FW: Surface sales physics after a week

We're at a point where we have enough data about the velocity and potential velocity for Surface sales to need to make a change. We're really in a very tough spot and I feel like we're on the verge of an unrecoverable situation. This is really just about the physics of how much we can sell through our store presence and online, and the number of units we have and will have. We are going to be sitting a very large inventory very soon and there's no real potential to have sales keep up with inventory growth unless we stop manufacturing, and the implications of that are significant. This is decidedly not a statement of our stores and popups. The traffic is crazy. We are holding steady in terms of traffic and at the limits of sales execution per square foot given traffic, associates, and time with customers (all assuming traffic holds). Here is the San Fran store this morning at an opening:

The only major learning is that we're not selling the units through online that we expected—the physics were such that we had to sell upwards of 70% of the units through online to make the overall sales match inventory/production and we're not even close. While we've had significant problems with the merchandising and selling motion on the site (and fulfillment) and this is likely to taint sales at least in UK and Germany given the breadth or reporting of these issues.

But the core learning and challenge is really that people want to touch Surface—does it type, how does it feel, etc.. Even when available, our experience centers are suffering from a low conversion rate because of frustration that you can't give us money and receive a unit right then and there. So all we can do is look for ways to get the product into people's hands when they can conduct a transaction and receive a PC right away.

The solution is to broaden our retail footprint as fast as possible outside the US, and to extend our retail presence in the US. These are two different choices. Outside the US is much like China and that we just decide to work with partners or not if we want to sell the PCs. Inside the US there are deeper implications. So these are separate choices.

In all cases, we have a plan we can execute on starting Monday that will have a footprint on 12/1 in store and expanding the footprint from a merchandising perspective through the boxing day and sales selling season. It is obviously less than a black Friday presence but it is too late for that. We know retailers are anxious and willing.

My suggestion is to rapidly move on this starting Monday—putting people on planes to make deals. There's not a lot of data beyond the selling data that we can gather. It is about faith we can do something credible. We have structures to maintain margin and pricing, accessory attach, and so on. We will not undermine the pricing and value proposition to land this.

If we don't want to do this right away then we are going to need to do something about production as we will reach an inventory level that cannot be sold through in 2013. I would recommend we stop production and reconsider GTX (which we believe is likely to be low volume at this point).

After reading this if you have any other ideas we should consider them now. We have literally spent the entire week looking at velocity and I really don't see another path.

From my view, this is conservative because it does not add aggressive online distribution which would move units— Amazon and pure play tech online.

Let's look at the specifics of what we want to start on.

Approach:

We will start to engage retailers in each of our current markets starting next week. Each region with a slightly different purpose. The negotiation theme is the same for each- in order to get the best margin possible, we will only offer exclusives to key retailers (list below). We will have walk away points for each retailer and will do so if we can't strike the right deal in margin, placement, and volume (the deal would include a minimum commitment of volume that they own so we don't put a bunch of inventory out there we have to take returns on). We push to hold our margins as best as possible, yet still get assorted (much like the Suning deal we struck).

Background:

The feedback that people believe this is a great product and the desire to touch and feel our device is cool to see. There are many questions about whether the touch cover really works and for a device that people want to carry around with them, understanding the feel of Surface in their hands is very important. Surface is also at a price point where most customers (with the exception of a small group of tech trendsetters) will want to be sure they want this product before they purchase it. We are seeing that today in that all of our Stores are FULL daily with folks that want to see and play with Surface before they purchase. And we're basically selling as fast as we can in the store without sacrificing the whole store experience.

Chart- If we take our current per week sales numbers and assume an increase of 10% growth each week, we would sell about 260K units between now and Jan 1. (These averages remove the peaks of preorder and launch date as well as Black Friday, but have a consistent growth each week). That leaves an inventory of —1 M units (about $500M plus accessories). It is difficult to model the increase in online—there's a network effect of sorts so 10% a week as a linear growth is likely not the right model for online as there might be a steeper curve that kicks in later.

Based on our manufacturing rate against the current throughput from the stores and online, we believe we will have about 1M units in inventory at the end of the calendar year. While we have opened commercial orders, these will likely take some time before getting to significant volume and that model still must be proven out as we walk a delicate balance with OEMs and manage through an enterprise sales cycle of evaluation, requirements, etc.

The approach is to go to EMEA retailers in the next week, this will enable us to get into stores by 12/1and still affect the majority of the holiday shopping season. In addition, a meeting with retailers now would help position us more positively when the RSPs are talking to consumers (obviously right now this is fairly ugly as the basic answer from an RSP is "the product is so bad we don't even stock it"). Optimistically, They can then tell customers to come back on 12/1to buy it, rather than it's not a good product. Over time as our reputation grows among broad consumers and more and more have experience with Surface that they talk about, we hope online will also continue to pick up.

Who on the retail team worked this up

Sent from my Windows Phone

Daryl, Vince, and Jeremy and their managers as far as I know. Tons of meetings this week. They are anxious to go.

This is a huge decision with ramifications on consumers, retailers and oem's Our OEM's would certainly be upset given their expectations The timing does not allow care I think we need a discussion with you KT, me, tami, and chriscap at min to walk through I do not want to make a mistake on this the downsize seems large compared to short term upside What margin are we thinking for the retailers on the various sku's that was never really worked through to the best of my knowledge thanks for pushing

I am in Europe all week It will be tough but perhaps we can do a phone call with all relevant parties. I cannot say yes based on what I know I did call KT on Saturday afternoon and this plan was news to him too

What do you want to learn? What other data can we provide?

Surface is about to catastrophically fail in a very public way. We don't know how to explain selling 1/10th the number of devices as the lowest end of the lowest expectation. Word will get out very soon. There is no long term without this.

We all agree we need to expand distribution How and when have not been discussed amongst the three of us is chris cap looped in

Jeremy Dale has been involved but I don't know what he has communicated. We are trying to keep this low until we decide given the sensitivities.

Vince Messina on our team is doing the primary driving as he did the Sunning deal in China. Since he does all the hardware assortment already, he worked closely with CCG who supported his lead.

This is a complete surprise to me.... I had always planned on us bringing Surface to mass retail in the first quarter of 2013 and this is something that requires us to really carefully think through.

Let's take a step back. The intent was not to surprise, but to act on where we are. I think we're all surprised. I'm surprised at where we are in volumes, and honestly I don't think anyone feels we have "plans" to broaden distribution in January. So let's just assume we all have a bit of surprise and see what we can do to manage what I think is a drastic situation we find ourselves. There's nothing intended other than to get us to a better spot and certainly this is not about the efforts going on everywhere to amplify what is going on in our own stores—we've all spent considerable energy personally and the efforts of those working in the stores are historic.

We can disagree on how Surface will be labeled. Here's the data I am working with. Wall Street analysts have come up with estimates as low as 1 million units and on average in 3.5 million units for 2012. These are not made up. It is clear these are based on sourcing from component providers (likely nvidia but others as well). In other words, it will be pure "spin" to say we are hitting our own targets because in fact we have made about 1.2-1.5 million units this year (the 1.2 number is based on delivery before holiday, so add one more week of production). In addition, we are up against the confusion that got put in place over whether we are committed to Surface or it is a boutique product designed to "push OEMs". Since we will certainly not announce a number, it is likely everyone will conclude whatever we did (and whatever we say) are not meeting even our own expectations. We will be in a spiral very quickly. I've personally talked to several of the analysts who write the reports you send around and I am certain they will look at a lack of a number as a negative and if estimates start to surface (pun intended) that approach reality (250K) we will be in real trouble—that is 1/4th the lowest estimate and not the consensus estimate of 3M. The whole project will be labeled "Zune" and this will be a broad failure. The impact this has on sales in 2013 will be significant just as we saw with Zune—the partners won't carry it, the margins will erode, and pretty soon we'll be in RIM Playbook territory. We need to keep in mind how the Apple favored press will amplify these low numbers and in addition how the OEMs will use this as well. I really struggle with how we can make it through this. The story is out there written just waiting to be told.

Of course we are just comparing our own views of how this can play out in the landscape. If we want to be optimistic we can be. But I don't know how 250K units will meet any views we currently have. But for the purposes of this we can assume the most optimistic scenario. That's because there are real financials and sales velocity we can rely on rather than just predictions about the press.

There are no doubts about the velocity we are selling at—the sales per square foot. We need to have 4x the current sell-thru to be at a steady state. On current path we are going to be sitting on 1M Units of inventory. It is unclear under what plan we can ever burn through these. We can say we planned wrong, but we knew how many we could make and, frankly, we just went in optimistic over how much we could move online. We are currently moving about 28% of units as online. We need to be doing 70% online. But at the same time we more than double our online units we need to

increase our total units. It means our online units need to go up by about 8x. It does not seem like that has any chance of happening.

The actions proposed are all excellent. I don't think one could disagree with them. But math says it won't be enough:

1. Take Surface NOW to other retailers in China. Gome, Mall Stores, etc. {Suning has a much larger footprint already so this won't double the runrate}

2. Extend our Holiday stores NOW for next calendar year. {The math on this will be positive, but this all is next calendar year and will not change the velocity we are seeing so this doesn't add to the unit runrate}

3. Start on a plan now to properly take Surface to mass retail in Jan/Feb with the Pro launch,. (We agree we have to plan now. I am suggesting that as we plan this we will find an appetite and capability to do more sooner}

4. Strategize how we tell our OEM's on our plan to take Surface to mass Retail, then we must properly tell the OEM's. {We have to do this no matter what if we follow your recommendation 3.}

5. Accelerate our physical Stores in the US and open physical and pop up stores in the Canada, UK, Australia and China in 2013. (This is a small marginal increase in volume}

We're missing what we would do in Europe, Asia, Pacific. Online and experience centers are not working to move units. With the fulfillment challenges we have had it is not clear we can recover from that—there's a good chance we have a significant SAT issue that will remain for quite some time.

Your issues raised are all real. Let me try to talk about them a bit in terms of the categories of issues:

• OEMs. We are in a tough spot as we operationalize things internally in that when there are differing views one or more folks hold up the possibility of upsetting OEMs. But we're not consistent in what we do or how we do things, so this isn't really something we can model or operationalize. From the outset we've been in a tough spot. When we priced Surface at $499 we sided with "our own" interests. When we included Office we upset the x86 side of things. And so on. I think we can agree, that selling now or later will have the same impact on the dialog. One could argue that OEMs are stocked out for holidays and that there are no tablets or touch screens at volume so we're really not taking "money" as you put it. I'm just pointing out that this is not so cut and dry.

• Retail execution. I've attached a very significant drill down on how this could work. The team that executing on Suning has put this together. It is essentially the deck we would go to Retailers with. It has margin details and an overall approach. We can doubt the ability of the team to execute, but they believe that they can deliver. We will never execute this as well as our stores. We have all done shopping this past week (I went to Northgate and Southcenter) so I'm assuming we all had the same experience of 8 out of 10 PCs "dead", no networking, and poorly trained retailers (I listened to a retailer completely fabricate a Windows 8 phone scenario). It looks really bad for Surface, but frankly unless our plan is store within a store I am not sure what we can ever hope to expect. Yes that makes me sad and is why we bet on our retail.

• SKUS, Online inventory and merchandising. We made a call to price at $499. Given that we can't secure attach very well online we limited this to 10% of the runrate, which is driving the stock out. This was going to have the implications we expected. The color choice was a known tradeoff because we did not want to sell unbundled for margin, value prop, and competitive reasons. While we know enough now on color mix and attach, any change in this (like adding green) will make the complexity of this significant. We've seen the impact of stock out on the blue cover.

We know the demand for coverless 64GB as well. Our margin structure is based on 110% attach. Less than that is problematic. All of this was known in the move to $499 coverless. The retail model we have in place focuses on attach, but is a risky margin proposition and stock out of colors can be a real issue.

• Enterprise. I'm excited to open this up. It is tough to see this as a material impact to the overall model.

• Product quality. I think this is a red herring. We've seen nothing at all to indicate product quality issues. Even twitter is silent on quality issues. The tone of product reviews started off positive and is increasing. The 8% number doesn't match the data we have but even then is close to the modeled number at 6%. Regardless, I don't know what we would do other than merchandising and scripts to change this since the product is what it is.

• Supply chain. I think we've worked this out and know how to scale.

• USA retail. I will defer. In many ways this is the least of our challenges given our footprint in the US. I have a hard time thinking WMT would stock us effectively given the low priced tablets they sell currently.

I'm not trying to be flip and not pay due to these issues. What I want to say is that all of them are being worked on. I think we have three courses of action:

• Plan starting now on how we expand for January. We can call this plan of record. I am not so sure it was. In any event let's do that now. It still involves folks getting rolling now. So we need to get them going.

• With those dialogs happening we can see what we can execute in Europe, Aus now. This is where we have no "see and buy" presence and we can definitely get something going—at least folks think so. We should allow them to have the dialog.

• Decide on a US plan. This seems a separate choice given the footprint we have here.

There is a fourth action which is we essentially do nothing now. I don't think anyone is recommending that.

Arguably there is an option where we just do way more marketing outreach to hope that is a substitute for physically touching the device for Holiday.

What concerns me is that we're not having a dialog about the material issue. 1M units/$500M in inventory on 1/1 is a major problem and that grows by 250K units per week. There are only two ways to fix this. We sell more between now and 1/1 or we stop the manufacturing line. If we stop the line it is a crazy high cost since startup is high. This is just manufacturing management. Even slowing it down means letting workers go. If we don't sell more we're going to need a new building to hold all the inventory. This is the real issue. Everything else feels like tactical issues to address relative to either selling more or making less.

I feel like under any circumstances we should unblock people from going to retailers and having the dialog about January. You indicate we need time to plan this and so we need to start. We can let them do this over the week and

based on what we hear we can decide to do more. Absent that, our only option is to reduce manufacturing. I don't see it as feasible to inventory 1M units. And then we'll see how we can manage Wall St expectations.

Related to this is the notion of "Pro in January". I think we should temper expectations. This product is a niche product. It is $1000 and is not "the best tablet and the best laptop". It is a convertible with compromises. It runs x86 software but it does so at a size, weight, and battery life that will not please when compared to the world of 7" tablets. It is a small ultrabook (in 2 of 3 dimensions and weight). It is an ideal PC for a Windows 8 developer or for ruggedized industrial uses. It is not the ideal student PC (battery life) or knowledge worker PC (battery life, weight). It is incredibly nice. But it is not a blockbuster. Our chips are on Surface RT.

I know everything about Surface has been thoughtful. This is just as thoughtful. I've attached the retail deck. This is real work that has been going on for months. The roadshow is what we present to retailers based on the Suning work. Slide 23 has the retailer margin. Slide 26 starts with the gives/gets. Slide 29 has the instore efforts on 12/1. Slide 39 is the RSP strategy.

The GM looks like this:

Open

Max

Suning

32gb Standalone
0%
0%
0%

32gb Bundle
1%
4%
4%

64gb Bundle*

3%?
6%?
6%
Covers
20%
25%
25%
Accessories
20%
25%
25%

The following outlines the negotiation scenario financially:

Does this propose these retailers are exclusive for 2-3 years. Who will make the calls on the partners. Both questions are valid whenever we proceed

What do you want to do? Just tell me how to unblock.

I just went through the math again and the cost of shutting down production is off the scale. And the ability to sell thru what we are making just can't happen if we don't act now. There's a really big financial issue. Even opening the door now doesn't escape the sell thru math but gives us a shot.

lets get folks talking today. We did suning from nothing to a unit run rate equivalent to the us stores in 3 week. We can do something in EC and Oz at least.

The handling with the retailers and oem's is challenging. what time commitment from Chris, you Steven, kt, and me is required and when. This will take selling is there a proposal or was the ppt for china alne

The ppt is customized by retailer with the regional account managers in ccg.

The folks who work for Chris are there for delivery and were part of making the decks. They were ready for this. This isn't the Surface team flying solo.

I don't see why the oem relationship is more challenging now than janaury. I get the emotion but that is already there. As a practical matter it isn't a legitimate concern and doesn't change in January.

If we want to sell units this year they need to start now...using the 3week timeline we used for suning. That was in the first mail.

Otherwise they need to start now for a more elaborate plan for January.

But if we don't sell units this year we have to stop the line.

This is really just math.

Who should i put with questions about how this work.s kt, Chriscap, steveschueler or. Their repoerts

From my side, I remain uncomfortable with Dec 1 jam in outside China. But I am supportive of the unblock for a calendar Q1 approach to mass retail. I would pursue more distribution in China now and we must ensure Sunning is in the loop.

Nick would need to begin the work now on the oem talk track which we would all need to go through and role play. Chris, Stephen S., Jeremy, and Daryl would need to work with Vince on the retailer GTM and I can put cycles on this with them next week. As a reminder, this week in retail is slammed with Halo 4 launch.

I also believe we should do the remaining points i outlined below as well...

Just let me know how you want to proceed as I am in Saudi Arabia today but will do my best on mail.

They cannot do meetings until the plan is approved by me. Please let them know Steven. If I read the deck correctly they want to offer 2.3 year exclusives

But this is for January. Kevin previously indicated this was already the plan and given that we want to do a good job in January and there is only a little bit of more work time relative to 12/1 it seems like we are on a path not to have time to do what is viewed as a good job in January either.

So I was just going along with what he said was the plan for O1. I didn't even know about that was a plan as I had previously indicated--I just held them back from everything while we talked about doing something near term. Their view was to roll in the near term with the longer term as you saw in the deck.

Are you saying now that there was not a plan for Ca?

Jeremy Dale and Alan Bowman in CCG, along with Tami and I if this is about retail execution. Just Tami and I if this is about OEM relationships.

The group you say below has all been working -- that's the deck they have (which is the suning model).

If you want to meet with them then by all means please do -- set up a call or anything. The deck I sent you is the deck they would use except for the near term part of course. They will focus first on Europe and Oz.

They understand that they are going to meet with folks in order to land January. The timeline for this is equally tight since not much can happen in terms of planning in December (which is partially why they remained optimistic about landing for 12/1).

They are likely booking trips and ready to go is my guess.

MS wrote off 900M on inventory...this is a mail thread from November saying this will happen. Kevin Turner is the COO.

Even better--at the last minute this 900M was an increase over the "planned" write off. Classic "well it is bad news so let's bank some of it"....