Scratch the Surface: Microsoft Should Exit Hardware

NEW YORK (TheStreet) -- A couple of weeks ago, I asked, "Where's Microsoft Going?"

It was a rhetorical question, one that I've been pondering for quite some time. Although I've always liked this company and have come to its defense on more than one occasion, I don't believe that management has taken the sort of risks necessary to grow Microsoft ( MSFT) beyond its core businesses.

Though Microsoft has struggled to compete with Apple ( AAPL) and Google ( GOOG) as the importance of mobile devices grows, the bull case for Microsoft has always been the company's strong cash flow, which has been spurred by its Windows and Office franchises.

But given the dire state of the PC industry, which has been in perpetual decline, Microsoft now appears to be constantly "in transition." This now seems to be the popular excuse for the company's weak recent results, including its recent miss in its GAAP gross margin, which declined by five points in the fourth quarter.

Missed estimates is one thing, but I can't overstate enough the magnitude of this new reality. Nor can I ignore the company's slashing of prices of its failed Surface tablets in hopes of increasing higher adoption. Unfortunately, the strategy, which has come at the expense of better margins, is not working. And now Microsoft is running out of options.

Let's recall, it's been only a couple of weeks since the company announced that the price of its Surface RT tablet, which has been a failure by many standards, was going to be trimmed 30% from a price of $499 to $349. Raise your hand if you didn't see that coming. How Microsoft felt that it could go toe-to-toe with Apple by putting Surface at a price point where the iPad is dominating, is still a mystery to me.

Although Surface has decent features and a real nice ad campaign, retailers were struggling to sell the product. Looking to incentivize shoppers, Microsoft then responded by offering a free keyboard cover. But that didn't work either. So you didn't need a crystal ball to see that last month's price cut was the logical next step.

So it also came as no surprise Sunday when the software giant went back to the cutting board -- this time slashing the price of the its Surface Pro tablet by $100 from $899 to $799. Here again, I don't believe that this will be enough to get shoppers to switch, especially since at $799, there are comparable laptops/hybrids that come as compelling alternatives for much less. And even if someone insisted on a tablet, both Google's Nexus tablet and Apple's iPad still come off as more cost-effective.

There is a lot of speculation as to why Microsoft has begun to reduce its prices. The most popular idea is that the company is gearing up to launch its new generation of Surface tablets, which are rumored to run on Intel's ( INTC) new Haswell processors. I have two issues with that. First, I don't believe that anyone is going to care about a new Surface tablet. The Street never bought into the hype with the current iteration. And for that matter, and perhaps more importantly, consumers never bought it either.

Second, Microsoft's management, in particular CEO Steve Ballmer, has never been able to effectively answer, "What's next?" As noted, the company brings in tons of cash. But the company's track record does not show that Microsoft knows how to effectively deploy that cash to grow. A perfect example is that the company was forced to eat $900 million on the Surface RT due to unsold inventory.

If that doesn't raise an eyebrow, consider that the entire Surface business only generated $853 million in revenue for Microsoft, essentially 5% less than $900 million writedown. If that is not an example of cash-flow mismanagement, I don't know what is.

And the idea that the company insists on prolonging its hardware futility with another iteration of Surface is beyond comprehension. Management can now say that it has "dabbled" in hardware. We've seen the results. It hasn't worked. It won't work. And now it's time to kill it.

At the time of publication, the author held shares of AAPL.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a co-founder of StockSaints.com where he serves as CEO and editor-in-chief. After 20 years in the IT industry, including 5 years as a high school computer teacher, Saintvilus decided his second act would be as a stock analyst - bringing logic from an investor's point of view. His goal is to remove the complicated aspect of investing and present it to readers in a way that makes sense.

His background in engineering has provided him with strong analytical skills. That, along with 15 years of trading and investing, has given him the tools needed to assess equities and appraise value. Richard is a Warren Buffett disciple who bases investment decisions on the quality of a company's management, growth aspects, return on equity, and price-to-earnings ratio.

His work has been featured on CNBC, Yahoo! Finance, MSN Money, Forbes, Motley Fool and numerous other outlets.

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