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Microsoft's Surface turns first profit in 2 years

Gregg Keizer | Oct. 27, 2014
But gross margins -- between 9% and 13% -- aren't sufficient to sustain a profitable business.

Microsoft's advertising campaign for the Surface has been substantial, with widespread television spots, and its marketing spending has also been brisk, including a reported $400 million deal with the National Football League (NFL) that put Surface tablets on the sidelines.

Microsoft called out the Surface Pro 3, which went on sale in June -- making the September quarter the first complete quarter that booked Surface Pro 3 revenue -- in its earnings call with Wall Street for sparking the surge.

"Unit sales are pacing at twice the rate of what we saw with [Surface] Pro 2," said CFO Amy Hood, referring to the now-discontinued model launched in the fall of 2013.

"The release of Surface Pro 3 in June 2014 contributed to a 126% increase [in revenue], reflecting higher premium mix of devices sold," Microsoft said in the 10-Q filed with the SEC.

Thompson seized on the latter's "higher premium mix" to make the case for why Surface revenue jumped. He pointed out that the high prices of the Surface Pro 3 -- between $799 and $1,949 -- generated the increase, while the revenue in the comparative quarter of 2013 was fueled by large numbers of Surface RT tablets that Microsoft sold at fire sale prices to unload an overstock. Last year, Microsoft cut the price of the Surface RT to $349 for consumers and to as low as $199 for educational institutions, representing 30% and 60% discounts, respectively, from the original list price of $499.

Both Thompson and Dawson noted that Microsoft did not reveal Surface unit sales, making it impossible to determine which models have sold best or tell if volume was up, flat or down.

"We don't know the number of units sold or average selling price for the Surface, but considering that the Surface Pro 3 starts at more than double the price of last [year's third quarter] Surface RT, it's likely that Microsoft actually sold fewer Surfaces this quarter than they did a year ago," said Thompson.

"How many Surface devices did Microsoft sell in the quarter? Well, they won't say, but given the new version starts at $800, it's entirely possible that the company sold a million or fewer Surface tablets in total, and likely well under a million Surface Pro 3s in their first full quarter on sale," added Dawson.

As a comparison -- although Microsoft denies that the Surface Pro 3 is a tablet, preferring to dub it a notebook replacement instead -- Apple sold 12.3 million iPads in the same quarter, producing $5.3 billion in revenue.

Microsoft must do better if Surface is to be a viable business rather than a vanity project. "The gross margin has to keep moving up at this point," Dawson said in an email reply to questions. "It's at a point in its history when it has to get beyond the early losses to a sustainable business."


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