Satya Nadella’s next challenge: selling Surface

Satya Nadella has enjoyed a fairly smooth ride in his first 100 days as Microsoft CEO, but he risks hitting a rough patch next week when he unveils the latest models of the tepidly received Surface tablet.

Investors have lapped up Nadella’s “mobile first, cloud first” strategy to recast the venerable software maker as a “devices and services” company, sending its shares up 9% since he took the helm.

So far he has stressed the services side of the business, making the momentous move to put Microsoft’s Office suite on Apple’s iPad. This was popular with Wall Street and more importantly with consumers, who downloaded it 27 million times in a matter of weeks.

But Microsoft is expected to unveil the third generation of its Surface devices at an event next week, laying hints that it will also introduce a smaller tablet, to address the fast-selling lower end of the market dominated by Apple’s iPad mini, Amazon’s Kindle Fire, Google’s Nexus and Samsung’s Galaxy range.

The devices side of the strategy has been a challenge. Microsoft’s Surface, launched in October 2012, has about 2% of the market and has not made a dent on Apple’s iPad. That fits with Microsoft’s 3% global share in smartphones.

Given that tiny market, some investors believe Microsoft should not waste time and money on the low-margin hardware business. ValueAct Capital, which led the shareholder revolt last year which culminated in previous CEO Steve Ballmer’s retirement, has lobbied against Microsoft’s hardware effort, including its costly acquisition of Nokia’s handset business.

“Nadella is off to a golden start as CEO, although turning around the tablet and mobile business over the next 12 to 18 months remain his two key Herculean tasks,” said Daniel Ives, an analyst at FBR Capital Markets. “If the turbulence gets too rough on the tablet and/or mobile segment, we can potentially see some strategic changes on the horizon around the hardware business.”

Devices in the mix

Despite unspectacular sales, there are signs that Microsoft’s Surface Pro 2, which runs the full Windows operating system, is starting to attract Microsoft’s core business customers.

“There’s certainly tons of interest in the Surface Pro as an Ultrabook replacement that has tablet capabilities,” said J.P. Gownder, an analyst at tech research firm Forrester. “It is the No. 1 model I get asked about, it’s going to have a lot of eyes on it.”

Even if the Surface never dominates the market, Gownder thinks Nadella and Microsoft are right to persevere with hardware, if only as a way of showing other device makers how best to make use of Windows.

“Microsoft would be nuts not to have devices in the mix. The danger is in not exploring,” said Gownder. The Surface “is an important product to basically show what their overall vision is for Windows, and also to offer businesses and consumers another choice.”