What Microsoft Corporation's Surface 3 Means For ARM Holdings and Intel Corporation

By Markets Fool.com

Microsoft this week unveiled the new Surface 3 tablet, its successor to the Surface RT and Surface 2 tablets.

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Microsoft's Surface 3. Source: Microsoft.

The base model of the Surface 3 -- which has a 10.8-inch 1920 x 1280 display, 2GB of RAM, and 64GB of internal storage -- will cost $499. The $599 version sports twice as much memory and storage. Both versions include a one-year Office 365 subscription and will get a free upgrade to Windows 10 later this year.

But unlike the earlier ARM (NASDAQ: ARMH)-powered Surfaces that ran on Windows RT, the Surface 3 is powered by an Intel (NASDAQ: INTC) Atom processor and runs Windows 8.1. Let's look at why Microsoft made that swap, and why it represents a missed opportunity for ARM Holdings in the PC market.

Microsoft makes the right play
Surface RT and Surface 2 both ran Windows RT, the unpopular operating system that only worked with ARM-based processors. Microsoft launched RT in response to ARM-based processors marginalizing Intel in the smartphone and tablet markets.

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But since Windows RT was designed for ARM processors, it couldn't run software designed for traditional x86 Windows PCs. Instead, RT users had to ditch their older software for a much smaller selection of apps from the Windows Store. Both customers and OEMs were frustrated by that gap, and by late 2013 all of Microsoft's OEM partners had abandoned the OS.

Nonetheless, Microsoft kept RT alive with the Surface 2 and the Lumia 2520, which both launched in late 2013. However, consumers clearly preferred the Surface Pro line, which was powered by Intel processors and ran regular Windows 8. Therefore, the replacement of NVIDIA's ARM-based Tegra chips with Intel's Atom on the new Surface 3 was inevitable.

The Lumia 2520. Source: Microsoft.

Left out in the cold
But with their removal from the Surface, ARM and NVIDIA lose their toeholds in the PC market. Intel respectively controls 90% and 83%of the laptop and desktop markets, according to IDC. Most of the remaining market belongs to AMD's x86 chips.

The only progress ARM has made in the PC market is through select Chromebooks, Linux PCs, and Windows RT devices. Together, those devices account for less than 2% of PCs worldwide, according to NetMarketShare. Although Windows RT failed to gain traction with OEMs, Microsoft's focus on "universal apps" for phones, tablets, PCs, and consoles had been considered a positive development for ARM-powered PCs. If Microsoft had kept ARM and RT on the Surface 3 and upgraded the device to Windows 10, other OEMs might have given ARM-based chips another chance.

But with the death of RT, ARM's options for expanding across the PC market remain limited. Its only other hope is if Appleends upputting its own A-chips in Macs, which has long been rumored.

Stuck in the mud
ARM still dominates the smartphone and mobile markets, but both are being rapidly commoditized. This demand for cheaper mobile devices results in ARM licensing out more lower-margin designs than higher-margin ones. As of last quarter, 44% of ARM's cumulative licenses were for "classic" (32-bit ARM 7-11) designs, while 17% came from higher-margin Cortex-A designs.

Meanwhile, Intel made big gains in the tablet market by subsidizing OEM partners. Last year, it overtook ARM licensee Qualcomm as the world's top non-iPad tablet chip manufacturer, with a 20% market share, according to Strategy Analytics.

IDC expects overall tablet shipments to rise just 2.1% in 2015, compared to 52.5% growth in 2013 and a 4.4% gain in 2014. However, IDC also believes sales of Windows tablets and 2-in-1 devices will soar 41% annually this year and claim 7% of the global tablet market. In other words, ARM is locked out of the fastest-growing section of the tablet market as it loses ground to Intel.

Acer's Iconia Tab 8 W. Source: Acer.

The takeaway
The new Surface 3 will start shipping on May 5 in the U.S. and Canada. Its arrival will mark the death of Windows RT and unite the Surface line under a common processor instruction set and operating system. It also sends a clear message that backward compatibility with Windows PCs, one of the Surface's top selling points, remains a major defensive barrier that Microsoft and Intel have against companies such asGoogle and ARM.

The article What Microsoft Corporation's Surface 3 Means For ARM Holdings and Intel Corporation originally appeared on Fool.com.

Leo Sun owns shares of Apple. The Motley Fool recommends Apple, Google (A shares), Google (C shares), Intel, and Nvidia. The Motley Fool owns shares of Apple, Google (A shares), Google (C shares), and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.