Late Monday afternoon, Dividend Growth Portfolio holding Microsoft () announced that it will release a tablet, known as the Surface. This technically isn’t the firm’s first tablet, as the company invented the original tablets in 2002. These were not at all successful, and Apple () eventually popularized the device several years later. Regardless, though some may be underwhelmed by another Microsoft device–going as far as to call it the next Zune–we think the tablet will have significant implications on the computing industry.
It Is Not An iPad Killer
Apple’s iPad dominates the tablet market, and as we’ve said many times before, we do not expect that to change. iPad has the iTunes store, an enormous app marketplace, and has the most market share in the space. The company also has an extremely loyal consumer base, as well as the intangible popularity factor that helps propel sales, in our view.
Like the Nokia (NOK) Lumia phone, we don’t think the Surface will steal much, if any, market share from the iPad. However, it may be successful at stealing share from other tablets. The Surface is a unique product in the sense that it seeks to replace laptops rather than supplement them. The Surface fully integrates with the Microsoft Office Suite and could help boost worker productivity and potentially make the tablet attractive to enterprise customers. Even if the company is unable to gain success in the consumer space with the Surface, significant traction in the enterprise market, if achieved, could more than compensate for it. However, as we outline in a previous note (click here), the battle for the enterprise market will be a fierce one.
The Apple Model Works
In our opinion, one of the most interesting effects of the Surface launch is admission that hardware and software integration makes for a better all-around product. Much like how Microsoft lets HP (HPQ), Dell (DELL), and Sony (SNE) create PCs that run Windows, Microsoft could have allowed hardware makers to simply run Windows 8 for tablets and let the industry take its shape. However, CEO Steve Ballmer remarked during his presentation that the firm needs to innovate in both hardware and software. We think this means the company doesn’t fully trust its partners to create great tablets. This has negative implications on both Dell and Sony, though Microsoft did note that it values these partnerships and isn’t looking to end them (we think Dell is cheap, but we’re not excited about the company’s recent fundamental performance).
The Surface actually has 2 versions: one that runs Windows RT (apps only, ARM (ARMH) processor); and Windows 8 Pro (full computing power, Intel (INTC) i5 processor). The Windows 8 Pro version has an interesting market position, in the sense that it might replace some laptops and notebooks. This is another negative for the computer hardware companies, but neutral for Intel, assuming the Surface Windows 8 Pro is able to replace notebooks.
More generally, we think this signals that Microsoft is admitting the Apple business model works. After the tempered success of Lumia, we think Microsoft sees full integration as a chance to control marketing and presentation for its devices. This business model certainly increases the fixed cost structure for Microsoft, but if it can sell more products at higher margins, we do not think investors will complain (we won’t). The firm has already proven to be successful in the hardware market with Xbox and Xbox 360, so we’re confident Microsoft can successfully produce tablets. We’re anxious to see if Google () follows suit.
Google Should Be Worried
The Nokia Lumia has come, and pretty much went without much fanfare, but we think the Surface is just the beginning of the reinvention of Microsoft’s mobile strategy. We wouldn’t be surprised if a new Microsoft phone is announced in the next year, and we think Google is actively looking for a competitive response. We’ve previously noted that Android retention rates aren’t great, and that Android’s market share is more of a factor of flooding the market with products and poor execution at Blackberry () rather than the result of the product’s quality.
We continue to believe that there’s room for a competitor to unseat Android and perhaps that competitor is Microsoft. Aside from the Kindle Fire (AMZN), which runs a version of Android, we do not see a tablet running the Android OS that can compete with the Surface. The Kindle Fire is an inexpensive device that doesn’t really try to compete with the iPad, but we think the Surface can unseat the Samsung Galaxy and become the number two tablet on the market.
In our view, the Surface looks better than current Android tablets and offers a truly differentiated product from the iPad (which competitors have yet to do). Microsoft actually took its time to develop a product that can truly compete in the mobile space, in our view. With a combination of the Office Suite, the potential for books via the Nook (BKS) network, and a unique product offering, we think the Surface may establish Microsoft as a legitimate player in the mobile space. We hold Microsoft in our Dividend Growth Portfolio, and we continue to think the firm is undervalued.