Playing Microsoft's Mobile Victory In China

| About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) recently declared that passing Apple's (NASDAQ:AAPL) smartphone share in China was but a stepping stone to passing Google (NASDAQ:GOOG) to gain the top spot in the China mobile market. Not that Microsoft has passed either company's mobile platform share in any country, but the fact did little to dissuade the company from declaring its impending victory.

The secret? Phone hardware in the range of CN¥1,000 ($158). This price includes the operating system software license.

The idea that Microsoft might somehow target high-performance luxury phones likely to achieve a cachet similar to that of top-end Android devices or Apple's iPhone line was quickly dispatched by Simon Leung, head of Microsoft's Greater China region: "We will continue to drive the price down. Our goal is number one. Having a goal to be number two is not really a goal."

It's clear from Microsoft's framing of the issue A) that Microsoft equates victory with unit share, and B) that Microsoft expects to achieve unit share through commodity pricing. Commodity pricing of hardware might not impair Microsoft in claiming its per-unit license fees, but it hasn't worked out very well for Microsoft's "partners" in hardware manufacturing. Here is a chart of the results Dell's (NASDAQ:DELL) investors have enjoyed since the week Apple first sold an Intel-based Mac, and Dell was first in the position of competing with Apple directly on hardware:

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In this time, Microsoft's longtime "partner" Dell competed with its rival Hewlett Packard (NYSE:HPQ) for the largest-PS-vendor crown, and at third place in volume holds over 12% of the global PC market (in the U.S., second place at over 22%). Chinese competitor Lenovo (OTCPK:LNVGY), which has shown faster growth than the other top-three competitors, holds second place worldwide with 14% share. The top spot is held by Hewlett Packard Co. (global share 26%, U.S. share 23.1%), the "growth" of which in PC market share was recently negative. Lenovo, which plans to be the global PC unit volume leader within a few years, has pressured PC prices at Dell and HP.

And what has commodity competition been for Microsoft's hardware "partners"? Hewlett-Packard's margins are as high as they are because it owns significant intellectual property of value in the high-end server and storage markets, and because it's got a huge enterprise consulting business. Dell recently talked down its consumer hardware business, indicating that for profit the company depended on customers "trusting us with their comprehensive IT needs, from the datacenter to the device." After all, Dell's hardware-only competition with Apple in music players and phones hasn't exactly painted a picture of thriving success. Dell doubtless expects success in China's mobile market because - unlike its previous venture into phones (yielding no discernable market share) - it will enjoy backing by Microsoft in handsets running its operating system instead of Android. Perhaps Dell forgets how Microsoft's backing worked out for it in the music player business. It's possible to make a competitive position out of a volume business, but Dell hasn't shown the knack.

If this gives one the idea that Microsoft's strategy to deliver mobile hardware to China may not really work out to the profit of commodity vendors like Dell and Lenovo, who are clamoring for the volume lead, one should not be surprised. A look at the marketing training presentations contained in the exhibits (pdf) to Comes v. Microsoft (ultimately settled) reflect a culture accepting blatant use of the term pawns to describe what the author notes are sometimes called partners. Microsoft plans in the mobile space to use hardware manufacturers to sell OEM licenses of Microsoft operating systems so that Microsoft profits regardless the financial success of the physical hardware, and so that end users can become consumers of further Microsoft properties (stores, subscriptions, etc.).

Apple vs Microsoft
Is this really so different from Apple's strategy? Apple's OEMs are negotiated down to razor-thin margins. They are also subjected to comprehensive oversight of compensation, hiring practices, working hours, wages, and reporting requirements that some might regard as making third-party assembly vendors part of Apple's own operations. Is being Apple's OEM partner such a cakewalk compared with being Microsoft's?

In the case of Apple's OEMs, they may have to report to Apple significant details about their operations, but they obtain from Apple a contracted-for price designed to leave them with a profit (however thin). In the case of Microsoft's OEMs, hardware vendors may benefit from Microsoft's marketing support and become eligible for funding from Microsoft to help vend hardware with Microsoft's applications pre-installed, but nobody promises them that their sunk costs for device design and preparation will be recouped from whatever sales result from their efforts.

When Apple contracts with Samsung to manufacture Apple-designed CPUs, Samsung doesn't worry Apple won't buy them as contracted. Apple's OEMs may not live in the lap of luxury, but they appear to bear little risk of market failure: Apple has picked up the costly design overhead and takes responsibility for marketing, and even capitalizes on its own balance sheet the machinery and equipment needed to build Apple's products. Apparently, Apple takes not only the lion's share of the profit, but also of the risk.

Microsoft's OEMs, by contrast, bear operational risk while having little protection against adverse market conditions. Microsoft's contribution to the products - the operating system - does not increase materially with volume as does the exposure of its hardware manufacturers, who bear the risk their inventories will not find a favorable market. Microsoft enjoys licensing revenue with each unit, but has no per-unit participation in risk. Would you want to own one of Microsoft's OEM hardware partners?

Microsoft vs Microsoft
By placing OEMs in a position of significant risk in a market in which products have a risk of failure, Microsoft deprives its OEMs of the motivation to make significant investments in potentially differentiating technology. To invest in differentiating characteristics involves added capital risk, and with limited upside in a commodity product market there is simply not much to invite the willing acceptance of additional risk.

Microsoft, on the other hand, has repeatedly suffered failure in little devices. The Zune died. The Kin died. Windows Phone 7 Series - whose evangelists promised WebOS developers "what you need to be successful on #WindowsPhone" - underwent a name change as launch was under way, better to appeal to buyers, and still proceeded to lose share.

Today, with all Microsoft's effort to partner with Nokia (NYSE:NOK) and Samsung (OTC:SSNLF) to put its operating systems on hardware, Microsoft has only just now managed to pass the market share of Symbian in the UK. After being sidelined by Nokia, Samsung, Motorola (MOT), and Sony Ericksson (NYSE:SNE)(NASDAQ:ERIC), Symbian was in the U.K. still outselling Microsoft's mobile operating system until this week. Microsoft's U.S. share continues to slip, and its worldwide share is exceeded (at 2.1% vs 1.9%) by an operating system called Bada. Ever heard of Bada? (It's a Linux smartphone OS from Samsung, and carries no per-unit license fee.) With all this bad news for Microsoft's platform, and so little to recommend manufacturers to make investments to grow share for low-cost commodity products, who has a real incentive to make sure hardware shipping with Microsoft's mobile operating system sells in volume?

Microsoft does.

Microsoft plans on making the lion's share of the profit from the market share it hopes to take, and only Microsoft has sufficient incentive to put on a good enough fight to take the share it wants. Microsoft's efforts to advertise its mobile phones (e.g., through product placement on Hawaii-Five-O) has slumped toward 5% in the U.S., and in the last year fallen from 3.4% to 1.9% globally. Excited about its own products and confidently dismissing rivals over claimed weaknesses, Microsoft publicly concludes that sales don't require a better product but better marketing. So, expect vigorous marketing.

But Microsoft isn't just marketing its new phone. Microsoft has developed another interface for its operating system and committed to supporting ARM instructions (as opposed to the instructions supported by Intel's x86 line of processors) on a version of its mobile operating system. ARM support is important to Microsoft, because in the mobile space its historic dependence on Intel for processors proved as disadvantageous to it as reliance on Motorola for processors once proved to Apple. But ARM isn't an easy road. Microsoft must provide OEMs highly detailed specifications to govern ARM device design and construction: because ARM chips aren't made by one manufacturer but by anyone willing to license ARM and design a compliant chip, vast differences in features and performance can exist between ARM chips, as was never the case with chips vended by Intel. For example, ARM vendors to date don't typically hardware-accelerate DirectX graphics, though Apple's ARM chips hardware-accelerate not only the OpenGL ES standard but instructions available through OpenCL. However, Microsoft's graphics depend on the Microsoft-only directX instructions on which all its developers depend to make graphics on Microsoft platforms. Microsoft will need, therefore, to be involved in approving chip designs before chips are designed by Hewlett-Packard, Dell, and Asus. Microsoft will be involved so intimately with the devices, their architecture, and their components that it might as well be building the devices itself.

Microsoft vs The World
The Windows 8 tablets and smartphones will benefit immediately from support we should expect Microsoft to bake into its desktop and server operating systems and applications. Microsoft's licensing scheme isn't intended to sell hardware, it's intended to enhance the network effect of its software ecosystem. Microsoft will presumably offer marketing support to its choice vendors, who will be pitted against iOS and Android offerings for OS share - and against each other for share of the market available for manufacturers of Microsoft-running smartphones and tablets.

Will Microsoft's efforts to get third parties to compete down prices to take share in smartphones while paying per-unit licensing fees to Redmond work better in phones and tablets than it did in music players - and to date, also phones and netbooks and tablets?

One thing is certain: the way to play a bull bet on Microsoft's share in the mobile market is to bet on Microsoft or key software developers targeting Microsoft's mobile platform, not Microsoft's commodity hardware partners. One might bet on a Microsoft-supported hardware vendor, incidentally, with an investment based on its expected success selling IT-related services (consulting, storage, backup, etc.), but the nature of the hardware commodity market suggests that a bet on hardware profits for a Microsoft mobile device is a lost cause.

Disclosure: I am long AAPL.