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Microsoft Mission Impossible

 

You’re Microsoft’s new CEO. How do you like staring at the abyss between two mutually exclusive ways of making money? The old business model, Windows and Office licensing, is going away. The Devices and Services future puts you in direct competition against the likes of Google and Apple as well as former licensing vassals such as HP and Dell. Can you take the company to the other side, or will you fall to the bottom of the business model transition canyon?

Life used to be simple and immensely profitable at Microsoft. As its name implies, the company started as a supplier of microcomputer software. Simplifying a bit, it all started with the BASIC interpreter, which found its way into many early personal computers including the Apple ][. After that came DOS, the operating system for IBM’s Personal Computer; and Multiplan, an early foray into desktop productivity. DOS begat Windows, and Multiplan was succeeded in steps by the full Office suite. Through a series of astute business and lawyerly maneuvers, the Windows + Office combo eventually spread to virtually all PC clones.

This made Microsoft the most successful software company the world had ever seen, and its founding CEO, Bill Gates, became the richest man on the planet. In 2000, the company’s market capitalization reached $540B (approximately $800B in today’s dollars). As this Wikinvest graph shows, Microsoft dwarfed all other tech companies:

msft_graph1

(At the time, the NASDAQ index of mostly tech stocks stood a little above 4,000, it closed at 3,792 this past Friday.)

Back then, Windows + Office licensing was the only money pump that really mattered. Everything else — all other software products and even sales of enterprise servers — either depended on Microsoft’s huge PC installed base, or didn’t move the needle. Hardware and entertainment lines of business were largely immaterial; online activities weren’t yet the money sink we’ve seen in recent years.

According to the company’s 2000 Annual Report, the combination of the “Windows Platforms” and “Productivity Applications” accounted for $19.3B in revenue ($9.3B and $10B, respectively). That’s 84% of the company’s $23B total revenue and, even more important, 98% of Microsoft’s Operating Income!

Moving to Q1 2013, the market capitalization picture has drastically changed:

msft_graph2

Google is in many ways becoming Microsoft 2.0, Oracle has grown nicely, and Apple is now on top.

What happened?

Mobile personal computing happened. Smartphones and tablets are displacing conventional PCs, desktops, and laptops.

To put it even more succinctly: the iPhone did it.

When Steve Jobs stepped onto the stage at MacWorld in January, 2007, there were plenty of smartphones on the market. Windows Mobile, Palm Treo, Nokia, Blackberry… But Apple’s iPhone was different. It really was a personal computer with a modern operating system. While the iPhone didn’t initially support third party apps, a Software Development Kit (SDK) and App Store were soon introduced.

Android quickly followed suit, the Smartphone 2.0 race was on, and the incumbents were left to suffer grievous losses.

Riding on the iPhone’s success and infrastructure, the iPad was introduced, with Android-powered tablets not far behind. These new, mobile personal computers caused customers to Think Different, to re-examine their allegiance to the one-and-only PC.

As these products flooded the market, Microsoft went through its own version of the Stages of Grief, from denial to ultimate acceptance.

First: It’s Nothing. See Steve Ballmer memorably scoffing at the iPhone in 2007. Recall ODM Director Eddie Wu’s 2008 predication that Windows Mobile would enjoy 40% market share by 2012.

Second: There is no Post-PC…”Plus is the new ‘Post’“. Smartphones and tablets are mere companion devices that will complement our evergreen PCs. The party line was eloquently asserted two years ago by Frank Shaw, Microsoft’s VP of Communications:

“So while it’s fun for the digerati to pronounce things dead, and declare we’re post-PC, we think it’s far more accurate to say that the 30-year-old PC isn’t even middle aged yet, and about to take up snowboarding.”

Next comes Bargaining: Microsoft makes a tablet, but with all the attributes of a PC. Actually, they make two Surface devices, one using an ARM processor, the other a conventional Intel CPU.

Today comes Acceptance: We’re indeed in a Post-PC era. PCs aren’t going to disappear any time soon, but the 30-year epoch of year after year double digit growth is over. We’re now a Devices and Services company!

It’s a crisp motto with a built-in logic: Devices create demand for Microsoft services that, in turn, will fuel the market’s appetite for devices. It’s a great circular synergy.

But behind the slick corpospeak lurks a problem that might seriously maim the company: Microsoft wants to continue to license software to hardware makers while it builds a Devices business that competes with these same licensees. They want it both ways.

Real business model transitions are dangerous. By real transition I don’t mean adding a new line of peripherals or accessories, I mean moving to a new way of making money that negatively impacts the old one. The old money flow might dry up before the new one is able to replace it, causing an earnings trough.

For publicly traded companies, this drought is unacceptable. Rather than attempt the transition and face the ire of Wall Street traders, some companies slowly sink into irrelevance. Others take themselves private to allow the blood-letting to take place out of public view. When the curtain lifts some months later, a smaller, healthier outfit is relaunched on the stock market. Dell is a good example of this: Michael Dell gathered investors, himself included, to buy the company back and adapt its business model to a Post-PC world behind closed doors.

Microsoft can’t abandon its current model entirely, it can’t stop selling software licenses to hardware makers. But the company realizes that it also has to get serious about making its own hardware if it wants to stay in the tablets and smartphone race.

The key reason for Microsoft’s dilemma is Android. Android is inexpensive enough (if not exactly free) that it could kill Redmond’s mobile licensing business. (Microsoft might get a little bit of money from makers of Android-powered hardware thanks to its patent portfolio, but that doesn’t change the game.) This is why Microsoft offered “platform support payments” to Nokia, which essentially made Windows Phone free. And, now we have the belated, under duress acquisition of Nokia’s smartphone business, complete with 32,000 angry Finns.

(Microsoft is rumored to have approached HTC with an offer to dual-boot Windows Phone on HTC’s Android handsets. It’s not very believable rumor — two competing operating systems on the same smartphone? But it has a satisfying irony: In an earlier incarnation I saw Microsoft play legal hardball against anyone who tried to sell PCs with both Windows and another OS installed at the factory…)

Another example of trying to keep one foot on each side of the abyss is the Surface tablet. Microsoft tried to create a hybrid “best-of-both-worlds” PC/tablet, complete with two different UIs. I bought one and found what many experienced: It doesn’t have the simplicity and agility of a genuine tablet, nor does it offer the classic workflow found on Windows 7. We’ll have to see how helpful the upcoming Windows 8.1 is in that regard.

So… What about our new CEO?

  • S/he finds a company that’s in the middle of a complicated structural and cultural reorganization.
  • The legacy PC business is slowing down, cannibalized by mobile personal computers.
  • Old OEM partners aren’t pleased with the company’s new direction(1). They have to be kept inside the tent while the Surface tablets experiment plays out. Success will let Microsoft discard Legacy PC makers. Failure will lead Redmond to warmly re-embrace its old vassals.
  • The Windows Phone licensing business lost its clients as a result of the Nokia acquisition.
  • Integrating Nokia will be difficult, if not a slow-moving disaster.
  • The Windows Phone OS needs work, including a tablet version that has to compete with straight tablets from Android licensees and from Apple.
  • Employees have to be kept on board.
  • So do shareholders.

How would you like the job?

JLG@mondaynote.com

(1) HP’s Meg Whitman now sees Microsoft as a competitor — and introduces a Google-powered Chromebook. What we think this will do for HP’s Personal Systems Group revenue and profit is best left unsaid.

The Rebirth of Windows Mobile

 

by Jean-Louis Gassée

The decline of PC sales finally caught up with Microsoft, resulting in weak quarterly results that force Steve Ballmer to admit a strategic mistake and propose a radical change of direction.

Last week’s Monday Note focused on Microsoft’s conversion from a divisional to a functional organization. It resulted in interesting discussions in the comments section as well as in e-mail exchanges and conversations around a couple of Valley watering holes. Some thought Microsoft’s statements had the sincerity of a death-bed conversion, others pointed to the challenges in remaking a cricket team into a football squad, most expressed doubts about Microsoft’s ability to successfully adapt to a world where the PC no longer reigns supreme.

On Thursday, Microsoft released its numbers for the quarter ending in June, the last of their 2013 fiscal year. They were not good. MSFT lost more than 11% the following day, taking its long-suffering partner HP (- 4.5%) with it.

Wall Street’s brutal dumping of the stock after “shockingly” bad news isn’t surprising, but what should we make of the dogged complacency of the financial seers leading up to the announcement? Did they really not see this coming? Despite a historic five-quarter decline in PC sales, investors hadn’t wavered in their belief that Microsoft would find ways to compensate for plummeting Windows + Office profits.

Perhaps I ought to have written cronyism instead of complacency, above. Before the SEC frowned on the excesses of “managed earnings“, Microsoft was famous, and comfortable, for always emerging just a penny above its wink-and-nudge guidance. To pull off this funambulist exploit, the company shuffled money in and out of the Unearned Revenue cupboard and other reserves. To paraphrase the old saying, You Didn’t Get Fired For Owning Microsoft.

If you think the accusation of cronyism is too strong, take a stroll through the latest Earnings Call Transcript, courtesy of Morningstar, especially the Q&A section. With such an earnings surprise, you’d expect Wall Streeters to inflict company execs with combative questioning and probing follow-ups; you’d look for Steve Ballmer to be front and center, explaining and hectoring. Instead, we have Amy Hood, the newly appointed (but very experienced) CFO, parrying deferential questions (and very few follow-ups) with mind-numbing answers such as this one:

I think I feel good. I think in some ways the reorg we announced last week along with our increased focus and our single strategy has allowed us to really look and say what are the things we’re going to put behind and focus and to improve our execution and so I feel quite good about our ability to do that. And you have heard us say before many of the reasons we did this reorg are about doing things better and more efficiently.

Pity the long-suffering analyst… and if their suffering continues, perhaps we should expect Ballmer himself to show up at the late September analyst indoctrination event in Redmond.

The Microsoft surprise, dubbed by TechCrunch Its Biggest Drop Of The Century, has infused the discussions of the company’s future, what Ballmer will do with his new organization now that the Redmond Giant (finally!) seems to be aware that it’s playing catch up in a Post-PC era.

As luck would have it, I got a draft of Ballmer’s memo to a small group of Microsoft execs. I can’t vouch for its authenticity — it was “regifted” through a series of contacts, friends and foes of old OS wars — but I hope you’ll find it interesting:

[Confidential – Burn Before Reading]

From: Steve Ballmer
To: Microsoft Leadership Team – Do not Distribute
Date: July 20, 2013, 6 a.m.
Subject: Windows Mobile 9

It’s time for me to confess a serious strategic mistake – and to ask for your commitment to change course and breathe new life into our legacy business.

This is about tablets.

Our own unsuccessful attempts to enter the tablet market (Widows for Pen Computing in 1991, and the Tablet PC in 2002) lured us into thinking there was “no there there”. Because of this, we downplayed the impact of a new wave of devices from Apple and Android licensees.

Neither our PR campaign to negate the advent of a Post-PC era nor Frank Shaw’s valiant efforts to position the new devices as “PC Companions” has had any effect on the market. We even leveraged our long and cosy relationship with IDC and Gartner and got these to firms to create a dismissive category label for these new machines: media-consumption tablets – with the clear implication that they were unsuitable for business uses. All these exertions were for naught. For five consecutive quarters, we’ve watched PC sales decrease and tablet shipments skyrocket.

This has become a significant threat to the very foundation of our business model.

For more than two decades, the Windows + Office tandem has been a source of incredible power and wealth, it has enhanced the life of more than a billion users and has allowed our company to expand into other high-margin Enterprise products and services.

For all these years, we scrupulously followed McKinsey’s “Not A Single Crack In The Wall” advice, we’ve managed to successfully Embrace and Extend each and every possible threat to the Windows + Office combo.

While we initially underestimated these new tablets, their threat soon became obvious and we started thinking of ways to protect our franchise. 

That’s when I took the company in the wrong direction. 

To prevent these tablets from penetrating the Office market, I followed our Embrace and Extend strategy and endorsed the creation of hybrid software and hardware: The dual-mode (Desktop and Touch UI) Windows 8 and Surface tablets.

The results are in. Windows 8 hasn’t taken the market by storm. The Windows 8 tablets manufactured by our hardware partners are sitting in warehouses.  We just took a $900M write-off on our RT tablets, now on fire-sale.

It doesn’t matter who actually proposed or implemented the failed strategy, I endorsed it. What matters most — the only thing that matters — is what we’re going to do now.

I have a plan. It’s conceptually simple but I won’t sugarcoat the situation. It will be extremely difficult to execute, particularly given the urgency.

First, I am tasking Terry Myerson, our EVP Operating Systems, with creating Windows Mobile 9, a tablet-capable version of Windows Phone 8 that will serve all of our mobile products. Until last week’s reorg, Terry was leading our Windows Phone group and is therefore ideally suited to the new task.

Qi Lu, EVP Applications and Services, will work with Tim to deliver a full, real Windows Mobile Office without the limitations imposed by RT. And, in keeping with our strategic need to spread Office everywhere and to provide the widest base for our on-line Office 365, Qi Lu will also produce Office versions for Android and iOS platforms.

Moving to hardware, we cannot rely on Nokia and other hardware partners to create enough momentum for this new platform, so I’ve asked our JLG (Julie Larson-Green) to develop first-party mobile devices — a Microsoft smartphone and a Microsoft tablet — that run Windows Mobile 9. The use of the somewhat damaged Surface name for these products will be evaluated as we go.

Everyone else in the company, from Operations to Evangelism, from HR to Finance is expected to give their full support to this most urgent, most vital initiative. In particular, our most recent hire, Mark Penn, EVP Advertising and Strategy, is tasked to come up with the right narrative for the strategic transition to Windows Mobile 9. Earned in unforgiving Washington politics, Mark’s long experience with complicated situations will help us navigate the troubled media waters ahead of us.

I know you love this company as much as I do. Thanks for pouring all your energy into this effort.

Steve

I know I didn’t fool anyone with this apocryphal memo. While it could be viewed as satirical, it’s actually deadly (that’s the right word) serious. And it raises serious questions.

First, there’s the small matter of implementation. To mangle Brooks’ law, nine engineers can’t gestate an operating system (or an Office Suite) in one month. Coming up with a “sincere” tablet OS and the corresponding Office version will take time, time during which Android and iOS tablets will continue to cannibalize PCs — and gain hardware and software muscle. This leads to the inevitable question: Has Microsoft arrived too late to the tablet feast?

Then there’s the question of price and its impact on Microsoft’s financials. Software on today’s tablets is either free, or priced at a fraction of its desktop PC equivalent. (In retrospect, significantly lower prices for tablet software might have played a role in Microsoft’s “safe” decision to stick with a PC/tablet hybrid.) If they go the real tablet route, Ballmer & Co. will have to tell shareholders to expect lower numbers, even if Office 365 subscriptions partially compensate for the loss in Windows licenses and conventional desktop software.

Another thought arises from Ballmer’s (actual, not mythical) reference to “first-party devices”, meaning smartphones and tablets made by (for) Microsoft and sold by the company, whether through its own stores, its intramural booths at the likes of Best Buy, or through more conventional retail channels. The math could be attractive: 30% Gross Margin on a $500 device sure beats 85% on $50 or less of licensing revenue — as long as the hardware unit volume cooperates.

For Microsoft, going for such a business model apostasy, renouncing software licensing for hardware revenue, is easier said than done: an “earnings trough” looms if the old model collapses faster than expected and if the new profit engine takes too much time to come on line. One might bring up the Xbox as an example of Microsoft successfully moving to a vertically integrated business model, but this would be forgetting there was no perilous transition away from juicy operating system licenses, the Xbox was vertically integrated at birth.

The coming months are going to become even more interesting as Microsoft must progress beyond grand statements about its new functional organization and explain in detail what the new team will actually do.

JLG@mondaynote.com

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