In the throes of a midlife crisis, Microsoft is making its boldest moves yet to prevent itself from fading into technological irrelevance.
It was a watershed moment for Microsoft. In January, the software giant surprised everyone by announcing in a blog post that it would make its flagship Windows 10 operating system (OS) available as a free upgrade for one year to people already using Windows 7 and 8.1 and Windows Phone 8.1— affecting hundreds of millions of users worldwide. The new operating system was released on July 29. It is the first time that Windows, Microsoft’s cash cow, has ever been offered at no charge as an upgrade to non-enterprise users when it would normally retail for $120 to $200.
The free offer is the latest earth-shaking move by CEO Satya Nadella, an introspective and mild-mannered Microsoft veteran faced with the challenge of reinventing the aging PC-centric company in a mobile-first world. The playground in which Microsoft has long dominated (the world of PCs) is shrinking, while the arena where rivals Google and Apple traverse (mobile applications and devices) is growing. Microsoft has been trying to build a bridge between the two worlds, but results have been lackluster at best.
Windows 10, however, could change all that. Microsoft is aiming to get a billion computers to use it—which it hopes will in turn attract app developers. “The fundamental truth for developers is they will build if there are users. And in our case, the truth is we have users on desktop,” Nadella told Business Insider in an interview published on July 14. One reason why Microsoft has not been able to get much traction in mobile is that far fewer developers are making apps for Windows Phone than Google’s Android and Apple’s iOS, because the latter two have far more mobile users.
But if Microsoft gets a billion desktop users on Windows 10, developers will be enticed to make apps for it. And here’s the key: Once they develop what Microsoft calls “universal apps” for Windows 10, these can run on any device using the operating system with only minimal changes to the code, the article said. So an app that runs on desktop can work on Windows Phone, Xbox or the HoloLens augmented reality device. “Even if you want to come to Windows because of HoloLens, you want to come to it because of Xbox, you want to come to the desktop, all those get you to the phone,” Nadella said. “When we hook them up on that, we have a phone app.”
While the Windows upgrade is free, Microsoft intends to make money off it in new ways. The company said the OS “will enable new post-license monetization opportunities beyond initial license revenues,” according to its fiscal 2015 earnings report filed with the US Securities and Exchange Commission. Indeed, the launch of Windows 10 is the last big bang, or all-upgrades-at-once, release of Microsoft’s flagship OS. Going forward, it will push out features and updates to users gradually, just like what Google does with Gmail. For the record, Microsoft skipped creating a Windows 9 to go straight to 10.
The key is that Windows 10 is intended to unify Microsoft’s applications across screens ranging from smartphones to PCs to tablets to new fronts such as the Internet of things and augmented reality. “The Windows 10 approach is a wise move,” says David Hsu, a management professor at Wharton. “Consumers want that seamless experience regardless of the screen.” The new OS brings back the beloved Start Menu of older versions and puts the much-criticized live tiles in a less intrusive place, while adding new features like the Cortana digital assistant and the long-awaited virtual desktops.
The strategy behind Windows 10 is a significant part of what Nadella said last year was his vision for Microsoft to be a leader in a “mobile-first and cloud-first world” and reinvent productivity. In the SEC filing, Microsoft said that “Windows 10 is the cornerstone of our ambition to usher in an era of more personal computing. We see the launch of Windows 10 in July 2015 as a critical, transformative moment for the company because we will move from an operating system that runs on a PC to a service that can power the full spectrum of devices in our customers’ lives.”
Nadella sees Microsoft as a “productivity and platform company”—instead of the devices and services business as described by former CEO Steve Ballmer—and it is this view that sets the context for other strategic moves he has made since becoming CEO in early 2014, only the third in Microsoft’s history. Notably, Nadella wrote off the Nokia acquisition—$7.6 billion in charges for a $7.2 billion purchase engineered by Ballmer in 2013—resulting in the exit of former Nokia CEO Stephen Elop, a Microsoft veteran who rejoined the company after the Nokia acquisition.
Nadella also cut 18,000 jobs last year and another 7,800 this year, primarily in the Nokia business. These and other charges pushed Microsoft to its largest-ever quarterly net loss of $3.2 billion, or 40 cents per share in the quarter that ended June 30, as revenue fell 5% to $22.2 billion year-over-year. Indeed, Nadella has pared back the company’s hardware ambitions to focus on high-value integrated devices like the Surface hybrid tablet-laptop as well as aiming for value phone buyers. Microsoft is also developing Office applications for Android and iOS.
Meanwhile, Microsoft has sold some of its mapping business to Uber and farmed out ad sales for its properties to AOL, which in turn will use the software giant’s Bing search engine and search advertising tools. Nadella has also stepped up Microsoft’s intelligent cloud platform by acquiring companies such as Revolution Analytics. He has revamped the management team and outlined “three interconnected and bold ambitions” to reinvent productivity and business processes, build the intelligent cloud platform and create more personal computing. “I feel better about Microsoft under Nadella,” says Saikat Chaudhuri, a management adjunct professor at Wharton and executive director of Wharton’s Mack Institute for Innovation Management. “The company is making the effort in all the key areas. That’s the key to avoiding extinction.”
Nadella has said that Windows’ model of continual upgrades—so-called Windows as a service—is a new approach for the company. In a first, Windows 10 was built with the help of “insiders,” or early testers, whose feedback was incorporated into development. After the software upgrade, hardware will follow in the months to come. From there, corporations will be courted to upgrade. “Everything is, of course, speeding up because in some sense we have taken a very different approach with this Windows as a service,” said Nadella on Microsoft’s July 21 earnings conference call.
Should Microsoft reinvent Windows to be a service that works across screens, Nadella will go a long way to repositioning the company. “The goal is to be a software platform and worry less about devices,” says Kartik Hosanagar, an operations, informations and decisions professor at Wharton. Chaudhuri adds that Windows remains critical because it is Microsoft’s best avenue to be a computing platform. “At some point, there will be a convergence of devices,” he says. “There’s still a chance that Windows could lead that convergence. Windows 10 is important in my eyes.”
Microsoft’s Mobile Missteps
For years, Microsoft has struggled with crafting a strategy for a mobile world. First, it missed the smartphone movement while Google’s Android and Apple’s iOS attracted customers, apps and software developers. In a November 14 story in Vanity Fair, ex-Microsoft CEO Ballmer said his biggest mistake was focusing on “Longhorn,” which was supposed to be the next generation of Windows, instead of phones or search. Longhorn became Vista, which was “released late, lacked key features and had many failings that enraged customers.”
While Microsoft faltered, Android and iOS roared ahead. According to comScore, Android held a 52.1% market share of the smartphone platform market as of May and Apple captured 43.5%. Microsoft trailed at 3%, down from 3.5% in February. In addition, Microsoft has flip-flopped between a vertical strategy where hardware and software are integrated—similar to Apple’s model—and a horizontal one that aims to put the company’s applications on as many devices as possible. “Microsoft had a fundamental conflict between pursuing a horizontal strategy and a vertical strategy. This led to all kinds of confusion,” says Hosanagar.
Nadella appears to be pursuing a more horizontal strategy. Mobile Office apps were developed for iOS and Android before Windows Phone and the Nokia phone ambitions have been downsized. The CEO wants differentiated hardware experiences via Surface and high-end Lumia phones, but does not want to run a volume handset business. However, the rationale for the Nokia purchase was to capture emerging market mobile customers and introduce them to the Windows platform. Hosanagar says Microsoft’s recent moves might clarify this dichotomy a good bit, but it is still in an awkward middle ground. “Either be aggressive with devices or focus on the software and let others do hardware,” says Hosanagar.
Hsu says that Microsoft’s current approach to hardware may make some sense. “In the early stages of a market, Microsoft could use hardware to drive acceptance and control functionality and pricing,” he notes. “Think of it as a jumpstart. HoloLens is a good example of hardware control, as well as research and development and experimentation.” However, when a hardware business scales, Microsoft could look to divest it to focus on its core mission, adds Hsu. Through that lens, Xbox could be worth divesting. If Surface takes off, divesting that could be an option too. “There’s a hardware balance to be found within Microsoft,” says Hsu.
Chaudhuri notes that Microsoft’s hardware strategy is likely to remain a work in progress. “It’s clear Nadella is shaking things up, but there are still four to five areas of focus,” he says “Will Microsoft really stay in mobile devices and hardware? I’m pretty sure Microsoft won’t keep every business it’s in today. Microsoft can continue to try a lot of different things in the next two to five years.” Microsoft has to stay in the mobile device game in some fashion, according to Chaudhuri. “Microsoft doesn’t want to exclude itself from markets like mobile since we all know it will be huge,” he says.
The Benefits of “Cloud First”
While Microsoft’s mobile strategy is a work in progress, the company has leveraged the success of its enterprise business to bring those services into the cloud, say experts at Wharton. In addition, Microsoft has been convincing consumers to pay monthly fees instead of upfront licenses. Its fiscal fourth quarter results, released in July, tell the tale. The company’s devices and consumer business saw revenue fall 13% in the fourth quarter to $8.7 billion. However, Microsoft added 3 million consumer subscribers to its Office 365 service to end the year with 15.2 million. These subscribers pay $6.99 a month for Office access on one PC or Mac, one tablet and one phone or $9.99 a month for access on five PCs or Macs, five tablets and five phones. Microsoft still sells versions of Office for $139.99 with access on one PC or Mac only.
Hsu says the promise for Microsoft is that it can bundle various services like Windows updates, storage, Office and other tools into one monthly subscription. “On the consumer and enterprise side, Microsoft has a lot of assets that can be leveraged in the cloud,” says Hsu. Indeed, Microsoft’s biggest cloud moves are on the corporate computing side of the business. That reality shouldn’t be a surprise given that Microsoft’s enterprise business provides most of the profits for the company. “To me, Microsoft is an enterprise company. The cloud is a natural extension of the enterprise business,” explains Chaudhuri. “As long as Microsoft can offer a path from its enterprise products to the cloud it’s easier for customers to stick with it.”
Microsoft has leveraged dominant products such as Office, Dynamics (a customer relationship management package) and its installed base of software to run data centers into the cloud. Microsoft was early to cloud computing via a service called Azure and is seen as the No. 2 enterprise player behind Amazon Web Services. Including Azure and online subscriptions to other services such as Office and Dynamics, Microsoft said its cloud business has an annual run rate of more than $8 billion. “In cloud alone, our annualized commercial cloud run rate surpassed $8 billion this quarter, and the revenue grew 88% year over year. We’re on a strong trajectory towards our goal of $20 billion in fiscal year 2018,” said Nadella on Microsoft’s earnings conference call.
To Chaudhuri, Microsoft’s enterprise cloud business is the most natural fit for the future. “Most of the areas where Microsoft can really make a mark in the cloud come out of the enterprise,” he says.
Tethered to PCs
Analysts give Microsoft credit for many of its recent moves. And Windows 10 looks like an early success with 14 million installs in the first 24 hours of availability, according to the company. Nevertheless, there are challenges for Microsoft that will not be easy to fix. Following Microsoft’s latest earnings report, Jefferies analyst John DiFucci told investors to beware of the company’s recent positive press. Why? Microsoft is still tethered to Windows and the PC market, which is in decline. Research firm IDC forecasts that PC units will fall 6.2% in 2015 and another 0.2% in 2016.
“Despite the change in strategic direction to a ‘mobile-first, cloud-first’ company, we estimate Microsoft still depends on the secularly challenged PC sector for 42% of revenue and 83% of operating income (pro forma for the Nokia Devices & Services acquisition),” wrote DiFucci in a research note. “We believe the Windows Phone platform will continue to be challenged and expect Microsoft to continue to make investments in it and other non-profitable adjacent markets.”
What is unclear is whether the PC market will stabilize enough to generate Windows 10 revenue for Microsoft and give it air cover for its transition to cloud and other services. Analysts such as Credit Suisse’s Philip Winslow are banking on improving PC sales in the second half of 2015. If that scenario plays out, Microsoft can continue a transition to be cloud first with being mobile-centric remaining the company’s biggest wild card.
Chaudhuri says the fears about the PC business are overblown. Microsoft’s Surface device could highlight the future of Windows where tablets and PCs meld together. “You can’t give up on the PC market and Windows because it will be part of a convergence,” he says. Even in the worst case, it’s not so bad that Microsoft is still tethered to the PC market to some degree. “As long as Microsoft remains the dominant PC player, it can use Windows as its cash cow to enter new markets,” Chaudhuri adds. “Microsoft has the money to experiment and see what works and what doesn’t.”
The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.