Can The Rumored Launch Of Surface Phone Boost Microsoft’s Revenues?

Microsoft (NASDAQ:MSFT) has dabbled in the smartphone market without much success. In fact, the company rolled back its plans to launch new smartphones under the Lumia brand in May this year as its strategy to offer cheaper smartphones for emerging markets was undone by Google’s Android One initiative, which undercut Microsoft’s prices by close to $20. As a result, the market share of Windows Phones shrank from 1.8% in Q3 of 2015 to 0.4% of all smartphone shipments during the second quarter of this year, according to IDC. ^[1]

However, with the rising popularity of its Surface devices, a case can be made that if Microsoft were to launch Surface Phones, targetting the premium segment of the market, it could capture a significant share in the market. News has surfaced that Microsoft is reportedly developing a smartphone version of its Surface tablet called the “Surface Phone,” according to an article at Windows Central, quoting Microsoft’s CEO Satya Nadella. ^[2] The rumored flagship device is slated for release in the first half of 2017. In this note, we explore the strategy behind this initiative and Microsoft’s prospects for success.

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Microsoft Targeting The Premium Phone Market

Most of Microsoft’s smartphones, barring the now defunct Lumia 950 and Lumia 950XL, targeted the sub-$200 segment and were sold in emerging markets that continue to witness growth in smartphone adoption. However, given the competitive character of the market, these phones typically generate very low margins (8-10%) and thus erode profitability. Meanwhile, the premium segment, which is led by Apple’s iPhone, has a gross profit margin of over 40%. These premium phones account for 12.1% of shipment and 104% profitability of the smartphone industry, indicating that some manufacturers were selling smartphones for a loss. ^[3] Considering this, it made sense for Microsoft to ditch its efforts to manufacture and sell cheap smartphones, and instead focus on selling premium quality phones at higher price points with some distinguishing feature and catering to a niche market.

Microsoft Plans To Bolster Its Surface Ecosystem

Microsoft has been trying to reinforce integration within its ecosystem by offering features and products that allow its mobile devices (smartphones, tablets and laptop) to work together seamlessly. With the re-launch of the Surface Pro in 2014 and Surface Book Pro last year, Microsoft tried to not only bridge the gap between PCs and tablets but also cover a shortfall in its hardware portfolio. Microsoft plans to leverage the Surface brand name and the growing popularity of its hardware devices to possibly re-enter the smartphone market in an ultra niche segment of the market. If this offering were to be launched, it would supplement the expanding Surface line, and thus improve its ecosystem.

Will The Surface Phone Succeed?

Considering Microsoft’s past record and the intense competition in the industry from Apple and the Android-based players, it seems unlikely that Microsoft will be able to capture a much bigger share of the market. The improvement in Surface sales, which have increased by 38% to $926 million (year on year) in Q1 FY17, can be attributed to two factors. Firstly, due to a positive mix of premium devices sold, specifically top-tier Surface Book and Surface Pro 4 models, revenues for Surface have improved. Secondly, Apple’s products had lost market-share due to product fatigue. However, the launch of the latest Macbook Pro has renewed interest in Apple’s product and should help Apple to shore up its share.

Nevertheless, Windows users who buy these devices, have many other even cheaper options available to them. This will be the case with Surface Phones, if they do not have any distinguishing feature. As a result, for the company to succeed with its Surface Phone, it will have to overcome not only the hurdles it faces for its Pro tablet and laptop, but also generate sufficient differentiation to attract consumers.

We currently have a $58.59 price estimate for Microsoft, which is inline the current market price.

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1. Smartphone OS Market Share, 2016 Q2 [↩]
2. Satya Nadella hints that Microsoft is at work on ‘ultimate mobile device’, November 22 2016 [↩]
3. Apple iPhone Grabs 104% Of Smartphone Industry Profit In Q3, www.investors.com, 11 November 2016 [↩]