Yesterday, Microsoft announced plans to enter the PC market by designing and manufacturing at least two models of a new product called Surface.Make no mistake: these are PCs, not just “tablets.”
Microsoft does not draw the distinction between PCs and tablets as Apple and other vendors have, and both editions will include fold-out keyboards, making them usable as notebooks. The second version — Surface For Windows 8 Pro, which will ship in late 2012 or early 2013 — will run legacy Windows apps and will be pitched to businesses and professional users as a MacBook Air or Ultrabook competitor.
This is a huge move for Microsoft, and a historic reversal of the company’s traditional Windows strategy, which is to sell relatively low-priced software very broadly, while spending a minimum on direct sales. That business model is great for Microsoft because once it covers its cost of development for a particular software release, each incremental sale is highly profitable. This is how Microsoft has been able to maintain operating margins of 70% or higher on Windows for decades.
But most of the growth in personal computers over the next five years will be in portable computers — tablets and notebooks. (See chart.) Right now, the only successful tablet is the iPad, and it’s eating into sales of traditional laptop PCs. Microsoft believes that Windows 8 will only be successful with high-quality hardware that combines the functions of both a tablet and a notebook, and it does not trust its PC manufacturers to do the job.
So is Microsoft in this for the long haul?
Looking at the company’s history, Microsoft builds hardware for one of two reasons:
- To enter a new market where it sees opportunity, and/or a possible threat to Windows PCs. This was the impetus behind the Xbox — Sony and others had built highly profitable game consoles, and were making noises about the console replacing the personal computer for consumers. Microsoft invested billions to build out this business and has become the market leader. It now earns profits on the Xbox, although it’s still about $4 billion in the hole over the life of the product. The Zune portable media player and short-lived Kin social networking phone fit the same category, although both were dismal failures.
- To drive a particular use case for Windows PCs. This was the impetus behind Microsoft’s first entry into the hardware market, when it started shipping mice in 1983. (!) In that case, Microsoft wanted to encourage a shift away from the character-based MS-DOS operating system that had been its main success thus far, and toward the graphic operating system, Windows, that represented its future. Mice (and keyboards) became a small but consistently profitable business, and Microsoft maintains it to this day. Another example is Microsoft’s brief foray into Wi-Fi routers in 2002 — Microsoft believed that third-party Wi-Fi routers were too complicated to set up, which was hampering a key use case for Windows XP. Microsoft exited this business in 2004 as manufacturers like Cisco (which bought Linksys) improved ease of use.
Surface is an example of the second scenario. Here’s the evidence:
- Microsoft says it will sell Surface at “competitive” prices to other Windows PC manufacturers. Microsoft is not making a play to grab market share by undercutting competitors (which it could easily do because it doesn’t have to pay $70 to $150 per copy of Windows). This is the only way Surface makes business sense for Microsoft — it has to maintain the price of Windows on its own hardware, or every Surface sale would essentially “steal” revenue from its its biggest and most profitable product.
- Microsoft has said repeatedly that it does not view tablets as a new market that must be conquered. It views tablets as a new type of PC, and believes that those PCs should run Windows. It has designed Windows 8 and Windows RT specifically for that purpose, and is emphasising hybrids as the main selling point versus the iPad.
Surface could become a nice profitable business that Microsoft maintains for many years, just like keyboards and mice.
But the primary goal is to spur other PC makers to build the kind of hardware necessary for Windows 8 and its successors to be a hit. That’s the only way Windows will keep selling hundreds of millions of units per year, and keep contributing more than $20 billion a year in revenue to Microsoft.
In other words, Microsoft is getting into hardware again because it has to. Not because it wants to.
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