Why Microsoft's Surface Pro 3 Sales Soared as Apple's iPad Sales Plunged

Apple (AAPL -1.59%) reported its fourth-quarter earnings on Oct. 20, impressing investors in all areas except for iPad sales. iPad shipments fell year over year for the third consecutive quarter, dropping 13% to 12.3 million units. iPad revenue ($5.3 billion) also came in lower than Mac revenue ($6.6 billion) for the first time in years.

Three days later, Microsoft (MSFT 0.48%) posted its first-quarter earnings, revealing that sales of its Surface tablets had more than doubled both year over year and sequentially, to $908 million. Microsoft attributed that surge in demand to "strong interest from students, professionals, and increasingly enterprises for Surface Pro 3."

Apple's iPad Air 2 (L) and Microsoft's Surface Pro 3 (R). Source: Company websites.

The decline of the iPad and the sudden rise of the Surface highlights an interesting divergence between the tablets and "laplets" markets. Let's look at what this market shift could mean for both companies in the long run.

Why the iPad is falling
Demand for the iPad is waning for three main reasons: a longer upgrade cycle, a lack of compelling new features, and its premium price tag.

iPhone sales are fairly predictable, thanks to two-year carrier contracts that end with an inevitable upgrade. The iPad, on the other hand, is upgraded in a manner similar to PCs, meaning it is only upgraded upon becoming outdated. Moreover, many customers are handing down their old iPads to family and friends before upgrading, which throttles sales of iPads to new customers.

On Oct. 16, Apple unveiled the new iPad Air 2 and iPad mini 3. While the iPad Air 2 was slimmer, lighter, and had better specs than its predecessor, the mini 3 has the same specs as its predecessor, with bigger storage options (up to 128GB) and a Touch ID sensor. This refresh, while expected, simply won't convince customers to ditch their old iPads. Moreover, the iPhone 6 Plus will probably cannibalize sales of the iPad mini 3.

That brings us to the third issue: the iPad's questionable ability to maintain its pricing power. Lenovo (LNVGY -2.32%), for example, recently unveiled the Yoga Tablet 2 Pro, an impressive 13.3-inch Android tablet with a built-in Pico projector, a subwoofer, and a 32GB hard drive, starting at $500. That's the same price as an entry-level iPad Air 2, which has a 9.7-inch screen and 16GB of storage. Granted, these two devices appeal to different types of customers, but it's not hard to see how the owner of an older iPad could be tempted by the Yoga Tablet 2 Pro. Meanwhile, low-end Android tablets are now so cheap that it's possible to buy two or three for the price of one new iPad.

Lenovo's . Source: Lenovo.

These three problems have caused the iPad's global market share to fall from 60% in the second quarter of 2012 to 27% in the second quarter of 2014, according to IDC.

Why the Surface is rising
Microsoft's Surface had a rough start when it hit the market in October 2012, but customers eventually realized the device was more of an ultrabook than a tablet. Microsoft also heavily marketed the Surface as a productivity device for students and professionals, rather than going head-to-head against the iPad as a consumer tablet.

Microsoft leveraged Windows' dominant market share of PCs to give businesses a smoother way to upgrade their older computers without abandoning legacy software or older network setups. With the docking station ($200), the Surface can be converted to a full desktop with a wired ethernet connection -- which can't be accomplished by first-party means on an iPad.

In September 2013, Delta Air Lines (DAL -1.61%) announced that it would equip 11,000 pilots with Surface tablets installed with paperless "electronic flight bags" with key charts, reference documents, and checklists. Hospitals, including Seattle Children's Hospital and the University of Pittsburgh Medical Center, have also deployed the Surface Pro 3 to help doctors seamlessly access electronic health records from the patient's bedside and their desks. Some retail stores have even installed the Surface in customer-facing kiosks that link to their sales database.

More importantly, the arrival of the Surface has convinced Microsoft's hardware allies (and competitors) to develop similar convertible devices targeting both regular and enterprise consumers. This helps Microsoft generate more revenue from industrywide Windows OEM licenses, which are far more important to its top line than Surface sales.

The tortoise and the hare
While many consumers like to compare the iPad and the Surface, investors should remember that the two devices are designed with two very different strategies in mind.

The iPad is focused on leapfrogging over legacy PCs and into the future. That's why it eschews the microSD card readers and USB ports that can be found on the Surface. The Surface is developed as a more practical transition between PCs and tablets, since it can fully replace traditional desktops and laptops without forcing businesses to sacrifice legacy software and hardware.

Therefore, Apple might have jumped too far ahead when it launched the iPad four years ago, which has now caused it to burn out and lose momentum. Meanwhile, Microsoft built the Surface with enterprise needs in mind, which is now helping it slowly, but steadily, gain market share.