iPad Air 2 vs. Surface Pro 3: Does Apple or Microsoft Need a Blockbuster Tablet More?

The latest quarterly reports from Microsoft (MSFT -4.42%) and Apple (AAPL -0.22%) revealed a surprising trend: Surface Pro 3 tablet sales were rising, while iPad sales were falling.

In a previous article, I discussed why that happened. The iPad's upgrade cycle was too long, improvements between generations were minor, and cheaper and more innovative tablets were hitting the market. The Surface Pro 3 gained ground by positioning itself as a hybrid enterprise device, which bridged the gap between old Windows PCs and tablets by supporting legacy software and hardware.

Source: Company websites.

In this article, I'll look at a what the iPad Air 2 and Surface Pro 3 respectively mean for Apple and Microsoft's businesses, and if either company actually needs a hit tablet.

What the iPad means to Apple
According to IDC, Apple controlled 22.8% of the world's tablet market in the third quarter, down from 29.2% a year ago. Samsung claimed 18.3% of the market, down from 19.3% last year.

Yet it doesn't really matter if the new iPad Air 2 and iPad mini 3 bomb and sales keep falling. That's because even though iPad sales are down significantly, companywide revenue bounced back strongly in the fiscal fourth quarter, diminishing the weight of iPad sales on Apple's top line:

Source: Apple quarterly reports..

That's why Apple investors shouldn't fret about lost iPad sales. Instead, they should focus on the tremendous success of the iPhone 6 and 6 Plus, which helped iPhone revenue surge 20% to $23.7 billion in the recent quarter, and strong demand for its Mac products, which also posted 20% sales growth to $5.6 billion.

The iPad won't fade away anytime soon, but Apple is clearly setting it on the same path as the iPod with new colors, slimmer models, and incremental upgrades. This means iPads could eventually decline into a niche market before being integrated into Apple's other businesses. Larger iPads, for example, could likely be marketed alongside Macs, while the iPad mini would join phablets such as the iPhone 6 Plus.

Is the iPad headed the way of the iPod? Source: Apple.

Another key point is that iPads, like all Apple products, are sold at high margins. An IHS teardown of the iPad Air 2 revealed that the $499 16GB Wi-Fi model only costs $275 to make. Margins are even higher with the $929 128GB Wi-Fi/Cellular model, which only costs $358 to manufacture. Therefore, Apple will likely sell new iPads as long as people buy them, without worrying too much about market share declines.

What the Surface means to Microsoft
Microsoft's Surface got off to a clumsy start in October 2012, but it regained its footing after the company focused on winning over business users and students instead of the consumer market. When users realized that it made more sense to compare a Surface Pro 3 to an Ultrabook instead of an iPad, the Surface Pro 3's price tag of $799 to $1,949 didn't seem too high. It's still a niche device, although the market share of Windows tablets notably rose from 1% in 2012 to 2% in 2013 on the back of Surface sales, according to Gartner.

Although Surface revenue more than doubled year-over-year and sequentially to $908 million, that still represents less than 4% of Microsoft's first-quarter revenue of $23.2 billion -- an unimpressive figure considering that the company racked up nearly $2 billion in losses over the past two years trying to make the device a hit.

The Surface also has much lower margins than Apple's iPads. Based on Microsoft's past SEC filings, Computerworld estimated that the Surface line has an average gross margin of 13.4%, which is roughly "half or a third of the margins on tablets." This means that if Surface sales slip and Microsoft slashes prices again to prop them up, its bottom line will suffer.

In my opinion, Microsoft shouldn't save the Surface if demand declines. It has already served its purpose of inspiring Windows PC makers to develop more innovative convertible devices, which fuels growth of Windows OEM revenue. Instead, Microsoft should consider licensing the Surface brand to partners such as Hewlett-Packard, and let them manufacture the hardware instead.

The road ahead
Looking ahead, Gartner expects tablet sales to fall 11% year over year in 2014, sharply down from 55% growth in 2013. Yet shipments of "ultramobile premium" devices are expected to rise 78% by the end of the year, which would be a boon to the MacBook Air and the Surface Pro 3. Meanwhile, sales of iPads and low-end Windows tablets will likely decline.

As a result, neither Apple nor Microsoft probably care about launching a "hit tablet" in the coming year. Therefore, Apple investors should focus on iPhone and Mac sales, while Microsoft investors should see if the Surface inspires more Windows PC makers to approach the enterprise market with similar hybrid devices.