Monday Note

My appetite whetted by three days of rumors, I went online last Monday and watched Microsoft introduce its Surface tablets. After the previous false starts — the moribund Tablet PC and the still-born Courier — Microsoft finally took matters into its own hands. Ballmer & Co. could no longer wait for OEMs to create vehicles worthy of Windows 8’s “reimagined” beauty and function, not while the A-team ran away with the tablet market.

It was a terrific performance that hit all the right notes:

• World-class industrial design by Microsoft’s guru, Panos Panay.
• An ARM-based consumer tablet running Windows RT, and an x86 enterprise version on Windows 8, both with the innovative Metro UI.
• A “digital ink” stylus for handwriting and drawing, faithful to Gates’ famous dictum: “I’ve been predicting a tablet with a stylus for many years, I will eventually turn out to be right or be dead.”
• Creative, thoughtful touches: the integrated kick-stand, a novel smart cover with an integrated keyboard, the magnetic stylus that sticks to the side of the device.
• MicroSD, USB 2.0, and Micro HD video connectors.
• 10.6” displays: ClearType HD for the ARM-based tablet, ClearType Full HD for the x86 device.
• Both tablets are slim and light: 9.3 mm/676 grams for the consumer model, 13.5 mm/903 grams for enterprise. (That’s .37”/1.5 lbs, .53”/2 lbs, imperial.)

47 minutes later, Microsoft has jumped to the head of the tablet race. Yesterday’s laggard is now the Big Dog. Thrilling. I want one — probably the lighter Windows RT model.

The live demo wasn’t fumble-free, as a number of critics have pointlessly pointed out. Yes, Windows Chef Steven Sinofsky had to swap out a busted tablet, but this (probably) means nothing, it happens all the time, trust me — I gave my first computer demo 44 years ago and have fumbled through a few more since then.

I smile when I imagine Ballmer on the phone to Tim Cook, letting Apple’s CEO know that a complimentary toaster/fridge – the “convergence” of his nightmares – is on its way to Cupertino’s One Infinite Loop. (Perhaps I should explain: In a recent D10 Conference interview, Cook dismissed the notion of a hybrid tablet + laptop with a quip: “You can converge a toaster and a refrigerator, but those aren’t going to be pleasing to the user.”)

Fantasy phone call aside, this is an historic event. Microsoft decides to make its own hardware and, straight out of the gate, unveils two attractive products that combine the best features of tablets and laptops, both supported by the huge Windows ecosystem.

Unsurprisingly, the momentous happening unleashed an orgiastic excess of premature evaluation. Reactions were fast and predictably polarized. It was, in the repurposed words of one witty blogger: Choo, choo, all aboard the Pundit Express to PageHitsVille! (He was referring to a different event, but I can’t resist repeating the epigram.)

After a few hours, a pattern started to emerge:

- Reviewers who weren’t in attendance, unencumbered by direct experience, were more inclined to view the new products through pre-existing biases and to issue clear-cut predictions.

- The privileged few who were invited to the press event in Los Angeles were more nuanced in their analyses, but with a recurring complaint: They didn’t have an opportunity to use the product for themselves, they were hurried along in small groups to look at non-functioning machines. A couple examples:

I was only permitted to touch the device while the machine was powered off. Microsoft representatives were happy to show off the device, but they didn’t let me actually use the new tablet (Slate’s Farhad Manjoo).
As for performance, we’ll be honest: tech press were treated to about two minutes at each of several stations, some of which demoed design, and not so much the power that lies inside that thin frame.
…
Unfortunately, we didn’t get to see a working demo of the keyboards. As in, we weren’t permitted to type sample sentences and feel what it’s like to hammer out characters on a flat keyboard, or on keys that have just 1.5mm of travel (Endgadget’s Dana Wollman).

With these observations in mind, I took another look at the video and realized how many other important details were omitted from the well-oiled presentation: Price, delivery dates, battery life, wireless connectivity, display resolution (could we have an unequivocal definition of the ClearType HD and ClearType Full HD?).

The missing data, the evasions, the lack of hands-on examination, even the circumstantial evidence of a stage struck device…it all smacks of products that aren’t ready — or even almost ready — for customers’ mitts and credit cards.

This leaves us with a list of questions.

First: Why now? Microsoft’s agitprop specialists aren’t new to the game. They know what happens when you show up with less than fully-baked devices and refuse to answer simple, important questions. Why not announce on, say, October 15th – the beginning of the Holiday shopping season — when they would have a better chance of running a FUD (Fear Uncertainty and Doubt) campaign against the opposition? Why the rush?

Maybe it’s the expectation that Google will announce its own Android tablet at Google I/O later this week…but I find the argument unconvincing. Microsoft would have been better off letting Google speak first so they could analyze the product and come up with a sharply targeted counter, especially if Google ships much sooner than Microsoft.

Second, the Apostasy question. For decades, the Redmond company has preached the Righteous Way of its OEM ecosystem, the wide range of hardware configurations and prices for its Windows platform. Now Microsoft pulls a 180º, they design and contract/manufacture Surface tablets by themselves, with distribution through the Microsoft Stores and online. That’s a whole different religion.

Why?

Is it because, as one supporter put it, “greedy” OEMs have become “obstacles of innovation”, that “the software giant has bled too much for OEMs far too long”? That’s one way to look at it. (Another reading of history sees that under the Windows thumb, Microsoft’s vassals have had little choice but to engage in a price war, in a race to the bottom. For PC makers, this undercut the margins they needed to design and manufacture the “innovative” products that their overlord now chides them for not having in their arsenals.)

There must be a more sensible explanation, and our friend Horace Dediu doesn’t disappoint. In his Who will be Microsoft’s Tim Cook? Dediu comes up with an eye-opening analysis that focuses on the “business model inversion” that has taken place in the last two years.

For decades, software generated much higher margins than hardware. Microsoft was admired for its extremely high margins, while Apple was criticized for stubbornly sticking to hardware and its lower profitability — to say nothing of lower volumes as a marginal PC player. But now, as Dediu points out, Apple is the company with both the higher revenue and operating margin [emphasis mine]:

If we simply divide revenues by PCs sold we get about $55 Windows revenues per PC and $68 of Office revenues per PC sold [1]. 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.

Which leads Horace to his killer conclusion:

For Microsoft to maintain their profitability, they have to find a way of obtaining $80 of profit per device. Under the current structure, device makers will not pay $55 per Windows license per device and users will not spend $68 per Office bundle per tablet. Price competition with Android tablets which have no software licensing costs and with iPad which has very cheap software means that a $300 tablet with a $68 software bill will not be competitive or profitable.
However, if Microsoft can sell a $400 (on average) device bundled with its software, and is able to get 20% margins then Microsoft is back to its $80 profit per device sold. This, I believe, is a large part of the practical motivation behind the Surface product.
The challenge for Microsoft therefore becomes to build hundreds of millions of these devices. Every year. Sounds like they need a Tim Cook to run it.

It’s difficult to argue with Horace’s logic, but there’s another way to look at Microsoft’s new posture: It’s just that, a posture, a way to wake up PC OEMs and force them to react. “If you do the right thing and come up with the world-class product Windows 8 deserves, we’ll back off and let you enjoy the just deserts of your efforts.” It’s a devious thought, but it could be more realistic than the notion that Microsoft will produce something in the order of 100 million Surface tablets in 2013 in order to keep their dog in the fight. (For reference, the lead PC maker, HP, currently ships about 16M devices per quarter.)

I’m also curious about Microsoft’s rigid insistence on calling these devices PCs. See their official site announcing a “New Family of PCs for Windows”:

Try as they might, Microsoft won’t be able to convince folks to refer to the Surface as anything other than a “tablet”. The Redmond team seems fixated on a best-of-both-worlds product: Everything a PC does plus the best features of a tablet. This is what John Gruber calls being caught Between a Rock and a Hardware Place. (Gruber’s post, which quotes Dediu’s, is itself quoted and felicitously expanded upon by Philip Elmer-DeWitt.)

Peter Yared offers his help with a witty clarification:

In the end, I can’t see how Microsoft can suddenly morph into a tablet, er, PC maker capable of pumping hundreds of millions of devices per year. The fuller Surface story is yet to unfold.

—JLG@mondaynote.com

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