Microsoft's Surface line-up posts 2nd straight profitable quarter

Surface Pro 3 powers gross margin improvement to between 19% and 20%

surface pro 3 stock

Microsoft yesterday reported a second consecutive quarter of gross profit for its Surface tablet line, and said that revenue broke the $1 billion mark for the first time.

"Strong interest in Surface Pro 3 helped to drive record revenue as well as improved gross margin," said CFO Amy Hood during Monday's earnings call with Wall Street.

For the three months ending Dec. 31, 2014, Microsoft recorded just over $1.1 billion in revenue for the Surface line, an increase of 24% over the same quarter in 2013 but far under the 127% boost seen in the third quarter. The December quarter revenue was a three-month record for the Surface, which consists of the touch-centric Surface 2 and the it's-a-tablet-it's-a-notebook Surface Pro 3 2-in-1.

Using information in Microsoft's Monday filing with the U.S. Securities and Exchange Commission (SEC) and data from earlier quarters, Computerworld calculated the quarter's cost of that revenue at $894 million, leaving a gross profit of $210 million. Cost of revenue is the cost to make and sell a product, but excludes expenses such as advertising and R&D.

The $210 million in gross profit was nearly double the previous quarter's $122 million.

According to Computerworld's estimate, the gross margin was 19%, higher than the 13.4% of the September quarter, but still far under Microsoft's usual software numbers. Calculations by Jan Dawson, chief analyst at Jackdaw Research, tagged Microsoft's gross margin for Q4 after hardware was stripped out at 77%, or more than four times that of the tablets.

In the 10-Q submitted yesterday to the SEC, Microsoft explained the margin increase by saying, "Gross margin benefitted from the mix shift to Surface Pro 3." That wasn't surprising, as Microsoft has made little effort to promote the Surface 2, the less-expensive tablet that runs the now-dead ended Windows RT.

"Surface revenue increased $211 million or 24%, primarily due to Surface Pro 3 units sold, offset in part by a decrease in revenue from other Surface devices sold," Microsoft added.

The Surface Pro 3, which was unveiled in May 2014, comes with much higher prices than the Surface 2 -- between $799 and $1,949, with those prices sans the virtually-mandatory $129 keyboard -- and thus higher margins, especially on the top end.

Dawson also regularly uses Microsoft's SEC filings to come up with his own estimates of the tablets' cost of revenue and margin. For the December quarter, he pegged the cost of revenue at $887 million, the gross profit at $217 million, and the gross margin rate at 20%, up significantly from his extrapolation of just 9% in the September quarter.

Dawson published his Surface estimates on his blog, where he also posted a broader analysis of Microsoft's December quarter financials.

"They've moved from selling more of their older devices at a loss to selling mostly new devices at or near full price," Dawson said in an interview Tuesday. "That's the big difference compared to a year ago. They're not selling huge numbers yet, but they are getting to a place where margins are ticking up. The story until now has been challenging, because it was difficult to see how [the Surface line] was solving any strategic problem or making money. That made it hard to justify continuing.

"Although I'm still dubious of the strategic benefits, the positive margin means they're probably not losing money at this point," Dawson continued. He expected that calls for Microsoft to drop the OEM experiment will fade if the company can continue to capitalize on the two-quarter trend.

Microsoft has never revealed unit sales for any Surface tablet, and it stuck to the practice Monday. (The closest it came was when Hood said the Surface Pro 3 has now outsold the Surface Pro 2 by three-to-one.) At the Surface Pro 3 prices, however, the company may have sold a million. Or not: It's impossible to tell.

But Dawson, for one, thought it was. With most fourth-quarter sales coming from the Surface Pro 3, he said it was sensible to peg the number somewhere between 900,000 and just over 1 million.

That the Surface Pro 3 drove sales was understandable, as the third iteration of Microsoft's 2-in-1 has been the best-received of the company's attempts so far.

"The Surface Pro 3 is a reasonable product, even though it's not one that will dramatically change the world," said Bob O'Donnell, chief analyst at Technalysis Research, in an interview last week. "But some organizations really like the Surface Pro 3 because it's a clearer 2-in-1 story than they've gotten from other vendors."

O'Donnell thought that the Surface Pro 3 -- and its OEM-made ilk -- will do even better later this year once Microsoft has launched Windows 10. "With Windows 10, Microsoft's tablet-to-desktop-mode transition will be much more interesting and compelling," O'Donnell said. "I think we'll see a lot more 2-in-1s [with Windows 10]."

Although Microsoft turned the corner into gross profitability in the second half of 2014, the Surface line remained saddled with a red ink burden. In the tablets' first seven quarters, they ran about $1.7 billion in the hole, more than half of that in a single mid-2013 hit of $900 million, when Microsoft wrote off that amount so it could heavily discount an unsold glut of Surface RT tablets.

The last two quarters' gross profits have knocked down the total losses to around $1.4 billion by Computerworld's count.

Surface revenues, Q4 2014

On Tuesday, Microsoft posted a gross profit for the Surface tablet for the second straight quarter.

Copyright © 2015 IDG Communications, Inc.

7 inconvenient truths about the hybrid work trend
Shop Tech Products at Amazon