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Why Microsoft Doesn’t Care That Apple Just Copied Surface

By Evan Niu, CFA - Sep 11, 2015 at 2:00PM

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You might intuitively think that Microsoft is annoyed that the iPad Pro is a bona fide Surface Pro clone. You'd be wrong.

Microsoft demonstrated the newest versions of Office for iOS at Apple's event. Image source: Apple.

In no uncertain terms, Apple's (AAPL 0.93%) new iPad Pro is a clone of Microsoft's (MSFT 1.20%) Surface Pro in a lot of ways. Both devices start at $799 and have available stylus and keyboard cover accessories that can be purchased to increase functionality. Given the blatant copy of its first-party tablet, you might think that Microsoft would be a little annoyed at the situation.

Quite the contrary, Microsoft seems downright excited about the iPad Pro. The software giant even participated at Apple's announcement event, demonstrating the latest versions of the Office on iOS apps on the iPad Pro, which are made to take full advantage of the new Apple Pencil. Here's why Microsoft is so happy that Apple just copied Surface.

Office is more important than Surface ...
Even though Surface Pro and iPad Pro will compete directly, investors should remember that what Microsoft truly cares about is selling more Office 365 subscriptions. To that end, Microsoft has fully embraced a cross-platform strategy under Satya Nadella in a way that it never did under Steve Ballmer.

Apple is going to compete on the hardware front; there's no avoiding that. Embracing iPad Pro and its emphasis on productivity is absolutely the right call since Microsoft can continue Office's successful transition to a subscription model. And it's not like Apple actually cares all that much about its own iWork productivity suite, which the Mac maker made free in 2013.

Office has long been Microsoft's most profitable software suite (even more profitable than Windows), making it easily the company's most important business to maintain. Considering Apple's dominance of the tablet market, focusing development efforts on Office for iOS is extremely important in addressing tablet users that need to get work done. And that's exactly what Microsoft is doing.

... by a lot
Put another way, Surface revenue last fiscal year grew 65% to $3.6 billion. Over the same time, Microsoft nearly tripled Office 365 consumer subscriptions from 5.6 million to 15.2 million. That rapidly growing user base is now generating an annual revenue run rate of $1.5 billion.

But Office 365 revenue is much more valuable thanks to its extremely high margins. Last year's Surface cost of revenue was $2.9 billion, translating into a gross profit of around $700 million. Surface has a gross margin of "just" 19%, while the entire consumer licensing segment enjoyed a gross margin of 93% throughout fiscal 2015.

More importantly, all of this is only on the consumer side. Microsoft's core customers are all enterprise clients that buy volume licenses for Office and other products like Windows and Windows Server. It should go without saying that software is Microsoft's core business, while its recent hardware ambitions are more like ambitious side projects meant to set an example for hardware OEMs.

Microsoft has its priorities straight and competing with Apple on the hardware front is not one of them -- growing its Office 365 subscriber base is.

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