Ballmer Finally Gets It Right

Aug.29.13 | About: Microsoft Corporation (MSFT)

While investors celebrated Steve Ballmer's decision to retire with a nice 7% pop in stock price, the more important decision that Ballmer got right was the one announced in July to transform Microsoft (NASDAQ:MSFT) into an integrated "devices and services" company. Many inferred that this was about imitating Apple (NASDAQ:AAPL), but the strategy is really a response to the challenge of Google's (NASDAQ:GOOG) Android. Market share growth in Android tablets and smartphones was mainly responsible for the relatively small market share that Windows mobile devices achieved in the first half of the year.

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This contention is supported by Gartner's smartphone market share data for Q1 and Q2 of 2013, summarized in the table below (shipments in millions):

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Also this is supported by IDC's tablet market share data for Q1 and Q2 of 2013, summarized in the table below (shipments in millions):

Click to enlarge

In the tablet market, Android's market share stood at 59% while Windows had 4%. In smartphones, Android's market share was 76.7% while Windows Phone was 3%. In both tablets and smartphones, Apple's market share declined year over year. Year over year growth for Windows devices was the largest of the big three, but this was by virtue of having miniscule mobile device share in 2012.

Microsoft's approach to mobile devices was basically the same formula that had worked so well for the company for PCs: build an inexpensive but competent OS and distribute it on commodity OEM hardware. Microsoft was used to competing on price, not quality, with its main personal computing rival, Apple.

This time, the tried and true formula didn't work so well for Microsoft mobile devices, not because the formula was fundamentally flawed but because Google's Android device partners could undercut Microsoft's device partners on price. Since all manufacturers have done everything possible to cut cost by off-shoring production, manufacturing costs are about the same for a phone or tablet with equivalent hardware. The roughly $50 per device that Android manufacturers saved by using a free OS was a huge price advantage given that typical manufacturing costs and materials run about $200 per device, smartphone or tablet.

Much of the analysis of Windows 8, RT and Phone has focused on technical pros and cons, but this misses the fundamental economic disadvantage of Microsoft's fee-based model relative to Google's Android.

Addressing the Economic Disadvantage

The decision to become an integrated devices/services company does bear a striking resemblance to Apple's business model, but this was driven by a need to improve cost competitiveness rather than admiration for Apple.

By becoming the device maker as well as the device OS maker, Microsoft achieves a number of things:

1) Microsoft can run with leaner profit margins because it's making the profit of both the device manufacturer and OS developer. This allows it to minimize its cost disadvantage relative to Android device makers but probably doesn't completely eliminate it.

2) Microsoft realizes some additional cost savings by consolidating both types of operations within a single company and merging the marketing and administrative organizations.

3) Microsoft can develop better integrated products.

Microsoft had already begun experimenting with the integrated devices and services model through its Surface devices and the Xbox. Surface has not sold well, and MS had to take a write down on Surface RT inventory. Given what happened to Surface, as well as Apple's losses of market share in 2013, one could argue that the integrated devices model is a failed strategy. There are two response to this:

1) Even though the Apple model hasn't demonstrated the ability to retain market share in the face of commodity Android devices, it has demonstrated the ability to be profitable for the OS developer. Microsoft would certainly find consolation in this for a less than dominant market share position.

2) The more salient argument is that Microsoft simply has no other choice. Lacking a profitable search business, MS can't afford to give its mobile OS away and try to emulate the Google model. And it can't go on as just an OS supplier as its OEM partners get crushed.

Will it Work?

There's no guarantee that the strategy will work. The main pitfall for Microsoft is a potential lack of organizational commitment, partly as a result of Microsoft's corporate culture, partly as a result of a certain fuzziness in the strategy. Microsoft execs appear to believe that they can pursue the integrated device maker strategy while bringing along their existing OEMs in a sort of hybrid approach.

It will quickly become apparent that this doesn't work for the OEMs. It doesn't solve their cost disadvantage relative Android manufacturers, and it creates a powerful competitor in Microsoft that has advantages of cost and superior hardware/software/services integration. What Windows OEM box maker wants to compete with Microsoft? Most will end up fleeing into the arms of Google, making Chromebooks and Android tablets and phones.

The best chance for the strategy to work is if Microsoft standardizes on Intel (NASDAQ:INTC) architecture processors. This will allow Microsoft to cut some costs as well as offer a more unified and consistent user experience, something it claims to be important. It will also allow MS to take advantage of the new low power Haswell and Bay Trail Intel processors for tablets, and the Merrifield SOC for smartphones that are due to ship to OEMs in Q4.

I consider the advantages of the all-Intel approach to be so compelling for MS that the switch is all but inevitable but probably won't be made public before the start of 2014.

What Investors Should Watch

Investors should keep an eye on Windows device sales in Q4 for indicators of the "one Microsoft" success. Microsoft will have replaced its Surface Pro with a new lighter Haswell based version and will probably be selling Surface RT at a discount to clear out its inventory. Not wanting to alert consumers that they're buying a dead end, MS will make no announcement about RT until after the holiday shopping season, but there won't be any new RT devices from MS or its partners.

New light and thin Bay Trail tablets will be out, probably in Microsoft and OEM brands. If Windows 8.1 devices manage to arrest the downward slide in the overall PC market, as well as increase market share in mobile devices, this will be further encouragement that the strategy is working.

Things get even better for Microsoft in 2014 as Intel's Merrifield arrives for smartphones, allowing it to ditch ARM processors altogether. This won't guarantee success for MS since Android makers will be able to use Bay Trail and Merrifield as well, but Microsoft will have the advantage of a fully scalable OS platform that spans from servers to workstations to desktops, to mobile devices. This should be enough of an advantage to allow it to carve out a third mobile device ecosystem and drive up its lagging share price.

Disclosure: I am long INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.