Responses to 'Craptops' and Thoughts on Microsoft's Challenging Future

On Tuesday, I received the following response to my recent blog post:

“While I understand the imperative for PC builders to increase R&D spend and focus more on differentiation, how big of an issue is this really for Microsoft? Even though hardware manufacturer fortunes have been in persistent decline, Microsoft continues to sell its OS licenses. In addition, the PC market may “self-correct” with Dell’s departure. As vendors exit, the pricing pressures for the remaining participants (e.g. HP) will ease pricing issues and this increased margin will enable them to invest in and market their innovations.”

While the logic above is fair, it’s overlooking a few key points:

• First, it’s never good to have a partner who is dependent on your service fail and for the time being, Microsoft still needs hardware vendors to drive their sales. Furthermore, the death of Dell’s consumer PC business (the third largest in the world) would send a pretty discouraging signal to the remaining vendor.
• If prices did go up, it’s possible that a new Asian vendor would enter the market – especially as tablets and laptops converged. It may not seem like it in North America, but the third and fourth largest smartphone vendors in the world (by units) are Huawei and ZTE.
• Finally, the consumer electronics industry is increasingly about end-to-end experiences. To some extent, this has always been the case. However, today’s vendors and ecosystems are slowly achieving parity in terms of manufacturing quality, touch screen capabilities, app catalogue, content stores etc. As this occurs, the richness and depth of the experience will become the key differentiator. Unless Microsoft does more to control this experience at all endpoints, it will not be able to compete with Apple and Google’s increasingly refined and expansive offerings.

Another email (lightly edited) said the following:

“Microsoft has been making shoddy products for years. As you yourself say, ‘Few PC customers would claim any of the big consumer brand names… make great, reliable or high quality computers, let alone innovative ones.’ Why is it a problem now?”

This is true. Microsoft has had significant and sustained growth in both sales and earnings. What the company hasn’t been able to do, however, is grow its share price. This means the market has compressed its multiples at a rate almost identical to its growth across various metrics. This hints at an underlying problem for the company. Clearly, shareholders do not have rosy expectations for the company going forward.

I actually believe the issues faced by the company are far more significant than the market currently recognizes. This is for four primary reasons, each interconnected, tough to resolve and critical to Microsoft’s ability to remain relevant to consumers.

1. The PC market is dying and Microsoft’s ability to monetize remaining sales is diminishing

Global PC sales seem to have hit a global ceiling. 2011 was the first time since the dotcom crash that unit shipped decreased year over year (by 1.2%) and despite coming off of a down year and featuring the new Windows 8 operating system, Q4 2012 unit sales were down a shocking 14%. As sales of Microsoft’s two largest product lines (Windows and Office) are primarily driven by new PC sales, this is obviously a problem. However, the company’s problem goes beyond unit.

Like HDTV’s before them, consumers have stopped demanding (read: paying for) technical improvements, such as are increased processing power, graphics, RAM and so on. This, in addition to natural reductions in component costs over time, has resulted in significant decreases in the average sales price (ASP) of a PC. Today’s Windows computers have an ASP of only $420, down some 25% since April 2010. This reduction provides Microsoft with reduced headroom when pricing its operating system, which is typically sold to the PC manufacturer, who then recoups it with the consumer purchase.

Historically, Microsoft has charged OEMs $50-85 for Windows licenses. When PCs cost between $500-2,000, this licensing fee made up only 4-10% of the overall retail sales price. As sub-$300 netbooks emerged in 2009, Microsoft began cuttings its fees to as little as $15. The company had feared that PC vendors would otherwise look to free OSs, such as Linux or Google Chrome OS, to preserve their dwindling margins. With ASPs down more than a third in 2009, it’s hard to imagine there per unit license fees have remained stable.

While Microsoft continues to have 85-90% market share, little of this still drives revenue today. Windows XP, for example, is still running 25-35% of PCs despite being close to 12 years old and replaced by Windows Vista in 2007, Windows 7 in 2009 and Windows 8 in 2012. Analysts have typically assumed that these users will “have” to upgrade eventually – and they will – but with such infrequent upgrade cycles, its bottom-line impact is a fraction of what the company would like it to be. Consider the fact that while 90% of Fortune 500 companies have deployed the iPad, only 66% (on average) have upgraded from an OS four times older than the first iPad.

Lastly, Microsoft’s consumer PC business is quickly losing share. Over 35% of those under 35 are buying Macs – a figure that grows every day. Over time, this will diminish Microsoft’s ubiquity advantage and force more CIOs to support Apple products – to say nothing of demographic implications. As more and more and more people use iPhone or iPad, this will only get worse.

Microsoft’s traditional market is slowing; its prices are becoming compressed; much of its share isn’t driving revenue and its losing ground on active sales.

2. Struggling Mobile Share

While the PC market may be decline, mobile devices are expected to grow more than 17% per year for the next five years. Unfortunately, the company is struggling to establish itself in both the smartphones and tablet markets.

As of Q1 2013, Windows Phone has less than 5% of both global and North American smartphone sales. This is despite universal critical acclaim, strong carrier marketing support and often $100-$200 discounts to relative Androids or iPhones. I’ve used the phone extensively – and there is a lot to like – but it simply isn’t connecting with consumers. On the tablet front, IDC is estimating that Windows 8 will run on only 4.7% of tablets sold this year.

Low adoption is causing a serious app problem for Microsoft’s nascent OS. Google has announced that it has no intention of releasing its apps (Gmail, Google Maps, Google Talk) until a more significant user base is established. Similarly, a number of “tier 1” apps, such as Instagram, Pandora, Hulu+ and the Wall Street Journal, are still missing.

The other interesting thing here is that Microsoft monetizes Windows Phone devices the same way it does with the Windows OS: it charges manufacturers a license fee. However, this fee is estimated to be between $5 and $15 dollars for smartphones – a far cry from its PC fees. Though its table fees are higher (approximately $30), it’s facing considerable pressure to reduce the prices to compete with $200 Kindle Fires and Nexus tablets. Unless Microsoft can find new (and significant) ways to monetize the mobile market, even significant gains in market share will not offset the cooling of the PC market.

3. Windows 8 – Microsoft’s Future or a Dead End?

Windows 8, released in October of 2012, has not had the reception Microsoft hoped.

• David Pogue, the New York Time’s Technology Editor: “Windows 8 means insane, productivity-killing schizophrenia. The Windows 8 learning curve resembles Mount Everest.
• Phillip Greenspun, a prominent Internet expert at MIT and Harvard: “(Windows 8) is a Christmas gift to someone you hate… Suppose that you are an expert user of Windows NT/XP/Vista/7, an expert user of an iPad, and an expert user of an Android phone… you will have no idea how to use Windows 8.”
• Jakob Nielsen, a leading user interface/experience expert: “Microsoft has now thrown the old customer base under the bus…. Windows 8 encompasses two UI styles within one product. Windows 8 on mobile devices and tablets is akin to Dr. Jekyll: a tortured soul hoping for redemption. On a regular PC, Windows 8 is Mr. Hyde: a monster that terrorizes poor office workers and strangles their productivity.”

How Windows 8 will sell in the long-run is unclear. However, the early indicators are not encouraging. The PC market typically incurs a “pop” of up to 40% when a new edition of Windows is released, as many would-be buyers had delayed their purchases in anticipation.   Despite that, unit sales were down more than 14% year over year in the holiday quarter.

The most ominous sign for Windows 8 may not be its market performance, but how it has impacted Microsoft internally. Steven Sinofsky, Microsoft’s Windows chief and heir apparent to CEO Steve Ballmer, left the company only days after Windows 8 was publically released and denigrated by the press. While there are conflicting stories surrounding his departure, the timing is hard to rationalize being anything but related. It’s worth noting that when Sinofsky’s vision for Windows was chosen, his two primary competitors (Robbie Bach and James Allard, who were responsible for the Xbox) were let go. were down more than 14% year over year in the holiday quarter.

4. Business Model Inversion

Microsoft is facing a fundamental inversion of the consumer electronics business models. The company has traditionally made its money via licensing its OS to vendors and by selling software such as its expensive Microsoft Office Suite to end-users. However, the mobile market appears to operate under different economic principles than the PC market: Android, after all, is license free, and software (or “apps”) sell for a fraction of the prices Microsoft has historically charged. As Horace Deidu writes, “…consumers (or IT buyers) would have a hard time justifying $67 for an Office license for every tablet when most apps are either free or under $10. Apple charges $9.99 each for iOS versions of Pages, Numbers and Keynote which can be installed on several devices.” Apple views software, applications and content as a sales driver for highly-profitable software – the opposite of Microsoft’s traditional business model.

This inversion is likely behind Microsoft’s first foray into consumer PC hardware, the Surface. While the company had previously designed the Zune MP3 player and two generations of Xboxes, this represented a dramatic shift for the company. It was also particularly dangerous. Coming out with the Surface meant directly competing with hardware partners (such as Acer, HP, Dell) – many of whom have publicly stated their feeling of betrayal. Though Microsoft received adulation for the Surface’s slick hardware and design aesthetics and accessories, many agreed with the Verge’s summary that “(The Surface) tries to do everything, but misses doing anything really well.” The product is estimated to have sold only 1M units during Q4 2012 and Q1 2013. To put this anemic performance in perspective, Apple moved 3 million new iPads in its first three days of availability.

The Rest of Microsoft

While Bing has been reasonably successful from a branding perspective, it has yet to make a series dent in Google’s growth. The company’s share of search remains above 2/3^rds in the US and over 90% in parts of Europe. Though Microsoft has about 1/3rd of Google’s market share in search, it has less than 1/10th the revenue.

Though the Xbox is believed to have been a cumulative net loss until only recently (and represented only 1.68% of operating income in 2012), it has actually become the company’s shining star. Despite its age, the console has continued to pick up steam over the past few years (in no small part due to the innovative Kinect motion sensor). In the United States, it has been the top selling console for the past 26 consecutive months. More importantly, as video gaming consoles replace cable-set-top boxes and household entertainment platforms, the Xbox is giving Microsoft a meaningful access point into to its target consumer’s lives. Though they have yet to use it to successfully drive sales of its other mobile devices, it is keeping Microsoft relevant and providing a building block for their ecosystem.

Where Microsoft is Today

Microsoft is in a tough position: its legacy business is in decline, it is struggling to gain traction in mobile and is facing pressure to fundamentally reinvent its business model. Furthermore, Windows 8 has not only failed to boost sales, it has “made PCs a less attractive alternative to dedicated tablets and other competitive devices” according to market research firm IDC.

There is perhaps no graphic more instructive than the below:

In 2004, Microsoft sold a record 56x the number of Apple devices. In 2013, IDC estimates it will drop below zero for the first time, with Apple devices outselling Microsoft’s by 10%.

The majority of Windows 8 criticisms focus on the OS’s massively reimagined and touch-focused user interface (previously known as “Metro”). The company’s goal here was and is commendable. They asked themselves how they would design Windows today if they had to start from scratch, rather than how they could incrementally improve upon the user interface and mechanics first established in the late 1980s and early 1990s. In addition, they looked to create a consistent user experience across all of their devices (the Xbox, Windows Phones, Windows PCs and Windows Tablets would all adhere to the same design and usage principles). In doing so, they would also make it easier for software and app developers to Write Once, Run Anywhere. At the same time, Microsoft recognized the need to support business users – and so they enabled Windows 8 to run both the Metro UI, as well as one that resembles their more traditional UI.

However, the changes turned out to be so dramatic that business, consumers and “power users” alike felt alienated.  Most criticisms focus on the need “schizophrenic” interfaces and the removal of the classic “Start Button”. More importantly, some have argued that Windows touch-focus and (over)simplifications crippled their ability to do work (as opposed to consume content). Looking at this trend above, it’s not hard to see how Microsoft though that consumers wanted a vastly different and simplified version of Windows. In addition, it explains not only why the company would want to take such a dramatic gamble, but also how they might have rationalized a bad one.

Going Forward:

Microsoft is a powerful company filled with very smart people (it files more patents than both Apple and Google combined). It has a massive user-base, close to $70 billion in cash and is the clear leader in business and productivity services. It’s also willing to make dramatic and dangerous changes, as evidenced by Windows 8 and Microsoft Surface. However, it is facing not only significant challenges internally, but formidable competitors in the market. In addition, it was estimated that the company lost 5-30 employees to Amazon, Apple and Facebook for every employee it took from them. The company’s lack of traction has also led to many writing them off – just look at the cover of The Economist’s December 1^st 2012 issue.

Some things will need to happen:

• CEO Steve Ballmer, who has held the role since January 2000, should be replaced. As Marisa Mayer has shown, a new leader with a fresh vision is often better positioned to energize the base and set a new direction. Of course, this is neither a sure-thing nor a quick-fix, but it’s hard to see how the 14th year of Ballmer’s leadership will inspire change.
• In 2010, Ivey Business Review wrote about rethinking its operating model. I think the conclusions and recommendations are still true.
•  Microsoft should dramatically rethink their Windows 8 UI and strategy. Until the OS is more than year old (covering two holiday quarters), it is unlikely the company will commit to any serious changes. In fact, most believe that Windows Blue, the company’s 2013 update to Windows 8, will further marginalize the traditional Windows UI in favor of Metro. This is a dangerous path to take and one already adorned with warning signs. Furthermore, as Apple’s Mac OS X & iOS and Google’s Android and Chrome OSs show, ecosystems do not need to be identical across all devices.
•  Microsoft should extend its manufacturing beyond tablets and gaming consoles into smartphones – and potentially laptops. With Surface, the company proved it can craft hardware as well as, if not better than, the leading consumer electronics giants. Expanding into new devices categories will allow them to better manage the transitioning of their business models and ensure a high-quality user experience from end-to-end. Furthermore, as more hardware is available, consumers will increasingly differentiate between Microsoft’s proprietary experience and the (spotty) one’s provided by independent OEMs. This move does have its costs; Microsoft’s vendor partners will, rightly, feel betrayed.

  In the case of smartphones, Microsoft has only one material OEM partner, Nokia. Not only has the company failed to ignite consumer attention, its handset business has received more than $2 billion in “support payments” ($250M a quarter) from Microsoft. Developing a phone in house is therefore both logical and would not significantly detract from Windows Phone’s market presence. That being said, the move would push Nokia (which has received continued acclaim for its hardware) to release Android phones, which would fortify Microsoft’s competition. However, given Windows Phone’s limited success to date, this shift is more likely to come at Samsung’s expense than Microsoft’s.

  With many PC manufacturers failing to “delight customers” (as Steve Jobs might have put it), looking to exit the market (such as HP and Dell) or trying chip away at the Windows hegemony (Dell, Asus), Microsoft should put neither faith nor priority on their needs. In the medium term, they will also have little choice but to continue releasing Windows PCs. In addition, Microsoft should target only key consumer segments and ignore desktop PC manufacturing in order to focus internal development efforts and leave room for committed vendors targeting business/enterprise users (such as Lenovo) or price-conscious users (Gateway).

  Either way, it’s essential that the company unveil strict minimum PC functional and hardware requirements (as outlined in my previous article). Finally, any of Microsoft’s efforts will be contingent on their ability to execute in these new hardware categories (which are not sure things) and may be futile without additional changes to Windows 8 (per the above).

• Find a way to rapidly bolster its presence in mobile. Here, there’s seemingly only one real (quite imperfect) option: Research in Motion. There have been rumors of a Microsoft acquisition of the company for several years now, and in many ways, they still make sense. The company has more than 70 million smartphone users, considerable internal talent and strong carrier support. In addition, their corporate strengths align well with much of Microsoft’s enterprise business. The problem here is that the acquisition would result in yet another fracturing of Microsoft’s already-schizophrenic OS/UI. Though Google and Apple support 2-3 different OSs across their devices, the two Windows UIs and RIM’s BB10 OS lack aesthetic and structural cohesion for dual support – even if they were split between business and consumer segments. Cutting either the Metro UI or BB10 operating system would also be devastating to internal moral, as both companies have been working on them fastidiously for more than two years. While many analysts expect Microsoft to acquire Nokia’s handset division, they effectively have already – and the purchase would do nothing to boost their role in mobile.

Microsoft faces few good options today – none of which are clean, simple or solutions in and of themselves. Every day the company is growing less important and less relevant in the mobile space, despite growth rates to large they ought to raise all boats. At the same time, its competitors are growing stronger and building ecosystems with increasingly high switching costs. Microsoft will keep moving forward and hope that Windows 8 takes off by the end of the 2013 holiday seasons. By then, it may be too late. And that’s a shame.

Update: On 16 April 2013, BGR reported that Microsoft’s summer update, Windows 8.1, may include the return of the Start button and an option to skip over the Metro UI on start-up. In recent months, thousands of users had been been installing third party workarounds to do the same.