The Upcoming Microsoft Train Wreck

| About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) has long enjoyed a dominating position in the PC market. Its one-two punch of the Windows operating system plus the Office suite of applications has served as the strongest of competitive moats for many years. In recent years, though, Microsoft has been held back as it has tried to figure out how to adapt Windows to run on tablets and smart phones.

Microsoft was front and center in the PC revolution for close to three decades, generating enormous profits due to its licensing agreements with OEMs. Intel released higher performing chips at a relentless pace, and when users upgraded their PC's in order to take advantage of the increased performance, each PC shipped with a new copy of Windows installed on it. In addition, many of those users bought Microsoft Office for a few hundred dollars more, filling Microsoft's coffers even further.

When Microsoft has dominance in market, it is a very formidable foe -- the pages of computing history are littered with companies that tried to take on Microsoft and failed. Novell, Netscape, Lotus and WordPerfect are but a few companies that are either long gone or shadows of their former selves as a result of battling Microsoft.

The PC market has now reached a plateau, with IDC predicting growth of just 0.9% in 2012, following 2011's 1.7% growth. In order to resume growth, Microsoft needs to find a new market for its products, and it has set its sights on the tablet market, which is on pace to grow 91.7% in 2012, and another 62.2% in 2013.

Microsoft's difficulty, however, lies in entering new markets. For years, Microsoft has been trying shoehorn Windows into the ultra-portable space, i.e. smart phones and tablets. With all the fanfare that iOS, Android and, yes, even Windows 8 have gotten, it's all but forgotten that Microsoft made its first foray into tablets a decade ago with the release of Windows XP Tablet Edition. While Microsoft's first tablet initiative flopped, its smart phone initiative did moderately better, and as a result, Windows Mobile has claimed a small slice of the market.

With the release of the iPad in 2010, Apple (NASDAQ:AAPL) established a market for tablets, succeeding where Microsoft failed. Apple did this by rethinking the role a tablet would take in a computer user's life and developing towards that goal, rather than taking the route Microsoft had tried, which amounted to slapping a slightly modified version of Windows onto a laptop with a touch screen rather than a keyboard and calling it a day. Google (NASDAQ:GOOG) followed suit, adapting Android for the larger form factor that tablets offer, and several months later, Android tablets appeared on the market.

(Author note: Yes, Apple did use Mac OS X's underpinnings in creating iOS, but from a user's perspective, a device running Mac OS X offers a completely different experience than one running iOS).

Google was only a few months behind Apple in entering the tablet market, yet even that slight lag caused Executive Chairman Eric Schmidt to admit "we were late to market for tablets compared to our competitors." Meanwhile, it has taken Microsoft over two years to have a tablet-ready operating system.

Microsoft took so long to enter the tablet market because rather than build a tablet-specific operating system, it rewrote Windows so that it could run on anything from phones to tablets to laptops to desktop PCs. This way, Windows tablets would be able to be used for content creation, rather than content consumption, which is what the offerings of Apple, Google and Amazon (NASDAQ:AMZN) excel at.

My opinion is that Microsoft has bet wrong and will fail to make serious inroads into the tablet market. Worse, it stands to do great damage to its reputation and that of Windows in the process. I'll explain why below.

Apps And Purchased Media Constitute A Moat

Customers contemplating purchasing a Windows tablet will be confronted with a few uncomfortable facts:

First, Windows 8 and RT are incompatible with iOS and Android apps that have been purchased from the iTunes store, Google Play, and any other source, hence, users will lose all of the apps they currently use. A user who has only acquired free apps might be open to switching to Windows RT if equivalents are developed for it, but users who have purchased many apps may be reticent about abandoning all those purchases.

Secondly, the bigger challenge will be convincing Apple customers who have purchased significant amounts of media from the iTunes store to switch to a new platform. Movies and television shows purchased from the iTunes store are encumbered by DRM, meaning that they require iTunes for playback. Apple hasn't provided a version of iTunes for Android, and there is little reason to believe that it will develop iTunes for Windows RT, which would only provide customers a means to abandon their iDevices.

Additionally, Apple has been aggressively pursuing educational publishers, trying to get them to publish books in Apple's iBooks format. As iBooks can only be read on Apple platforms, this move may provide another avenue for Apple to build up its moat through the use of proprietary formats. That strategy is far from new -- Microsoft was one of the pioneers of the strategy, with undocumented Windows API's, proprietary file formats, and numerous examples of attempting to "embrace, extend and extinguish" numerous web standards.

(Author note: Music purchased from the iTunes store is DRM-free, meaning it can be played on any platform. However, it is my opinion that tablet users are more likely to watch movies and television shows on their tablets rather than listen to music.)

The Real Train Wreck

I haven't gotten to the worst part. It's my belief that Microsoft has made a major misstep in even releasing Windows RT.

It would be one thing if the Surface was simply an ultra-portable Windows 8 device. The Surface could occupy a niche in the tablet market, offering users the ability to use the productivity tools they use on their desktops anywhere they please. One still might wonder why users would opt for a Surface over an Ultrabook if that was their intention, but the Surface would at lest have a clear position carved out for itself in the tablet ecosystem.

Instead, Microsoft created another version of Windows RT, which is what ships on the Surface. This is a major gaffe that will cause much confusion among its customers, as Windows RT will likely be perceived as a severely hobbled version of Windows due to its incompatibility with applications written for Windows 8, as well as with programs written for previous versions of Windows.

The reason for the incompatibilities between the different versions of Windows is due to Microsoft using new ARM processors rather than Intel's x86 family of processors. Programs compiled for one architecture can't run on the other architecture. Now, imagine that rather than being a tech-savvy investor who understands that there are vast differences between the Intel and ARM architectures, you are just an average, off-the-street user.

Commence computer lay-person speak

You're in the market for a new PC, and see a machine running Windows 8 on display at BestBuy (NYSE:BBY). You research your purchase even further, and come across the Surface tablet on Microsoft's website. You'd be forgiven for thinking that the Surface runs Windows 8, as not only is the interface identical, but the Surface was also released on the very same day that Windows 8 shipped. That the Surface runs Windows RT, if you even notice that fact, is just minutiae to you.

(Author note: During my quick perusal of Microsoft's ordering pages for the Surface, nowhere did I find any mention that ARM and Intel are incompatible, nor that Windows RT runs a different set of applications than what can be run on Windows 8. In fact, I can't imagine a way that Microsoft could explain these differences to potential purchasers without them realizing that they were purchasing a horribly hobbled piece of hardware.)

Resume computer lay-person speak

You've been thinking about buying a tablet, but you had decided that a tablet didn't fit in your budget, since you're trying to replace your current computer and you know that tablets can't run computer programs. The Surface looks like it fixes that situation, as it's a tablet that runs Windows -- so you buy one, anticipating that it will become your primary computing device. Only when you get it home, you discover you've made a mistake -- none of the programs you use day to day will even install on it. This includes Quicken, QuickBooks, iTunes, and Firefox.

In the best case, when you return it for a full refund, a salesperson explains the difference between Windows 8 and RT, and persuades you to buy a Windows 8 laptop. You'll still voice your disappointment to your friends -- that you bought Microsoft's new tablet computer, and none of your programs would work on it because it runs RT and not Windows 8.

A worse scenario for Microsoft would be that the person returning the Surface doesn't get an explanation about the differences between Windows RT and Windows 8. They'll simply conclude that none of their programs can work under Windows 8. At that point, the chains that have bound them to Windows have fallen off and, because they will need to buy new programs either way they go, purchasing a Mac suddenly isn't a far-fetched idea.

It only gets worse later on, when the Surface Pro becomes available.

At that point, perhaps at coffee shops or at the airport, casual users will see Surfaces running the Windows programs they want to run. The Surface and Surface Pro are more or less identical to the casual observer, so when people see Surfaces running programs for Windows and then purchase the more affordable Surface rather than the Pro version, they will be "rewarded" by having to return their first purchase and wait a couple of extra days for their Pro to arrive.

Even Windows Developers Will Have Problems

Windows developers have been writing applications for decades now. They've been able to rely on the fact that the application that they compiled on their PC would run on any other x86 compatible PC. Now, Microsoft is asking developers to target a new CPU.

It remains to be seen how successful Microsoft will be in convincing developers to build applications for ARM chips, but so far the results aren't promising. Developers don't seem all that enthusiastic about building apps for these chips. In the past, Microsoft went to great lengths to make sure that early versions of Windows NT could run not only on Intel's x86 chips, but also on DEC's Alpha, the PowerPC, and chips from MIPS. However, developers couldn't be convinced to target those new CPUs, and NT's support for other architectures was quickly dropped

This is another area where confusion will be created -- there will be some applications that can run on one version of the Surface, but not the other. If a user at a coffee shop notes a cool-looking app on a fellow customer's Surface, they will need to ask not only which app it is, but if that app is even available for the particular type of Surface that they have.

It Was Entirely Avoidable

The sad part about this is that all of this confusion was easily avoidable. Microsoft would have needed to be satisfied with slightly lower profit margins, and used Intel's Atom processor in its low-end Surface rather than using an ARM processor. Atom certainly could have provided the basis for a usable, low-end Surface -- it's incredibly energy efficient while still being x86 compatible, meaning it would run all programs that a higher-end Surface would run. The only reason that I can imagine for Microsoft choosing ARM over Atom was because the Atom processor costs slightly more than the ARM one. Talk about cutting off one's nose despite their face.

Ultimately, Windows 8 will eventually dominate the desktop space -- it will be soon be the default choice on every PC shipped, so there's no question about that. But I also believe that Surface will fail to take more than a small bite out of the tablet market. Moreover, I believe that Microsoft's foray into the tablet space is going to cause its brand a lot of harm. Will users be put off the idea of a Windows tablet altogether after experiencing Windows RT's limitations, or hearing about them from friends and colleagues?

Will Windows RT get such a black eye that even other vendors' tablets running Windows 8 may suffer as well? I don't know. Vendors could use the Surface's shortcomings in their own advertising. Just imagine an ad run by Dell stating that "our tablet is the same price as the Surface, but runs the full version of Windows 8, along with all of your favorite games and programs."

As for me, I'm steering clear of this. Microsoft sat on the sidelines for far too long while it adapted Windows to run on tablets and smart phones, so it is now attempting to enter a market that is already dominated by two juggernauts. Not only that, Microsoft has been here before, when it tried entering mature markets dominated by Apple and Google. How'd the Zune turn out? And how often do you "Bing it"?

Disclosure: I am long AAPL. 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.

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