The Transition From Legacy IT And Its Potential Consequences On Microsoft

| About: Microsoft Corporation (MSFT)

The transition from Legacy IT (PC-based) to Hybrid IT (PCs + Smartphones + Tablets) is on the way, and, according to some experts, it will soon lead to a new future called Next Gen IT (Smartphones + Tablets mainly).

PC companies have adopted several strategies to deal with this new landscape, including creating new categories like "ultrabooks" and other ultra-thin notebooks to drive sales, or reducing prices to lure more customers. Unfortunately for them, PC shipments are set to decline in 2012 for the first time in 11 years, according to iSuppli, and smartphone sales beat those of PCs for the first time ever in 2011, while recent tweets from Asymco's Horace Dediu seem to paint an even darker picture for PC producers - and Microsoft (NASDAQ:MSFT), the absolute leader in PC software sales.

Microsoft and the Gang of Four

Microsoft's pay-for-software business model is relatively simple and has, so far, been very rewarding for the company and its shareholders. Unfortunately, a declining PC market (both in unit numbers and average selling price) makes the company's "let OEMs fight for sales as they all pay for licensing our software" business model sound less appealing than in the past.

As Horace Dediu noted:

In 2011 Microsoft received about $18.7 billion in Windows revenues and $23 billion in Office revenues. The chart shows that this is a fairly steady growth business. According to Gartner, in 2011 there were about 336 million Windows PCs sold and that this too is a fairly stable and mature business.

If we simply divide revenues by PCs sold we get about $55 Windows revenues per PC and $68 of Office revenues per PC sold. The total income for Microsoft per PC sold is therefore about $123. If we divide operating income by PCs as well we get $35 per Windows license and $43 per Office license. That's a total of $78 of operating profit per PC.

Now let's think about a post-PC future exemplified by the iPad. Apple sells the iPad with a nearly 33% margin but at a higher average price than Microsoft's software bundle. Apple gives away the software (and apps are very cheap) but it still gains $195 in operating profit per iPad sold.

Fine, you say, but Microsoft make up for it in volume. Well, that's a problem. The tablet volumes are expanding very quickly and are on track to overtake traditional PCs while traditional PCs are likely to be disrupted and decline.

So Microsoft faces a dilemma. Their business model of expensive software on cheap hardware is not sustainable. The future is nearly free software integrated into moderately priced hardware.

Summarizing Apple's business model as "free software to sell highly profitable hardware" may sound like a stretch, but it is also a great way to highlight the major difference between the two companies' business models. Apple targets a niche market, compared to Microsoft semi-monopolistic approach, but it has been capable of grabbing most profits in the smartphone market, as John Gruber pointed out:

Oftentimes market share and profit share go hand-in-hand. Consider the PC market. Microsoft has a massive market share lead in operating systems and Intel has a massive market share lead in CPUs. There is a strong correlation between their market shares and profit shares.

Apple has a very different strategy, and there's no better example than the iPhone. With about only 5 percent of the total handsets sold, Apple is earning two-thirds of the handset industry's total profits. Their profits are way out of proportion with their market share. No one would be confused if Apple had 50 percent market share and 50 percent of the profits. But apparently it's very confusing to some that Apple has only 5 percent of the market share and well over 50 percent of the profits.

If we turn our attention to the internet space, Google (NASDAQ:GOOG) has been able to establish its ad-driven model as the winning one, with Microsoft struggling to gain market share (and achieve any profit for the division). In that case, MSFT strategy wasn't particularly effective, as the company failed to adapt to a new market/business model.

More than one year ago Google's Eric Schmidt identified a "Gang of Four" companies leading the Internet space - namely his own company, Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB) and Apple (NASDAQ:AAPL). Unsurprisingly, Microsoft wasn't part of this short list.

Three of these four companies are also fighting for leadership in the smartphone and tablet market -with completely different strategies and business models.

Google's Android OS, given away for free to OEMs, gives the company an added opportunity to learn what consumers (smartphone users) want, and adds "portability" to several key applications like Search, Gmail, Google Calendar, Google Maps, etc. Google's ad-driven business model benefits in the long term as customers increase their use of the company's services.

Apple's strategy has already been discussed (buy our very profitable devices, software and cloud services come included), while Amazon's Jeff Bezos has recently been very candid explaining the rationale behind Amazon's move in the sector:

"We sell the hardware at cost," he explained. "We want to make money when people use our devices, not when they buy them."

So the idea is that Kindle Fire users buy books, apps, films in huge and profitable quantities. Unlike Apple, its margins will remain wafer thin, but the sheer quantity of goods sold should keep revenues flowing and investors happy.

Microsoft's radical shift in strategy

Assuming this analysis makes sense, it's little surprise that Microsoft may be considering a radical shift in its strategy to address a new growing market, smartphones and tablets, where its Windows-based devices have so far been quite unsuccessful.

Microsoft supporters will object that MSFT owns the enterprise space, and has the financial resources to "buy" market share for its Windows Phone 8 devices, plus the unique opportunity of using the launch of its new PC operating system as a tool for establishing an end-to-end solution from PCs to cloud services, to mobile devices.

Microsoft's platform support payment to Nokia (NYSE:NOK), in the range of $250 million per quarter, and recent rumors about similar moves with other OEMs like HTC and Samsung support the impression that MSFT is not looking at making an immediate profit from its Win Phone 8 platform, but mainly trying to establish itself as the third OS in a key, strategic and fast growing sector:

"It will be a joint marketing campaign where our devices will be the signature devices, almost the face of Windows Phone 8 in the marketing collateral with Microsoft" [HTC's Graham Wheeler said]. This partnership extends to the device naming too, with HTC being the first and only manufacturers to include the Windows Phone 8 name in its product - a decision that was made between Microsoft and HTC.

The close partnership between HTC and Windows Phone is surprising given Microsoft's focus on Nokia, but the software giant, like a doting parent, seems to be equally happy about HTC's Windows Phone 8 devices. "Pairing HTC's beautiful new Windows Phone 8X and 8S with our brand is a big milestone for both companies," says Microsoft CEO Steve Ballmer. "Together we are offering customers a clear choice and a truly unique experience."

However, the launch of Microsoft's "Surface" tablets, and rumors about a Microsoft phone, too, seem to indicate a radical, Apple-like shift in business model which Seeking Alpha contributor Ashraf Eassa recently addressed as a "Potentially Fatal Mistake".

Why should Microsoft take the risk of upsetting its OEM partners?

According to an article on the NY Times, Microsoft decided to develop its own tablet as it was not satisfied by what seemed "lack of common ground" with some of its partners:

Microsoft worked with other hardware partners to devise products that would be competitive with the iPad, but it ran into disagreements over designs and prices. "Faith had been lost" at Microsoft in its hardware partners, including by Steven Sinofsky, the powerful president of Microsoft's Windows division, according to the former Microsoft executive.

H.P. fumed at Microsoft for not doing more to create Windows software that was better suited to touch-screen devices. Executives complained that Windows 7's keyboard software did not work well, and that on-screen icons were too small for fingers to tap.

Microsoft refused to commit significant resources to help H.P., partly because the company was devoting its energy to Windows 8, a new version of its operating system being tailored for touch-screen devices.

As Windows Phone 8 based smartphones are just being launched by Microsoft's OEM partners, it is probably too early to speculate that MSFT may already be unsatisfied with these products - however, developing an own solution may also be seen as Microsoft's plan B in case some of these partner do not perform well, for any reason.

Research in Motion's (RIMM) launch of its new OS, expected in early 2013, may also represent potential competitor for Microsoft in the enterprise market, pushing MSFT to keep an internal smartphone solution ready for launch, if needed.

There is no doubt that MSFT has the financial resources and carrier connections required to launch a Microsoft (or Surface) branded smartphone, but by doing so is not only at risk of upsetting some of its partners, but quite likely to add another "online services division" to its balance sheet - i.e. additional revenues that need to be financed and subsidized by the Business and Servers unit.

Microsoft's marketing contributions to support Win Phone 8 platform launches are supposed to exceed expected royalties, at least for the next few quarters. The company is already factoring a potential loss in its attempt to become the third eco-system in mobility. Unlike in the PC game, OEMs could potentially become the winners (in profitability), with the software producer, at least in the short term, breaking even in the best case scenario.

Even if successful in its strategy to gain market share in mobility, in the longer term MSFT may be forced, by the reality of the market, to move its sales from a high OEM license fee model (PCs) to a much lower one (smartphones and tablets) .

Time will tell if Microsoft is moving to an Apple-like business model to sustain its profitability, or if it will succeed in acquiring a reasonable share of the smartphone and tablet market, benefiting in a more traditional way from the volumes it might generate.

We believe that several moves from MSFT are indicating the understanding that the old business model may not reward as well as in the past, and we wouldn't be surprised to see a quick move toward Surface branded products in an attempt to better compete with Apple and Google.

Who stands to lose the most from a Microsoft shift in strategy?

Nokia is the only Windows Phone partner that is all-in with Windows Phone. Having bet the whole farm on its software partner, it certainly stands as the company which might lose the most if Microsoft decides to go the Apple way, and become a hardware&software company in mobility.

We do not share Nokia's CEO confidence that the company is comfortable with the partnership, as we believe that the reasons brought by Mr. Elop are relatively weak:

We have rights beyond any of the other manufacturers to do unique things and to enforce certain exclusivities for our products. We don't disclose what those are, or the extent of those. But we have the ability to differentiate.

We earned that right by being the only company who said, "we are placing our primary bet on Windows Phone." That was a specific negotiated aspect of the relationship.

Whatever these "exclusivities" are, the market doesn't seem to place a large bet on Nokia's possibility to succeed in its turnaround, and a low market cap may make the company an attractive acquisition target for Microsoft, that would end up solving many potential legal problems and add both a very well known brand and another nice asset, NAVTEQ technology, to its mobility portfolio.

Potentially a very sad ending for a once worldwide leader in mobility, now just aiming, according to his CEO, to become the 'Where?" company to survive.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.