Microsoft's second quarter was solid and the worst fears about the Windows division didn't play out, but the software giant's lack of metrics and color about Surface sales were a bummer.
We all know distribution was an issue for Surface since Microsoft only sold the device in its stores for much of the December quarter. There was also confusion about Windows RT. Surface distribution is just ramping.
Nevertheless, even with Research in Motion's PlayBook sales disappointment the company disclosed units every quarter. Microsoft provided no real disclosure on Surface.
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"While Win8/Surface adoption is still in early days, we were slightly disappointed about the lack of quantitative metrics around the Surface," said Oppenheimer analyst Shaul Eyal.
Eyal is charitable. Put me in the very disappointed camp. Surface is so key to Windows 8 that Microsoft should have coughed up more data. The lack of disclosure points to weaker-than-expected sales. Rest assured if Microsoft sold 3 million Surface units we would have heard about it.
What do you do in an information void? You guess. And analysts guess---a lot.
The unit guesses
1 million units! Tom Ernst Jr., analyst at Deutsche Bank, said:
Microsoft did not disclose the number of Surface units it sold in the quarter, but our calculations arrived at an estimate slightly shy of 1 million units. PC weakness continues to be a headwind, but Microsoft's ability to grow Windows revenue double digits in this environment is a positive.
500,000 units! Stifel Nicolaus analyst Brad Reback added:
We estimate that Surface RT sales during the quarter were likely around 500K units. While we believe that this number is disappointing and was also aided by Staples and Best Buy at the end of quarter (Microsoft recognizes sales of Surface to retailers on a sell in basis versus a sell through basis), we believe that the company's limited distribution (which it is addressing) heavily weighed on the uptake of the offering. Additionally, we believe the inability to run apps architected for x86 devices on Surface RT also limited uptake. We believe the company's Surface Pro, which is slated for release in February, combined with the company's expanded distribution should enable Surface sales to pick up over the next few years.
About 1 million units a quarter for 2013! Adam Holt, an analyst at Morgan Stanley, said:
However, we estimate ~1M Surface RT units sold in December with a total of ~4M units sold in CY13, which could prove conservative if Surface Pro gains traction in the Enterprise.
The bottom line here is that a lot of Surface's success rides with the Pro version.
Using gross margins to figure out Surface sales
The guesses on Surface volume are nice, but let's get real: They are guesstimates.
Microsoft didn't disclose much to give anyone confidence in Surface units. The only sure thing is that Microsoft didn't light up sales---inventory levels in the second quarter---and hardware hits gross margins.
Another common guessing game regarding the Surface revolved around tying Microsoft's falling margins to sales and units. Barclays analyst Raimo Lenschow noted that gross margins fell in the second quarter largely due to the Surface launch.
The fact that gross margin did not decline as much as anticipated implies that either the gross margin is higher than anticipated on Surface or the company did not sell as many units as expected by the street; we tend to believe it is the latter.
How does Lenschow know? Microsoft's inventory rose and it wasn't due to the Xbox, which is drawn down in the channel from the holiday shopping season.
Clearly Lenschow wants to make a Surface unit guess, but can't.
Our assumption is that unsold Surface units caused inventory in fact to rise from the prior quarter, again implying that the company may not have sold as many units as expected. We note, however, that build activity for the launch of Surface Pro could be having an impact here. While these are certainly assumptions, we are trying to make an educated guess as to the unit volume due to the lack of disclosure.