Surface damage mounts at Microsoft as red ink reaches $1.7B

The tablet business has lost money each quarter, and each fiscal year

Microsoft continued to lose money on its Surface tablets throughout its just-concluded 2014 fiscal year, adding hundreds of millions of dollars in red ink and boosting total losses to $1.7 billion since the device's 2012 launch.

According to the 8-K statement filed with the U.S. Securities and Exchange Commission (SEC) on July 22, the Surface posted revenue of $409 million for the quarter that ended June 30. But unlike the two quarters prior, Microsoft did not reveal the cost of revenue associated with the Surface for the period.

Without a cost of revenue figure, it is impossible to calculate a precise gross margin, a rough measurement of profit. However, using information in the 10-K that Microsoft filed last Friday, along with data from earlier reports, it is possible to estimate Surface cost of revenue.

Calculations by Computerworld show that the Surface's cost of revenue for the June quarter was $772 million. With revenue of $409 million, that put the tablet in the red to the tune of $363 million, the largest one-quarter loss for the Surface since Microsoft began providing quarterly revenue numbers.

Jan Dawson, chief analyst at Jackdaw Research, figured the June quarter's cost of revenue at a slightly different $733 million, for a loss of $324 million.

Some of the money in the cost of revenue -- and thus in the negative gross margin, or loss -- was due to a write-off Microsoft took for the quarter. The write-off, which wasn't tied to a dollar amount, was to cover costs of designing and producing an unknown number of Surface Mini tablets. "Current year cost of revenue included Surface inventory adjustments resulting from our transition to newer generation devices and a decision to not ship a new form factor," the company said in the July 22 8-K (emphasis added).

Microsoft was set to launch the smaller-screen Surface Mini alongside the Surface Pro 3 in May, but changed its mind at the last moment, reportedly because it feared the tablet would not sell well.

Also in that red ink, said Dawson in a Monday interview, were manufacturing expenses for the Surface Pro 3 line, which Microsoft started selling, but only in limited quantities, near the end of quarter. Although most sales would presumably be recorded in the following quarters, the initial production costs would have been booked into the June period. The fully-fleshed-out line only reached retail on Aug. 1.

Adding the $772 million in Q4 to the preceding three quarters' cost of revenue resulted in a total of $2.872 billion for Microsoft's 2014 fiscal year (FY2014), which ran from July 1, 2013 to June 30, 2014. During the same stretch, Microsoft reported $2.192 billion in Surface-derived revenue.

(Dawson's numbers for annual revenue and annual cost of revenue were identical to Computerworld's.)

The total loss for FY2014 was then $680 million ($2.192 in revenue minus $2.872 in cost of that revenue).

But that was small potatoes compared to what Microsoft lost on the Surface the previous fiscal year. Using Microsoft's stated revenue of $853 million and some arithmetic to backtrack to the FY2013 cost of revenue, Computerworld concluded that the cost of revenue for the 12 months starting July 1, 2012, was $1.902 billion.

The total loss for FY2013 was thus $1.049 billion ($853 million minus $1.902 billion in cost of revenue and adjustments).

Since Microsoft started selling the Surface nearly two years ago, it has lost $1.7 billion on the line. (Microsoft, SEC filings.)

Most of the FY2013 loss was attributed to the massive $900 million write-off Microsoft announced in July 2013. That write-off, the first of two the Redmond, Wash. technology company has been forced to take on the Surface, accounted for a glut of Surface RT tablets Microsoft couldn't sell.

So, since the Surface's sales debut, Microsoft has lost $1.73 billion ($680 million plus $1.049 billion) on the new hardware.

While that loss may not pose an existential threat to Microsoft's finances -- it represented just 3% of the company's FY2014 gross margin, and less than 9% of the year's gross margin for the Devices and Consumer division, of which Surface is only one part -- it's certainly real money.

If Microsoft had managed to just break even on the Surface in FY2014, for instance, it would have boosted its year-over-year revenue growth by nearly one percentage point, from 11.5% to 12.4%.

In an analysis published last week, Dawson put the Surface debit into context. "Continued losses will make it harder and harder for Microsoft to keep the Surface project going, so a good performance in the next quarter or two will be critical to justifying its continued existence," he wrote.

In the interview today, Dawson elaborated. "You can accept some losses for a while, but how sustainable is that in the long term?" he asked. "Can you run [into the red] indefinitely?"

Dawson didn't think so, especially now with Satya Nadella as CEO.

"My sense is that Nadella is less willing to accept losses than was [Steve] Ballmer," Dawson said, referring to the former CEO. "Ballmer was willing to make decisions that involved heavy losses," Dawson added, citing both the Surface and the Nokia purchase.

One hint of Nadella's unwillingness to pour resources into a money-losing business came from his comments on the July 22 earnings call with Wall Street. "At times, we will develop new categories like we did with Surface and we will responsibly make the market for Windows phone," Nadella said then. "However, we are not in the hardware for hardware sake, and the first-party device portfolio will be aligned to our strategic direction as the productivity and platform company."

Dawson picked up on Nadella's "make the market" comment. "Is it still worth 'making the market' if you're not making sales?" Dawson asked. "They're losing hundreds of millions and without a large volume of sales, they're not making the market or rapidly increasing the market for Windows 8 tablets."

The rest of the year will tell the tale. Microsoft has portrayed early Surface Pro 3 sales as promising. "While it's still early, sales are outpacing earlier versions of Surface Pro," chief financial officer Amy Hood said two weeks ago.

"But if the Surface is one, not growing sales; two, losing money; and three, not creating a market, what's the point ultimately?" Dawson wondered.

Exactly.

Gregg Keizer covers Microsoft, security issues, Apple, Web browsers and general technology breaking news for Computerworld. Follow Gregg on Twitter at @gkeizer, on Google+ or subscribe to Gregg's RSS feed. His email address is gkeizer@computerworld.com.

See more by Gregg Keizer on Computerworld.com.

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