
Gross profit is just the beginning. Microsoft doesn't disclose operating expenses related to Surface. Even without knowing specific figures, it's highly likely Surface is still negative on the operating income front, since Surface operating expenses probably consumed that $68 million.
Becoming operating income positive will be the next step for Surface if Microsoft hopes for its device to be sustainable in the long run. Even though Surface isn't primarily about making money -- Surface revenue was just 4% of consolidated revenue and is important in setting an example for other Windows OEMs -- it shouldn't be about losing money.
Building bridges
The overall tablet market is seeing a bit of a speed bump. Even market leader Apple is seeing iPad unit sales decline as growth shifts to emerging markets. Even though Surface lacks the brand strength of the iPad (consider the NFL commentator confusion), Surface Pro 3 has launched in 28 markets, and the business continues to mature.
Surface is here to stay, and it will be even more important in setting the stage for Windows 10, as Microsoft's upcoming operating system is all about bridging the laptop/tablet divide.
