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Amazon And Microsoft Are Desperate To Sell Mobile Devices, But Why?

This article is more than 9 years old.

Microsoft had a quarter that beat the consensus forecast while Amazon most certainly didn't. Yet both made headlines with reports about their mobile-device divisions. While those results seemingly paralleled the news for each company -- Microsoft touting a doubling of Surface revenues and record Lumia sales, Amazon taking a big writedown on the Fire Phone -- both had more in common than it might. Specifically, even if you total up Microsoft's $2.6 billion in phone sales and $900 million in Surface, that's barely more than 15% of total revenues and, in fact, drag on profits. While Amazon doesn't report its device sales, IDC has the company moving fewer than 1 million Kindle Fires last quarter and adding in the few phones the e-commerce giant did sell would still scarcely be noticeable amid its $20.6 billion revenue.

Both companies have serious challengers to their core franchises, competing most notably with Google on several fronts (Amazon in the cloud and for retail commerce; Microsoft with Office, in the cloud and in search). And neither can reasonably imagine a path to meaningful profits in mobile devices. Microsoft actually entered the space because current CEO Satya Nadella's predecessor Steve Ballmer believed that the extra margins from hardware -- call it Apple envy -- were worth pursuing. Ballmer is now an NBA owner; Nadella need not be bound by his decision. Amazon's Jeff Bezos famously claims those very margins are his "opportunity," as if to say he'll slice them to ribbons, hurting you and winning in the process.

In the meantime, however, both are managing to lose money from their increasingly quixotic endeavors to establish what amount to "third platforms" in phones and tablets, fighting for developer support as well as mindshare. And whatever strategic goals might be at stake seem better served by getting their stuff on the platforms people actually do use rather than the ones the two Seattle giants wish you were using. Let's break down their deficiencies.

Surface and Lumia: Thin veneers

Dig beneath those headlines about $908 million in Surface sales and there appears to be little to get excited about. While the number is up smartly from last year's $400 million, and Microsoft claimed the business generated a small amount of positive gross margin, it's still both losing money overall and having minimal impact in grabbing share. Surface Pro 3 -- which accounted for the lion's share of sales -- runs the gamut from $799 to north of $2000. It's nearly impossible to conceive of any scenario, therefore, under which Microsoft sold even 1 million units. With the giant product-placement fees the company pays, not to mention the $80 million per year it gives the NFL, combined with traditional marketing, it's spending more convincing people to buy Surface than it's earning from selling it.

Jan Dawson of Jackdaw Research figures gross margin was 9% or less than $100 million overall. That might sound like something, but keep in mind that Apple's gross margin is four times higher and that Surface has sustained losses of $1.7 billion so far -- according to SEC filings. Given that the most recent quarter has certainly deepened that hole a bit more, one has to ask what the endgame is. Though IDC doesn't consider the Surface a PC (don't ask why, just accept that it doesn't), it does have worldwide PC sales at 78 million for the most recent quarter. This means that despite the herculean marketing spend, Microsoft is selling what amount to fewer than 1 in 100 computers. If you prefer, IDC considers Surface a tablet, where Surface would have about a 1.5% share of the approximately 50 million sold.

What is the strategic value of being in a money losing business where you have a less than 2% share? I'd argue there isn't one that's conceivable. For all the merits of Surface Pro 3, there's a robust world of PC innovation out there and it's likely to only get better. You have an HP set to spinoff from its enterprise division, a private Dell able to take chances freed from Wall Street and an aggressive Lenovo all seeking share. Nothing Microsoft is doing with its minimal presence is going to meaningfully alter how many PCs are sold, what happens to Windows or really much of anything. But the constant obsession with Surface will distract the company from more important tasks, like focusing on Office and its Azure cloud offerings.

That said, Surface is certainly less of a distraction than its shockingly pointless phone division, which it seems oddly obsessed with as well. Yes, the headline number looks great: A record 9.3 million Lumias sold and $2.6 billion in sales. Now, let's see just how dreadful the quarter really was. Last year, Lumia managed 8.8 million sold, which means this year's result was up a paltry 5.6%. Contrast that with Apple's 20% increase in iPhones and it doesn't look so good, right? But it gets worse. Of the $2.6 billion, Microsoft earned most of the money from selling 43 million "featurephones," i.e. non-smartphones. The last clean number we got from Nokia on those phones had them selling for 27 euro, or about $37 (at the then-current exchange rate). Roughly, that means they account for $1.6 billion of Microsoft's phone sales.

That leaves just a shade over $1 billion for the Lumias, or perhaps under $110 apiece. It was around $195 a year ago, which already wasn't exactly the high end of the market. Now, however, it's the bargain basement. While Microsoft (and Nokia before it) has managed to achieve some decent results and really build some lovely products with Lumia, it hasn't attracted many of the kind of customers the company is actually seeking. At least with Surface, it can argue the few buyers are "Microsoft types" -- higher-end, corporate customers with strong spend. With Lumia, it's getting mostly cheapskates looking for a bargain-basement phone. Oh, and it seems fairly clear the $478 million in reported phone gross margins turn to red ink once marketing and other costs are included.

Basically, Nadella has two small anchors attached to the S.S. Microsoft and he can't seem to decide what to do with them. One, the aptly named Surface, bobs up and down periodically, making it look like there is something there. But it's still dragging behind the boat, not achieving much other than making TV networks squeal with delight. The other is Ballmer's folly. If Nadella really wanted to show his boldness, he'd just cut them both loose at once. Microsoft, he claims is "mobile first, cloud first" but when he recently clarified what that meant, nothing about Microsoft's own devices was at the fore: "Devices and device sizes will come and go... It's more about the mobility. In fact, if there's anything central to our vision, it's don't think of the device at the center, think of the individual, the people at the center."

Perhaps Bezos ought to listen.

Amazon's Fire has gone out

More than anything, what Amazon's decision to make tablets has done is make an enemy of Apple. What it hasn't done is make much of an impact on the tablet market. The Kindle Fire line appears to have hit its high-water mark back in 2012, when it reached 5.9 million sold in the holiday quarter. As with Apple's iPad, sales have been falling but Amazon's edged down sooner and no longer register in the global top 5, failing to reach 1 million in the second quarter of 2014, according to IDC.

The company admits the tablets aren't money makers but decided nevertheless to double down and enter the much more competitive phone market with the Fire Phone. Leaving aside the issue of AT&T exclusivity, the phone gives nearly no one a reason to purchase it and this space was skeptical from the beginning. Unsurprisingly, buyers have passed in droves. With investors beginning to grow weary of Amazon's continuing lack of profitability, the $170 million loss there stings.

But even the tablets may need to prove more than a quaint distraction if they're to remain around for much longer. Apple is now pressuring Amazon more aggressively with the $249 iPad Mini. While Amazon still has a distinct price advantage with tablets starting at $99, it doesn't have the seamless ecosystem crossover than iPhone users get when choosing an iPad. And given how heavily Amazon's sales are weighted toward the holiday quarter, it's less clear that pricing advantage will be potent enough given Apple's 16 different price points and 56 different iPad selections.

Again, though, the most salient issue centers on focus, of which Amazon has little. It runs a giant e-commerce business with scores of distribution facilities and sorting centers that is without peer. That segment generates significant cash flows and can continue to grow indefinitely as Amazon still controls little of U.S. commerce. Similarly, it's cloud offering, Amazon Web Services, is a dominant player, with more than a billion in quarterly revenue and near 40% growth. These strong units are used to fund a Netflix competitor, Amazon Prime Instant Video, which is a loss leader used to convince people to sign up for unlimited 2-day free shipping; a breakeven-at-best tablet business, which ostensibly encourages customers to shop with Amazon more; and a so-far pointless foray into smartphones.

Ben Thompson at Stratechery wonders why Amazon doesn't just spend more marketing Prime rather than take these convoluted paths to encourage people to shop with Amazon. I asked a different question here in Februrary when Amazon decided to make Prime more expensive: Why mess with something that hooks people on Amazon and gets them addicted to shopping with it?

In the meantime, Google has slowly but surely begun to disrupt Amazon's e-commerce moat with Google Shopping Express. To respond, Amazon is turning to the Post Office to assist in its nascent grocery delivery business. That's sound tactics as the threat from Google and the smaller Instacart is both real and growing. In the meantime, however, Amazon is finding shareholders suddenly restless with its endless long game. The company acknowledged the grumbling for a change when CFO Thomas Szkutak said: "There is still lots of opportunity in front of us, but we know we have to be very selective about the opportunities we pursue."

It might want to start by admitting the phone business isn't worth being in. And then perhaps it can find a way to reach a detente with Apple so it can cut down its enemies list.

Cloudy with a chance of profits

Both Microsoft and Amazon have big opportunities in the cloud even as the barbarians mass around them. For a long while, I believed that if someone could crack the Office monopoly Microsoft would suffer. Now, it seems inevitable that Windows itself will slowly decline, but I'm less sure that Office will die so quickly thanks to the subscription version, Office 365. Amazon, on the other hand, has much e-commerce growth for the taking so long as it focuses on continuing to delight customers with well-priced cardboard boxes showing up at doorsteps.

Neither company needs to sell a single phone or tablet to fulfill its vision. The obsession for both is a product of a special kind of megalomania that haunted Microsoft under Ballmer and nearly derailed Amazon early on when it foolishly believed it could take on eBay in auctions because, well, it was Amazon. Right now, the markets are smiling on Nadella for not being Ballmer and are annoyed with Bezos for being Bezos. Perhaps both could take a lesson from the company whose success in devices led to each pursuing these profitless endeavors in the first place. There's a thousand no's for every yes.

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