Microsoft's Surface strategy is doing what it was supposed to do

Former Windows chief Steven Sinofsky with Surface boss Panos Panay at the introduction of Surface last year. Credit: IDGNS

Yesterday Microsoft reported flat Windows revenue from the year before, despite an unprecedented drop in PC sales -- IDC put the drop at 14%, and outgoing Microsoft CFO Peter Klein suggested during the company's earnings call that the drop was in the "12-13-14" percent range.  

There are several factors that made this possible. As investor relations chief Chris Suh put it on the earnings call, "Non-OEM revenue grew 40% this quarter, driven by sales of Surface and continued double digit growth in volume licensing."

So how much did Surface help Microsoft's Windows revenue this quarter? Let's do a rough back-of-the-envelope estimate.

Surface sells for a much higher average price than the OEM version of Windows -- it retails for anywhere between $499 (for the lower-powered Surface RT) and $999 (for the highest-end Pro version), and that's not including the keyboard/cover. 

Let's assume that Microsoft leaves a reasonable margin for its retail partners, including its own stores. Some analyst estimates put Surface Pro sales around 400,000 for the quarter, and Surface RT sales at maybe 200,000. Let's say that Microsoft collects an average of $700 per unit, including attached peripherals like the cover. 

That would be $420 million. That's about 10% of Microsoft's adjusted Windows revenue of $4.62 billion (that's adjusted downward to make up for how Microsoft accounts for upgrade sales made in previous quarters). Even if those estimates are generous and the number was lower -- say 5% -- it means that Surface was material in helping Microsoft make up for a drop in PC sales this quarter. And those estimates could very well be low, which would mean that Surface was an even bigger factor in saving the quarter.

The rest of the difference was made up from Microsoft's corporate customers buying the Enterprise edition of Windows 8, which are available only on subscription volume license plans -- mainly Enterprise Agreements. Companies buy these licenses for a number of reasons, but the likely reason this quarter is that they know they're going to upgrade some PCs from Windows 7 to Windows 8. Buying the subscription license now lets them make those upgrades any time during the period of the agreement -- usually three years. The Enterprise edition also includes special features for management and security that are not available with lower editions of Windows.

In other words, Microsoft has successfully convinced enough consumers to buy hardware, and enough companies to "subscribe" to Windows upgrades, that it made up for a horrible quarter of new PC sales.

These year-to-year trends will likely continue through the year. And as the Windows XP deadline approaches in April 2014, at least some businesses with really old XP computers -- which can't be upgraded in place to Windows 7 or 8 -- will buy new ones, which could slow the PC market's decline. Many of these companies will probably subscribe to the Enterprise edition of Windows 8 to get the additional features, too.

Nice escape! 

But there's some bad news looming here as well:

  • Hardware has lower margins than software. The beauty of software is that once you've covered your development costs, every additional sale is almost pure profit. That's not the case with hardware -- only Apple has managed to maintain very high margins on its hardware, and even those margins are nowhere close to the 70% to 80% margins Microsoft has historically earned on Windows and Office. Replacing a higher-margin business with a lower-margin business means you have to grow revenue faster -- or cut other expenses dramatically -- in order to keep profits growing at the same rate.
  • The move to Windows volume licensing won't spur growth forever. As companies realize they're going to have to subscribe to Windows (i.e., put it on a volume license agreement, which is paid for annually) in order to get the top-of-the-line enterprise features they need, that will create a one-time bump in volume license revenue. But that growth will stop once all the companies who want these features are aboard, and paying their stable annual license fees. In the long run, the only way to keep the growth going is to convince more companies to add more PCs to their licenses -- in other words, to grow the business PC market -- or to raise prices.

As I wrote a couple weeks ago, Microsoft can keep going for a long time, even in a declining PC market. But eventually, business reality kicks in -- the only way to keep growing is to sell more product than you sold last year. In some form or another -- tablets, Surface, traditional business PCs -- Windows unit sales have to pick back up again, or the next five years will look increasingly bleak. 

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