Is it possible for Microsoft to bounce back after the downfall of its Surface division?

Is it possible for Microsoft to bounce back after the downfall of its Surface division

Are you a fan of roller coaster rides? Do you yearn for those steep descents where the car hurtles down at a mind-boggling angle, subjecting your body to a gravity force of 3.5? Do you feel a sense of anticipation as the car slowly ascends, making that distinctive clack-clack-clack sound, only to plummet downward, leaving your stomach behind as you accelerate to the bottom?

Prepare yourself for a ten-year journey alongside Microsoft’s Surface division, which has experienced a performance reminiscent of a Gerstlauer Euro-Fighter 1000. Following a less-than-auspicious start in 2012, the division began to steadily grow. In 2018, I provided an overview of this progress, highlighting that the division had generated nearly $5 billion in total revenue.

No one in their right mind would have placed a bet on that number five years ago. At the end of FY2013, Microsoft had to take a one-time writedown of $900 million to account for the spectacular failure of its Surface RT.
Many companies would have given up at that point, but not one run by Steve Ballmer, who famously described Microsoft’s approach as “long-term, tenacious, and partner-centric.”
As he once told an arena full of partners, “We don’t go home. We just keep coming and coming and coming. Tenacious, tenacious, tenacious.” (As Ashlee Vance noted when transcribing those remarks for the New York Times, “The man likes to talk in threes.”)
In fact, while PC shipments overall have been flat or down for the past four years, the Surface business has been growing at a compound annual rate of better than 22 percent a year.

The Surface division reached its peak at the close of FY22, amassing nearly $7 billion in revenue for Microsoft. But then… well, see for yourself.

That’s quite a remarkable downturn in FY2023. (Please note that the FY2024 number in the chart above is a projection.)

Deciphering these numbers from Microsoft’s financial reports proved somewhat challenging. The company ceased disclosing actual Surface revenue figures in FY22, opting instead to reveal changes in revenue as a percentage compared to the previous year. To add to the complexity, in 2023, the “Surface revenue” line item was replaced with “Devices revenue growth,” encompassing revenue from sales of accessories like keyboards, mice, and other peripherals.

Despite all these adjustments, the outlook for FY2023 (ending on July 30, 2023) was bleak. In its annual report, Microsoft stated, “Devices revenue decreased by $1.8 billion, or 24%, as elevated channel inventory levels continued to exacerbate the existing weakness stemming from declining PC demand.”

In simpler terms: The PC market is currently undergoing a significant correction, and Surface is underperforming its competitors.

The turmoil is far from over. During Microsoft’s FY23 fourth-quarter earnings conference call, Satya Nadella and his team forecasted a further decline in Devices revenue for the quarter ending September 30, 2023:

In Devices, revenue should decline in the mid-30s due to the overall PC market and adjustments we made in our portfolio with an increased focus on our higher margin premium products.

It’s challenging to envision significant improvements before the end of 2023. The most successful Surface products are the Surface Pro and Surface Laptop, both of which are over a year old. The Surface Laptop Studio 2, a high-priced device designed for a niche market, took center stage at this year’s fall Surface event in New York City and is unlikely to become a runaway success.

In the chart above, I’ve projected what the Surface revenue might look like if the company manages to recover to a loss of only 24%, mirroring this year’s performance. Essentially, they would be reverting to the state of the business in 2016 and 2017, which is far from ideal.

At Microsoft, a division needs to generate $10 billion in annual revenue to be considered a “game-changer.” Surface once appeared to be on track to establish such a steady, growing business, but that’s no longer the case.

Perhaps this explains the sudden departure of Windows & Devices chief Panos Panay, just days before the company’s fall Surface showcase event. His responsibilities had significantly expanded in recent years to include not only Surface devices but also Windows 11. According to Business Insider, quoting “anonymous insiders,” Panay was “dissatisfied with recent changes in the Windows + Devices division,” including “significant streamlining of the Surface business… and a greater emphasis on Microsoft’s successful products rather than the more experimental devices the company funded during prosperous times.”

The Surface Pro and Surface Laptop lines are undoubtedly the “successful products” mentioned in that report. Notably, both product lines have seen minimal changes to their physical designs in recent years, aside from the welcomed addition of Thunderbolt 4 support in the Surface Pro 8 and Surface Laptop 5. Most upgrades in these product lines have been incremental spec improvements, rather than game-changing innovations.

Two high-profile disappointments probably didn’t help those advocating for Surface within Microsoft. The Surface Duo, a dual-screen Android-powered phone, was prohibitively expensive and unconventional. I purchased one shortly after its release in 2019 but returned it six weeks later. (For more details, see “Five reasons why I returned my Surface Duo.”)

Then there was the dual-screen Surface Neo, announced at the same event as the Surface Duo in 2019, but it became one of the first casualties of the pandemic the following year. It never made it to market, and neither did the Windows 10X operating system it was supposed to run. If you’ve forgotten about this project, it’s understandable – 2020 brought a lot of upheaval! But the bottom line is that it was meant to be a “cloud-powered” competitor to ChromeOS.

CEO Satya Nadella hasn’t hesitated to discontinue products that aren’t performing well. Perhaps that will ultimately be the fate of Surface, but I have my doubts. In fact, something I wrote about Windows 10X when it was initially introduced may be relevant today.

Windows 10X is debuting as the native operating system for a new PC form factor, with multiple screens. But its core innovation is the ability to run traditional Windows desktop apps in secure containers that are isolated from the core of the operating system. It’s easy to imagine this technology migrating to more traditional form factors before long.

A dual-screen PC is a costly novelty and unlikely to gain mass-market appeal. That’s why the project was scrapped and is unlikely to be revived. However, consider the possibility of achieving similar goals as the Windows 10X project but on traditional hardware, such as an affordable laptop. This could present a credible challenge to Google’s Chromebook and potentially reestablish Windows as a dominant player in the education sector.

This seems to be what Microsoft has been working on for the past three years with its CorePC project, which may launch next year under the Windows 12 name, in whole or in part. For a detailed explanation, Zac Bowden at Windows Central can provide insights into this “modular and customizable variant of Windows.”

My sources tell me CorePC will allow Microsoft to finally deliver a version of Windows that truly competes with Chromebooks in OS footprint, performance, and capabilities. A version of Windows that only runs Edge, web apps, Android apps (via Project Latte) and Office apps, designed for low-end education PCs is already in early testing internally, and is roughly 60-75% smaller than Windows 11 SE.

Meanwhile, in the high-margin, premium device segment of the PC market, Microsoft desperately needs a way to contend with Apple’s M2-powered MacBook lineup (and we can expect Macs with even more powerful M3 processors to hit Apple Stores next year). Unfortunately, achieving performance and battery life that can match Apple’s flagship products requires Arm-based processors, and the entire PC industry is currently waiting for Qualcomm to release its next-generation Nuvia SoCs. This is what mentioned a few months ago:

As pretty much every rational observer has noted, Windows on Arm is far behind Apple, at least using Qualcomm’s current SoC designs. But they could play catch-up, and maybe even leapfrog their Cupertino competition, with a successful launch of the Nuvia-based Oryon architecture, especially if they can build some custom Windows features into it. (The SQ3-based Surface Pro 9 has a couple of nifty AI-based features not found in its Intel sibling, including eye-tracking and background noise reduction for video calls.)

This is likely why Microsoft remained silent about upcoming iterations of Surface Pro or Surface Laptop at its recent hardware event. Another incremental improvement wouldn’t make a significant impact. However, an Arm-powered device with double the battery life of x86-based hardware, a neural processing unit for advanced AI tasks, and the ability to run x86 apps in secure containers might be worth the wait.

Competing vigorously on both the low and high ends of the market, especially when facing budget cuts and the loss of a key leader, is a formidable challenge. Brace yourself for another ride on the Surface roller coaster.