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Microsoft (MSFT) delivered solid earnings results April 18th. Its adjusted revenues were up 8% year-on-year with a concordant 8% rise in EPS to $.0.65. With much celebration in the ranks of Microsoft and some analysts, one might be forgiven for thinking all of Microsoft's problems had magically disappeared. Yet they remain, they grow and they continue to require better responses than Microsoft has so far given.

In the days of the Roman Empire, whenever great Generals won significant wars, they would be honored with a parade in Rome. As they received the applause, a slave would whisper into their ears "Memento mori." This simple phrase, 'remember your death', symbolized the fact that all success is fleeting and in the context of the business sphere, failure can lie just around the corner.

Microsoft cannot afford to be complacent or within 4-5 years of this earnings release, it will be fast dwindling into irrelevance and destroying shareholder value in a spectacular fashion.

In the first of a series of articles, I will focus on one particular problem where Microsoft faces considerable risks. I will give an estimate of the level of the issue and present possible solutions.

Problem 1: The Windows App ecosystem is still terrible

It is… needlessly segmented

The Windows app ecosystem is segmented into two (and a half) currently incompatible versions serviced by different stores, or not at all.

The Windows Store services Window 8 and Windows RT operating systems. These apps look rather akin to the ones available for Windows Phone. If anyone wants to know what it feels like to take an app from your 4" phone and stick it on your large 24" screened home monitor, just download any app from this store. However, in a remarkable feat of incompetence, the Windows 8 and Windows Phone stores remain unreconciled. Therefore, despite having low-information density apps within the Windows store, these apps can't actually run on phones, the screen size many appear designed for. More pertinently, this also means that consumers have to purchase the same paid app for both versions, that is if they are available on both versions, which is not often the case.

Now we come to the "half" which lacks a store of any kind. The chances are you're actually using it right now. This is of course the "desktop." This information rich user-interface which most of us use is actually rather anarchic in where one can download software from. Gradually however, there have been attempts to present a more curated experience for consumers, led by Steam for Windows (a private company founded by former Microsoft employees). Outside of the ecosystem entirely lies the Mac App store (AAPL). This is designed to become the new home for all Apple products for their laptops and desktops. One cannot say this is the case for Microsoft products such as Office.

Microsoft is pushing through a partial solution to this problem known as "Blue." Supposedly this will unite the two stores. It remains to be seen how well implemented this function will be.

A decent response by Microsoft will require.

  1. Apps purchased on Windows Phone work on Windows 8 (perhaps for an additional fee)
  2. Apps published on Windows 8, automatically work on Windows Phone unless developers have a special use case which prevents them from doing so.
  3. A clear indication to consumers if the "desktop" UI will remain and if it will do so, then the immediate implementation of a Microsoft store for the desktop.

It is… pygmy-sized

Not only is the Windows store bifurcated, the diversity of the apps available is highly limited. The Windows 8/RT store has a mere 60,000 apps of which around 30,000 are available in any one country.

The Windows Phone store is rather larger with 130,000+ apps in total. Of course if one takes into account duplication within the two stores as well as variants, the true figure will be lower.

Regardless, these figures pale into comparison with the 800,000 plus available on both iOS and Google Play (GOOG).

Despite being a full order of magnitude smaller than its competitors, Microsoft management nevertheless sees it fit to take 30% of app revenues from its software vendors, the same as Apple. Now, in an oligopolistic market (Coke (KO) vs. Pepsi (PEP) being the classic example), non-price differentiation is the most optimal method of competition. Microsoft is suffering from rather inopportune hubris if it thinks itself remotely comparable to Google and Apple in the app sphere. Canalys this month calculated that Apple takes 74% of total app revenue worldwide. This phenomenal figure means that given an equal amount of time, rational developers will always create apps for iOS preferentially over Windows. Furthermore, from a slightly different angle, Android exists on well over half (70%+) of world smartphones and has the most downloads. This means that any advertisement-driven developer will if behaving rationally always select Android over Windows Store(s).

There is however a relatively simple mechanism for Microsoft to boost the attractiveness of its ecosystem. I am waiting for this to happen and will gauge how bold the company is by its next steps.

Microsoft can more than double the size of its market through carefully targeted subsidies for paid apps. For every paid app sold, Microsoft should give the developer an additional 100%. Therefore, for every dollar app sold, Microsoft should give the developer a further dollar (up to a maximum of $100,000). Therefore, if the developer sells a $0.99 app, instead of receiving $0.70, they receive $1.99, 2.84 times more.

This can help Microsoft in numerous ways: First it encourages a paid app culture in the Windows ecosystem (vital to make it attractive for developers). Secondly, it encourages competitively priced apps which consumers are more able to buy which also increases their stickiness to the ecosystem. Thirdly, by more than doubling the size of the market, it encourages software development, which in a virtuous cycle attracts further customers.

If Microsoft sets aside a $1 billion fund, it will serve as an incredible enticement to developers and a statement of intent to its competitors. Over time, depending on success rates, it can then pivot this subsidy down until, when it reaches true parity with Apple, it can be eliminated entirely. Microsoft is capable of making such a move as it has previously demonstrated with Bing and Xbox. Unlike those two services however, this inducement is carefully correlated with demand and will thus deliver better returns to Microsoft.

It is… badly managed

Microsoft's divisions often appear locked in a rather opaque, internecine and pointless war to the detriment of its consumers. I will delve into this deeper in the future. For this article, I want to highlight one particular aspect. Microsoft despite its problems has an excellent games development arm which has created several world famous titles such as Halo, Gears of War, Forza and Project Gotham Racing. Not one of these titles exists on either Windows 8 store or its Windows Phone derivative. Games such as these are precisely the product differentiation Microsoft needs to engage in to make its platforms attractive to consumers. By refusing to create a Halo derivative for example, it sends a signal to both consumers and developers that it is not committed to its platform. Why should Instagram build for Windows if Microsoft itself chooses not to? Keen followers of the Windows Phone ecosystem will already know by now that its success appears dependent on the resources that Nokia (NOK) can muster. For a $250 billion company to hand over the success of one of its core products to a company struggling to maintain cash flows is a sad indictment of Microsoft's corporate culture. This needs to change immediately. Microsoft needs to invest just as heavily into ensuring Windows Phone's success as is Nokia.

Conclusion

This is but one problem Microsoft faces. The company's multifaceted nature means it will always faces a variety of threats at any one time. However, the technology industry has over time become even more brutal and ruthless in eliminating unpopular products and services. Windows 8's initial success is a given due to Microsoft's brand name and marketing budget. Windows Phone receives a certain amount of halo effect due to the popularity of Windows. These two products nevertheless need to stand on their own merits. If Microsoft fails to create a compelling enough store, Windows 8 will be the last Microsoft operating system to sell in volume and Windows Phone will fail to gain enough traction. The world we will be left with will be dominated by Google and Apple in the consumer sphere with Microsoft left as a third party developer. Most importantly, this result would destroy considerable shareholder value in the process if it ever comes to pass.

In the next part, I will further delve into Windows Phone to give an insight into whether it can ever achieve sufficient market share to be viable.

Source: Memento Mori Microsoft: Record Breaking Profits Don't Make Problems Disappear - Part 1