Microsoft ( MSFT -1.46% ) began selling its Surface line of tablets at the end of 2012, and the company has so far struggled to turn its hardware ambitions into a profitable business. One of the original Surface tablets, the ARM-based Surface RT, sold so poorly that Microsoft was forced to write off $900 million in inventory last year, and the second generation of devices didn't exactly light the world on fire.
The Surface Pro 3, released earlier this year, is selling far better than its predecessors, and for the first time Microsoft has recorded a positive gross profit for the Surface business. Microsoft has positioned the Surface Pro 3 as a laptop replacement, going so far as to compare it directly to Apple's ( AAPL -1.19% ) MacBook Air on its website, and it appears that the strategy is starting to work. Surface sales more than doubled sequentially during Microsoft's most recent quarter (Q1 2015), besting even the 2013 holiday season, which was Microsoft's fiscal second quarter.
Source: Microsoft
Here's why a successful Surface Pro 3 is important for Microsoft.
It's all about businesses
Microsoft Windows dominates the enterprise PC market, but with the company having a very small share of the tablet market, the iPad has been able to gain traction in the enterprise. What Apple lacks, though, is a device that can function as both a laptop and a tablet, allowing for both productivity and mobility. You can slap a keyboard on an iPad, but iOS is ultimately built for touch.
The Surface Pro 3 attempts to offer both a laptop and a tablet in one package, eliminating the need for a stand-alone tablet. Windows 8 shines on a two-in-one device like the Surface, with both a modern touch interface and support for the legacy Windows applications that many businesses rely on.
The argument for buying a Surface Pro 3 is a simple one: instead of buying a laptop and a tablet, the Surface Pro 3 can do it all. The Surface Pro 3 starts at $799, although the keyboard adds another $130 to that price. Compare this to the price of a MacBook Air and an iPad, about $1,400 combined at the low end, and there's clearly a strong value proposition. This argument seems to be working for Microsoft, as Surface sales of nearly $1 billion in a single nonholiday quarter is an impressive feat, especially compared to previous quarters. At this pace, assuming that the upcoming holidays provide a sales boost, Surface could be close to a $5 billion business for Microsoft over the next 12 months.
The future of Surface
I expect that future Surface devices will be similar to the Surface Pro 3, aimed at providing a level of productivity that a stand-alone tablet can't match. The influx of non-Windows devices into the enterprise market threatens to weaken the stranglehold that Microsoft has there, but the success of the Surface Pro 3 offers a strong indication that Microsoft has finally designed a Surface tablet that people want.
I doubt that Microsoft intends to be a major seller of PCs, but the success of the Surface Pro 3 could spur similar devices from OEMs. There are already plenty of two-in-one Windows devices, and some, like ASUS's Transformer Book T100, have sold well. But most of these are powered by slower processors and have smaller screens, limiting their productivity. Larger and more powerful options are coming to market soon, like ASUS's Transformer Book T300 Chi, a 12.5-inch 2-in-1 powered by Intel's new Core M processor.
The best way for Microsoft to battle the iPad in the enterprise market is not by pushing stand-alone tablets, but instead by pushing two-in-one devices like the Surface Pro 3. Apple offers nothing like it, and the strong sales during Microsoft's most recent quarter are a sign that demand for devices more capable than stand-alone tablets is high enough to support the Surface business for Microsoft. Surface is still a small business for Microsoft, but it's an important one, and it looks like it can finally be called a success.
