Why Microsoft Should Kill the Surface Tablet

Microsoft (MSFT +1.50%) is widely expected to release new versions of its Surface tablets during a press conference in New York on May 20. Microsoft has launched four versions of the Surface so far -- the Surface RT and Surface Pro, which launched in October 2012, and their respective successors, the Surface 2 and Surface Pro 2, which were released a year later.

None of those devices helped Microsoft make a dent in the saturated tablet market dominated by Google (GOOG 1.56%)(GOOGL 1.67%) and Apple (AAPL +0.33%). At the end of 2013, Windows tablets only accounted for 2.1% of global tablet sales, compared to Google and Apple's respective market shares of 61.9% and 36%, according to Gartner.

The Surface family. Source: Microsoft.

Last quarter, Microsoft reported that the Surface had generated revenue of $1.8 billion over the past nine months, but the cost of revenue was $2.1 billion -- resulting in a loss of roughly $300 million. Microsoft attributed those losses to "a higher number of units sold," meaning that the more Surfaces it sells, the more money it loses.

Here come two new Surfaces
Two new Surfaces are expected on May 20 -- an 8-inch Surface Mini, which replaces the larger RT devices, and a more powerful Surface Pro 3.

Bloomberg recently reported that the Surface Mini will be powered by a Qualcomm processor, as opposed to the Nvidia chipsets previously installed in the Surface RT and Surface 2. The 8-inch Mini will be smaller than other Surfaces, which use 10.6-inch displays, and roughly the same size as the iPad Mini.

The Surface Pro 3 is expected to be slimmer than the Surface Pro 2, and could possibly be powered by Intel's new Skylake CPU. There has also been speculation that the Surface Pro 3 could be larger than expected, with a 12 to 13-inch display to compete against mainstream laptops.

One's a mobile device, the other's not
If those specs are accurate, they would clearly distinguish the Surface Mini as a mobile device and the Surface Pro 3 as a productivity device.

Microsoft's Surface RT was powered by an ARM processor and ran on Windows RT, the mobile variant of Windows 8, which could only run Windows Store apps. That meant that it wasn't backwards compatible with software for older versions of Windows or Windows 8. Microsoft's Surface Pro, on the other hand, came installed with Windows 8 and was compatible with older software.

The Windows store. Source: Microsoft.

But the problem was that both Surfaces mirrored the exact same problem that plagued Windows RT and Windows 8 -- they were incomplete as tablets, and confusing as laptops. Therefore, many customers decided to buy an iPad instead of a Surface RT, or a comparable laptop instead of the Surface Pro.

Not much bang for your buck
The Surface 2 and Surface Pro 2 failed to address those core problems last year. Instead, Microsoft simply upgraded the hardware in both tablets and renamed them. More importantly, the Surface didn't give customers much bang for their buck when compared to comparable products from Apple and Lenovo (LNVGY 1.78%).

Source: Company websites.

For just $50 more than a Surface 2, customers could buy the lighter iPad Air, which only weighs 1.05 pounds compared to the 1.49-pound Surface 2. Granted, the Surface 2 offers double the storage space of the iPad Air, but the Surface 2 lacks the iPad's undeniable brand appeal.

The Surface Pro 2 also wasn't priced competitively against Lenovo's IdeaPad Yoga 2 Pro or Apple's MacBook Air. With the touch or type covers included in the final purchase, the Surface Pro 2 cost more than both competitors. For a lower price, the IdeaPad Yoga 2 offered a larger 13.3-inch screen with a traditional keyboard. Meanwhile, the MacBook Air actually weighed less than the Surface Pro 2 when either keyboard cover was attached.

An 11-inch Macbook Air weighs less than a Surface Pro 2 with a keyboard. Source: Apple.

Simply put, Microsoft offered no compelling reasons for customers to purchase the Surface 2 or Surface Pro 2 over competing products.

Slim margins, market cannibalization
Microsoft's original plan with the Surface was to inspire its Wintel allies to make better Windows 8 machines while shifting toward a higher-margin first-party hardware business model like Apple.

Teardown costs from IHS backed up that idea -- the Surface RT (without the Type Cover) cost $284 to manufacture and launched at $499. Unfortunately, those dreams of hefty profit margins were dashed after sluggish demand forced Microsoft to slash the price to $350 last August. It also reduced the price of the Surface Pro by $100. As a result, discounts and marketing costs turned the Surface into another low-margin product like the Xbox. Today, for every $100 in revenues that the Surface generates, it spends $109.

Microsoft is also foolishly battling its key allies for a fragment of the tiny Windows tablet market. Microsoft's 2.1% share of the tablet market in 2013 represents a 198% increase the previous year, but according to Gartner, much of that growth was actually attributed to Lenovo's Yoga hybrids, and not the Surface.

Is it time to kill the Surface?
Considering that Microsoft loses more money than it makes on the Surface, and that it is cannibalizing the Windows tablet market, it makes much more sense to kill off the Surface instead of rolling out new models.

Unfortunately, Microsoft remains convinced that this artifact of Steve Ballmer's reign still has a fighting chance in the crowded tablet market.