Does Microsoft Have A Master Plan?

Aug.17.12 | About: Microsoft Corporation (MSFT)

The well executed Surface announcement earlier this summer marked a clear inflection point for Microsoft (NASDAQ:MSFT). Most prominently, Microsoft abandoned its long held strategy of producing software and leaving the hardware to a diverse ecosystem of OEMs, including industry titans like Dell (NASDAQ:DELL) and HP (HPQ) who built major businesses on hardware side of this model. With the Surface's design work performed in house and its Windows branding, Microsoft couldn't have more clearly redefined the paradigm in which its software is consumed, and if it thought OEMs would buy its lip service to the contrary it is now learning the hard way that they see the writing on the wall. Apple (NASDAQ:AAPL) has single handedly shown the value of an integrated hardware and software product ecosystem (to the tune of hundreds of billions of dollars) and Microsoft now appears set to create its own version, with Windows 8 integrating the full spectrum of devices from phones to tablets to PCs in an environment of increasing Microsoft hardware control. (The new laptops released by Vizio are another manifestation of this trend.)

Though the hardware element was surprising to many, integrating people's lives into a tight, self contained Microsoft ecosystem has been a goal of the company for most of the past decade, from its ill-fated Live social network to it's failed attempt to force Bing down the throats of internet users who are quite content with Google (NASDAQ:GOOG). The thing is, it's never worked. Windows Phones and Tablets (the two fastest growing device categories by far) are footnotes, with market shares of less than 3.5%. The Zune, recently discontinued (along with the rest of its device category, another victim of smartphones), never caught traction despite its shared heritage with what is still the world's dominant operating system. Overall, the general public seems to have bought into a view of Microsoft as old, stodgy, and incapable of doing almost anything right. A decade of cheap plastic hardware, compared with Apple's rigidly controlled (and, well, rigid) lines of beautifully designed gadgets has cemented this perception, and Apple's brutally effective "I'm a Mac" advertising campaign nailed the message home like the best of political attack ads. Many observers, myself included, saw a dim future for Microsoft ahead, built around its still wildly profitable enterprise solutions and with declining or stagnant market share in almost everything consumer.

This is where the Surface comes in. With its slick unveiling, impressive build quality, innovative (even Apple beating) design features (the kickstand and keyboard cover), it does just about everything right to reverse the negative momentum and make Microsoft cool again. At first it seemed like a prototype style effort designed to spur OEM reaction, but recent rumors about a price point of $199 (which Microsoft doesn't seem to have denied at my last check), through that possibility out entirely. Microsoft appears to be going for market share, pure and simple, even if it means a hefty loss per device sold. At first this didn't seem to make sense, but now I see it as part of a grand strategy Microsoft has to become a behemoth in the profit-laden consumer tech space... and I'm convinced that it might just work.

It goes something like this: Microsoft has assets. Namely, $56 billion in cash, a hugely profitable enterprise software monopoly and a virtual monopoly on non-Apple (aka cheap) computers. It also has liabilities, which include nearly everything in its slate of consumer offerings (exception for the XBOX, of course). The challenge is to leverage those strengths to retake the near lost consumer sector from Apple and Google (via Android). How? By selling Surface at a loss leading price of $199, with the addition (as many have suggested as the only way to make the price point reasonable) of a two year subscription to an Xbox branded streaming video and gaming service, with built in Microsoft Office. With significant tablet market share, Microsoft could remain significant in the consumer space, allowing for an eventual move further into hardware production of phones (Microsoft buying Nokia (NYSE:NOK) outright is a strong possibility in my opinion). By turning Surface into the killer App in the tablet space with a bargain price, Microsoft can leverage all of its strengths:

Cash- Microsoft can afford to sell the Surface at a loss because of its massive cash hoard. At a $100 subsidy per tablet (recouped in part by the streaming service) it would cost Microsoft about $3 Billion to get 30 million Surfaces into the world's hands, and as production ramps up hardware costs fall, perhaps getting Microsoft to the breakeven point in 2-3 years or less (making the subsidy automatically disappear, in effect, as often happens with video game consoles).

Enterprise- Perhaps the only software Microsoft still reaps accolades for is its Office Suite, which remains the standard for businesses everywhere. Having Office on the Surface is a huge plus over competitors such as the iPad (MS has remained mum on an office app for Apple's device), likely establishing the Surface Pro as the premier enterprise tablet, especially if the price is similarly aggressive. Other tablets are for consuming content, but the Surface may be the first tablet to be equally adept at creating it.

PC Market Share- Microsoft still dominates the budget PC market, which gives it another key advantage. Applications will be highly portable between Windows 8 PCs, tablets, and phones, and the huge chunk of the PC market Microsoft will capture by default will bring in the developers needed to create a robust thriving App-store, which has been a major struggle for other mobile players besides Google and Apple.

Xbox- Microsoft's Xbox console, perhaps the only consumer product it has which remains trendy, provides another target audience and strength for the new device. Look for the Surface to integrate tightly with the Xbox, including sharing the console's movie streaming service and likely including robust support for games, including potentially even controller functionality.

In short, Microsoft can use its existing strengths to make Surface the go-to tablet for penny-pinchers, office workers, and gamers. That is huge. But is the subsidy worth it? I think so, and here's why:

Ecosystem Building- With a substantial market share in tablets, PCs and (somewhere along the line) phones all connected by a unified operating system, Microsoft can finally achieve the critical mass necessary to build a product ecosystem to rival Apple's, and then some. Apple, after all, is not known for its gaming or productivity prowess and has no alternative to Google in search. For someone who ones an Xbox and a PC, a Windows tablet at $199 may well be impossible to ignore, and with all three of those a phone is a logical next step. The sales boost to Windows Phone and PCs from synergies with the Surface may well cover much of the subsidy cost itself.

Branding-In tech, innovation, and being labeled as an "innovative brand" is vitally important, with key impacts on not only consumer impressions but on corporate culture and mojo. Microsoft knows it can't afford another great but too expensive Zune in this case, and indeed a Surface failure would only reinforce the image of Microsoft in terminal decline, albeit a slow and profitable one based on boring enterprise software.

Cloud- If the Surface's teaser price includes a cloud service subscription as many have postulated, it represent an incredible opportunity to not only sell millions of tablets but also create perhaps the most powerful cloud in the world. With every Surface user storing their files on Skydrive, watching (and playing) content from the XBOX network and maybe even using Microsoft's "modern" new email service, Microsoft can make a hugely profitable, recurring revenue based (never underestimate the importance or attractiveness of that phrase) entry into cloud computing.

OEM Irrelevance- The most compelling argument against the $199 price point and overall aggressiveness I believe Microsoft is likely to unveil is that it will utterly alienate OEMs. This is true, and as I've mentioned I think it will certainly be harmful to their tablet hopes, which are already meager. The truth is, though, they have nowhere to go (Android isn't ready, nor is Linux) and will be left with the entire desktop PC market to themselves for now, with hundreds of millions set to be sold in 2013. If Surface tablets help Windows 8 become perceived as a must-make upgrade (Windows XP remains tied with Windows 7 so the potential is there), then OEMs might even benefit from additional PC sales that could easily make up for the few million tablet sales Microsoft might cannibalize from them, since hopes for competing with the iPad weren't very high.

To summarize, Microsoft has all of the necessary tools and incentives to stun the tech world with a massive comeback and coup d'etat, and by all indications they are set to launch the most ambitious plan a tech company has ever laid out. The implications for other companies could be mind boggling: Dell, HP and the other OEMs would see their tablet hopes crushed. Apple would stand to face a substantial slow down, if not outright decline, in iPad sales and a strong new threat in the phone space, wrecking high hopes for its future growth based on domination of entire product categories and likely its share price. Google would watch its Nexus product line become rapidly irrelevant, suffer in search as Bing infused mobile devices proliferate and face a resurgent Windows Phone bolstered by a ecosystem it can't match. There are barriers, to be sure, including heavily cast perceptions about Microsoft and somewhat lackluster early reviews of the OS at the core of it all, but there are also billions of dollars, a great product and a company with lots of strengths that should never be counted out. They also know better than anyone that if Surface fails from a sales perspective their future in the consumer space is effectively decided. I'm not certain it'll all work, but I have a strong feeling that Microsoft is about to successfully shake things up across the entire tech space, and I'm impressed enough by what I've seen so far to bet on it.

Disclosure: I am long MSFT.