Surface: Between a Rock and a Hardware Place

Watching the Microsoft Surface event video, I sensed uneasiness. Not panic, but discomfort. Some will argue that I’m simply spoiled by Apple’s on-stage polish, but Monday’s Microsoft event struck me as rushed and severely under-rehearsed. Ballmer offered nothing but blustering bromides, and nothing even vaguely resembling a coherent answer to the big question: Why? Steven Sinofsky was nervous and hurried. It didn’t help that his first Surface RT unit crashed before he’d done anything other than wake it up. There was a moment where he said Surface was perfect for sitting down, relaxing in a chair, and watching a movie. He sat in that chair for about three seconds before rushing into the next segment.

I found the presenters far less rehearsed and the presentation far less cohesive than an Apple event. (With the notable exception of designer Panos Panay, who was very solid on stage.) There was no story. It was all over the place: Here’s an ARM tablet. Here’s the clever keyboard cover that goes with it. Now here’s another tablet that looks much the same but a little thicker but in fact is running a different and incompatible OS. Oh and here’s another keyboard cover, this one with moving keys. Design is about making decisions, and Microsoft could not decide. ARM or Intel? Who should be on stage? Soft or hard keys on the keyboard cover? They went with “all of the above”.

The only hard decision they made was the big one: to turn against their OEM hardware partners.

I presume Microsoft timed this event to jump ahead of anything Google might be announcing at their I/O conference next week — and the consensus seems to be that Google is going to announce much the same idea: their own Google-branded, Google-designed tablet that will put them in direct competition not just with Apple but with their own OS licensees.

But no pricing, no battery life specs, no demonstrations of the seemingly extraordinarily clever cover-keyboards in action, or really much in the way of software demonstrations, period? That’s rough, even by the standards of pre-announcements. Skepticism about these things doesn’t require knee-jerk Apple fandom. It simply requires an open set of eyeballs. The message I took away is that Microsoft has concluded that, ready or not, it needed to move now. There is no longer enough profit to be had selling software alone.

Remember the introduction of the original iPad at the end of January 2010? The only product Steve Jobs talked about on stage was the iPad, but the presentation was about much more. Jobs opened by talking about Apple having crossed the $50 billion annual revenue threshold. (They’ve since gone on to cross the $100 billion threshold.) And they spent a large part of the event talking about the iPad’s integrated system-on-a-chip, the A4. I concluded my take on the event thus:

They’re Microsoft and Intel rolled into one when it comes to mobile computing. In the pre-taped video Apple showed, Bob Mansfield said of the iPad, “No one else could do it.” Only Apple. And so my takeaway from this — with the bragging about making their own CPUs and their annual revenue and their size compared to companies like Sony, Samsung, and Nokia — is that this is Apple’s way of asserting that they’re taking over the penthouse suite as the strongest and best company in the whole ones-and-zeroes racket.

This, it’s now clear, was correct. If anything, it was understated — Apple is now the strongest and most successful company in the world, across any and all industries.

If not for the iPad — imagine, for a moment, that the company still to this day had not shipped a tablet — Apple would still be thriving, based on huge (and hugely profitable) iPhone sales and the Mac’s steady continuing growth (six years of consecutive quarterly growth ahead of the overall PC industry). But it was the iPad that pushed Apple over the top. The iPhone suggested Apple would dominate pocket computing. The iPad suggests Apple will dominate computing, period.

Microsoft this week showed itself willing to do what was once unthinkable: design and sell its own PC hardware. This is a profound change of direction for Microsoft and the entire PC industry. The iPad, however, has been out for so long and has been so successful that no one seemed shocked by Microsoft’s announcement. But make no mistake: for better or for worse, Surface marks a watershed moment in PC industry history.

Harry McCracken:

After 37 years, Microsoft agrees with Alan Kay: “People who are really serious about software should make their own hardware.”

The ever-astute Lessien, tweeting shortly after Microsoft’s event:

Microsoft’s move today suggests it feared the irretrievable loss of the tablet market to iPad, if it continued to rely on third-party OEMs.

I’d go further, and argue they fear losing not just the tablet market, but the PC market as a whole. Not in sheer numbers, but in sheer profit. Apple doesn’t want to sell all of the world’s computers and phones; rather, Apple wants to reap all the profits in the computer and phone industries. There is no threat that Windows goes away, but there is a serious threat that Microsoft’s profit from Windows greatly diminishes.

Horace Dediu, today:

If we simply divide revenues by PCs sold we get about $55 Windows revenues per PC and $68 of Office revenues per PC sold. The total income for Microsoft per PC sold is therefore about $123. If we divide operating income by PCs as well we get $35 per Windows license and $43 per Office license. That’s a total of $78 of operating profit per PC. Now let’s think about a post-PC future exemplified by the iPad. Apple sells the iPad with a nearly 33% margin but at a higher average price than Microsoft’s software bundle. Apple gives away the software (and apps are very cheap) but it still gains $195 in operating profit per iPad sold. Fine, you say, but Microsoft make up for it in volume. Well, that’s a problem. The tablet volumes are expanding very quickly and are on track to overtake traditional PCs while traditional PCs are likely to be disrupted and decline. So Microsoft faces a dilemma. Their business model of expensive software on cheap hardware is not sustainable. The future is nearly free software integrated into moderately priced hardware.

There we have it: four short paragraphs that explain why Microsoft has turned its guns against PC-making OEMs. This move was driven by the iPad, but competitively it directly pits Microsoft not against Apple but against Dell, HP, Toshiba, et al. The intention is obviously to slow the iPad down, but the radical shift in Microsoft’s strategy is about the fight over the profits that remain after Apple’s. The math no longer works out for the Windows you-sell-the-hardware-we-sell-the-software model. It works for unit share (cf. Android), but it doesn’t for profit share. Nothing works sustainably in business without profit — profit is the oxygen companies breathe.

Even if Apple’s growth soon slows, Apple already reaps a massive share of the industry’s profits. And if Apple’s growth doesn’t slow in the next year or two, look out. All of Apple’s competitors in the phone industry, save Samsung, are now starving for profit. They’re dying, all of them — HTC is breaking even and the rest are deep in the red.

The iPad is growing faster than the iPhone. The Mac already owns the $999-and-over market (where the margins are), and the iPad owns the tablet market (where the growth is). The PC market is quickly heading to where the phone market already is.

Microsoft Surface is not fundamentally about Microsoft needing to control the entire integrated product in order to compete with the iPad on design. It’s about Microsoft needing to sell the whole thing to sustain its current profitability.

Surface is a bold move, and classic Microsoft. If the OEMs don’t like it — and they do not — what are they going to do? Turn to Linux (which no one wants) or Android (which no one wants on anything other than phones)? It’s the OEMs whom Microsoft thinks Surface can put into checkmate, not Apple.

If I’m right, it’s inevitable now that Microsoft will acquire Nokia.