Why Microsoft Needs To Make Windows And Office Free

| About: Microsoft Corporation (MSFT)

Analysts and investors were bullish on Microsoft's (NASDAQ:MSFT) recent earnings, sending the stock up 6% in Friday trading. Microsoft's enterprise businesses are driving higher profits while investors, the press and Microsoft itself were surprised by better-than-expected Windows results in light of the PC market decline. Many have used the 7% decline in year-over-year Windows revenues to argue that the PC market is bottoming out.

But is that really what the numbers show? Not quite. Rather, the numbers show continued significant declines in both Windows and Office consumer products.

Consumer Windows

While overall Windows OEM revenue dropped only 7%, Microsoft also disclosed that Windows consumer (i.e., non-Pro) OEM revenue dropped 22% year over year versus a 6% gain in Windows Pro OEM license revenue. See 10-Q. While the overall 7% decline was roughly in line with overall PC market trends, the consumer vs. Pro breakdown shows a real divergence that I expect will continue. (This is the first time that we have been provided with this precise breakdown between Pro and non-Pro OEM licensing revenues but we will be able to model these trends in coming quarters. Note that enterprise volume Windows licenses are reported in yet another segment, Commercial, and are not reflected in the Pro OEM licensing figure.)

The bottom line in terms of consumer success for Windows 8 is not the 7% decrease, it's a 22% decrease. And that is a huge drop.

Businesses are stuck with Windows for the foreseeable future, but consumers have other options and they are choosing to leave Windows. Whether it's Android or iOS tablets and smartphones or Chromebooks doesn't really matter. Windows consumer licensing fees are down 22% year over year, and I expect further declines until Microsoft changes its consumer business model.

With Wall Street demanding growth and management in transition, it's tough to change your business model, particularly if that change will result in decreased profitability over the short term. That's a lot to ask from Microsoft right now. But the business model of $100+ OEM licensing fees for consumer devices is broken. If Microsoft doesn't change its business model, it will only experience continued declines in OEM consumer licensing revenues and decreasing overall (PC plus tablet plus phone) consumer market share.

So what if Microsoft made Windows consumer licenses free? Quarterly results would take a hit as the large (but shrinking) consumer OEM license revenues would obviously go to zero. But market share would spike, and Microsoft could focus on other revenue streams, including the Windows app store and integration with all of Microsoft's other services. I think a good CEO could spin that story. The alternative is continued declines anyway as the future of consumer tech is inexpensive devices that will not support a $100+ OEM license model.

That would be decisive action, and I think would be good for Microsoft in the long run. Take the tough medicine now or just get sicker. To be clear, I'm definitely not expecting management to do this.

(Another interesting side-note here is that consumer OEM (non-Pro) Windows licensing fees excluding China were only down 17% versus 22% globally. What is the story in China?)

Consumer Office

So how is consumer Office doing in comparison? Again, the new reporting segments make direct comparisons difficult because legacy consumer Office is included in Devices and Consumer - Licensing, while Office 365 Home Premium is included in Devices and Consumer - Other. Microsoft is pushing Office 365 Home Premium and its $99 per year licensing fee, and has reported over two million Office 365 Home Premium subscribers as of September 30, 2013.

Two million Office 365 Home Premium consumer subscriptions at $99 (assuming no discounts) puts the product at about a $200 million annual run rate. For a company with nearly $78 billion in annual revenue, that represents around 0.25% of company-wide revenue. Now obviously this product is still relatively new and is growing, but 0.25% is nothing more than a rounding error for Microsoft.

And that makes sense because what consumer in 2013 is going to spend $99 per year in perpetuity on office productivity software? Yes, a few will, but that's a very limited market. With pressure from Google (NASDAQ:GOOG) and now Apple (NASDAQ:AAPL) with free alternatives, how many consumers are really going to spend $99 a year on this? This is just common sense. Consumers just don't like the idea of perpetual licenses fees. Office 365 Home Premium was a bad idea from the start. This is an enterprise pricing strategy being implemented in the consumer market. Office 365 Home Premium seems like the idea of a group of MBAs and salespeople trying to respond to the threat of Google Docs while still hitting their profit targets.

Two million subscribers is also a tiny minority of total consumer productivity software users and that creates a real long-term problem. If the vast majority of the consumer market is using non-Microsoft alternatives, those alternatives will become more familiar to the average person, and that is a real long-term risk when the value of the Office franchise depends less on its capabilities and more on its standard of familiarity and ubiquity.

So why not also make Office free to consumers? The loss of the current Office 365 Home Premium revenue stream is nothing more than a rounding error and the legacy Office software sales are declining. Microsoft already bundles free Office software with its Surface RT/2. Why not do this with all Windows machines? Sure, there will be a small short-term revenue impact, but in the long term it will drive consumer adoption of Windows machines, including tablets and phones, and probably deliver a knock-out to the threat of free alternatives like Google Docs.


Microsoft's needs to re-think its consumer strategies. Obviously Windows and Office are solid in the enterprise and it's likely that will never change.

But in the consumer world, embedded $100+ OEM non-Pro licensing fees are only helping Windows lose market share, contributing to the 22% year over year decline. The $99 per year consumer Office licensing fee is just a bad idea and completely misunderstands the modern consumer market dynamics. It's a risky strategy that pushes consumers to free alternatives like Google Docs in return for a rounding error's worth of revenues.

The numbers show it's time to make consumer Windows and Office free. Or, to be more precise, to make consumer Windows free and consumer Office free on Windows devices. With a low P/E and strong enterprise growth, this would result in little more than a temporary speed bump in the company's overall performance. The consumer story would be: device sales driven by these dynamics, together with "ecosystem" sales such as sales from the Windows app store, Bing integration with Windows, Skydrive integration, etc. Essentially this would be a hybrid Apple/Google strategy where software drives profitable device sales (Apple) and market share drives services (Google). To me, that sounds like the right strategy, or at least the inevitable strategy. The status quo is only going to drive more consumers to non-Windows and non-Office alternatives. In the long term, that's a real risk, even to some of the solid enterprise businesses.

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.

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