There's been a lot of buzz about Microsoft's (MSFT 4.20%) "Surface Phone" over the past few months. The company has neither confirmed nor denied reports, but a trail of breadcrumbs indicates that the device could arrive in the near future.
During a podcast last December, Microsoft Chief Marketing Officer Chris Capossela declared that just as the Surface was sold on the "notion of a tablet that could replace your laptop," Microsoft needed a "spiritual equivalent on the phone side." Reports that Surface VP Panos Panay and his team inherited the project seemed to support the notion that a "Surface Phone" was being developed. In January, Microsoft purchased surfacephone.com, which currently redirects to the main Surface website.
Previous rumors suggested that the phone might arrive in the second half of 2016 and that it could use an Intel (INTC 1.25%) x86 CPU to run full-blown desktop apps. More recent rumors claim that the device could have 8GB of RAM and 512GB of storage. If that claim is accurate, the Surface Phone would be the most powerful commercial smartphone ever released. However, I have serious doubts that Microsoft will launch a smartphone that powerful anytime soon, for two simple reasons.
1. It could be too expensive
If we assume that the Surface Phone will be a phablet, we can compare it to two of the most popular premium phablets on the market -- Apple's (AAPL 1.92%) iPhone 6s and Samsung's (NASDAQOTH: SSNLF) Galaxy Note 5.
Based on a teardown by IHS, the 16GB version of the iPhone 6s Plus, which has 2GB of RAM, has a BOM [bill of materials] of $236. IHS also estimates that additional flash memory only costs about $0.35 per GB, which means that the 128GB version probably costs around $275 to assemble. Tech Insights claims that the 32GB Galaxy Note 5, which has 4GB of RAM, has a BOM of $298.
Those sub-$300 BOMs explain how Chinese OEMs like Xiaomi, which spend much less on marketing, can sell their devices at lower price points than the $649 iPhone 6s Plus and the $740 Galaxy Note 5. If Microsoft is really developing a smartphone with 8GB of RAM and 512GB of storage, its BOM could easily be $200 to $300 higher, based on current RAM and flash memory prices. Microsoft might cut some costs if memory prices decline and Intel subsidizes its CPU and modem with contra revenues, but I think that the device's BOM could still easily hit $600.
2. Microsoft doesn't have brand or pricing power
Another problem is that the mobile market is currently a duopoly split between iOS and Android. In IDC's latest update, Windows Phone accounted for less than 3% of the global smartphone market. This means that Microsoft simply doesn't have the brand or ecosystem strength to sell a device with a $600 BOM at thin margins. Instead, it will have to boost marketing efforts for the already pricey device, which will raise its final retail price.
Microsoft also doesn't have the pricing power to compete against Apple and Samsung in the premium market. According to AdDuplex's latest report, the entry-level Lumia 520 -- which was released nearly three years ago -- remains the most popular Windows Phone in the world. Early sales reports regarding the high-end Lumia 950 and 950 XL, which respectively launched for $550 and $650 in the U.S., have also been dismal. This means that launching an even pricier "super phone" -- even one backed by the Surface brand -- could be a terrible move.
So why bother developing the Surface Phone?
Microsoft likely realizes that it's going to be tough to sell new phones, since Lumia sales fell 49% annually on a constant-currency basis last quarter. But if Microsoft can't capture a meaningful slice of the smartphone market with beefier Windows 10 Mobile devices, its Continuum strategy -- which transforms its mobile devices into desktop PCs -- will fizzle out. But beefier devices require pricier hardware, and its tiny Windows Phone market base clearly prefers cheaper devices.
Therefore, it seems like Microsoft wants to blur the line between its weaker mobile devices and stronger Surface ones, which posted 29% constant-currency sales growth last quarter. Microsoft already expanded the Surface line to include the Surface Book, so it seems reasonable to add a phablet to the lineup as well.
Unfortunately, I doubt that the Surface brand is strong enough to convince customers to buy a Microsoft smartphone that's pricier than a top-tier iPhone. It might appeal to certain users who want to replace their smartphones and PCs with a single device, but that market could be too small to matter.