My thesis on Microsoft

It’s earnings season and I generally post a particular kind of post when that’s the case, including the Microsoft earnings post I did last night. Typically, I highlight a few key data points and analyze those, without stepping back to do a big-picture view on a company. But sometimes I worry that this leaves readers without a good sense of how I see the company in question and its prospects. So I wanted to do a follow-up post to yesterday’s in which I take a broader view and share my overall thoughts on Microsoft and its prospects. I’ll provide a list of links to previous pieces on Microsoft at the end of this post in case you’re interested in exploring any of this in more detail.

Windows PCs are in a long-term decline

A big part of how you see the future of Microsoft depends on what you think the underlying trend is and will be in Windows PCs, so let’s start there. I see two theories in the market at the moment, and which of these theories you subscribe to very much provides the lens through which you see Microsoft’s results each quarter. One theory is that Windows PCs are on either a stable or growing trajectory over time, and that any quarters in which there is negative growth are the exceptions to that rule. The other theory is that Windows PCs are on a downward trajectory over time, and that positive growth quarters are the exceptions rather than the rule.

For the following reasons, I subscribe to the second theory:

• PCs as a form factor are now one of several that can be used for the purposes that once required a PC, with tablets and smartphones providing adequate computing power and capability for what many people need
• PC hardware has reached the point where even those who see a need for a PC don’t perhaps see the need to upgrade it as frequently, because a PC from several years ago is still perfectly adequate, especially if relegated only to those tasks other devices can’t perform effectively
• Competition is gaining ground, with Chromebooks taking significant share in education and Macs gaining share in the broader PC market, especially among college students and other key groups. As such Windows PCs will be an ever smaller share of total PCs
• People are choosing platforms other than Windows in new device categories such as smartphones, tablets, wearables, smart TV devices, and so on. As these other platforms increase the degree of integration within their ecosystems, it will be harder for Microsoft to sell Windows PCs that don’t integrate as effectively with Android tablets or iPhones.

For all these reasons, I see a downward trajectory over time in sales of Windows in total, even accounting for the many different form factors Windows runs on. As such, last quarter’s poor performance in Windows sales is much more indicative of the longer-term trend than short-term headwinds. I see Windows 10 slowing the decline a little, but I actually think the free upgrades could stall or postpone new device purchases for some users, which may be counterproductive in the short term. I don’t see Windows 10 solving any of the fundamental challenges I just outlined.

Software sales to consumers will shrink to zero

To my mind, the other major question about Microsoft’s future is its ability to continue to sell software to consumers for a price. I’ve talked for some time now about the fact that, in Microsoft’s two major software categories (OS and productivity), its two major competitors and essentially every other company now give their software away for free. This state of affairs will continue to increase pressure on Microsoft to follow the same path over time, and it will either have to succumb to this pressure or see its sales and market share fall significantly. We’ve already seen some concession to this trend over the past few months, with Office on iOS and Android now providing many core features for free which were once only available to paying users. But over the past week we’ve also seen the announcement that Windows 10 will be a free upgrade for users of Windows 7 and 8. Upgrade sales have never been a major component of Microsoft’s Windows revenues, but the company has also increasingly been giving away OEM licenses for nothing or next to nothing.

I think these concessions to reality are absolutely the right thing for Microsoft to be doing, and it’s good that it’s making them sooner rather than later. But the end game here is clear: Microsoft will come to generate very little revenue from consumer software sales. That’s a big deal, because its “Devices & Consumer Licensing” revenue stream is about $4 billion per quarter today, or around 16% of revenues (this trend has been going on for some time — it was over 25% of revenues just three years ago). Importantly, this is a 93% gross margin business, too, so it’s not just losing revenue but a big chunk of overall gross margins too (around a quarter at this point, though almost a third in the past).

Consumer software at Microsoft will come to be not a revenue and profit source as much as a driver of scale for its intertwined consumer and enterprise businesses. Though some have called for the business to be split in two along business and consumer lines, that makes no sense, as I explained in one of my first posts here. Microsoft will drive scale through consumer usage of its key services, maintaining its position as the default option for productivity and other software, but will monetize almost exclusively through business sales.

With prices falling (and prices for quite a few of Microsoft’s existing and new apps set to zero already) I actually expect these apps to do very well in capturing usage and market share. Microsoft is doing some interesting innovation in the apps space, including new properties such as Sway, and it already has popular free apps such as Skype in the market. But none of these will drive any direct revenue for Microsoft. I do think some of the difference may be made up in advertising revenue — Bing is doing reasonably well growth-wise, even though display advertising continues to perform poorly. But ad revenue will never be a significant contributor to Microsoft’s overall revenue, and there are some strategic drawbacks to overemphasizing that revenue stream too in terms of Microsoft’s commitment to privacy.

Devices and hardware

Microsoft made big bets on devices and hardware under Steve Ballmer, as part of his Devices and Services strategy. That strategy, as I’ve articulated elsewhere, was to my mind driven by a realization of the consumer software trends I just described. In other words, if the consumer software licensing model was dying, Microsoft needed to embrace two new business models to replace that shrinking revenue: one was services, and one was hardware sales. Hence the acquisition of Nokia’s devices business, and the launch of the Surface tablet line. I don’t believe Satya Nadella believes in this theory to anything like the same extent (if at all), but he’s inherited both those businesses, and subtly shifted the rationale behind them. Surface is now no longer about driving a significant hardware business but about spurring OEMs to do better with innovation, while Nokia is about making the market for Windows Phone.

I recently published an in-depth report on Windows Phone (available for free here), which outlines my overall thinking on the platform. But in short, I believe Microsoft needs to be in the mobile OS and mobile device business simply because its two largest competitors — Apple and Google — are driving increasing integration of their core services into the OS on their devices. As such, even were Microsoft to create a compelling set of apps for these devices, they will always suffer from an inherent disadvantage vis a vis those competitors’ equivalents. I think Microsoft needs it own OS on mobile as elsewhere to provide an equivalent tightly-integrated experience on its own platforms. However, this doesn’t mean that it will necessarily be successful, and as I outlined in my report I see several significant flaws to Microsoft’s current strategy for Windows Phone. As I wrote shortly before the Windows 10 event last week, I don’t see the Universal nature of Windows 10 doing much to fix the app problem on Windows Phone. And meanwhile the growth of Windows Phone is almost all coming at the low end of the market. Microsoft’s theory here is that if it can capture these users now, it can up-sell them over time to smarter and more lucrative devices, but there’s essentially no evidence that it can do this. Certainly, almost none of the feature phone customers it’s losing at a rapid pace seem to be transitioning to Lumia smartphones.

The Surface line is less defensible in my view. With Nokia, Microsoft was buying the OEM that made 95% of the devices in the market, and which needed saving to keep Windows Phone afloat. But with Surface I believe Microsoft was effectively creating tension with OEMs without any underlying strategic rationale other than wanting to capture device revenues. As long as Surface was also woefully unprofitable, there wasn’t even a financial argument to keep it afloat, but now that it’s getting on a better financial footing, the argument for keeping it around is improving somewhat, even if the strategic rationale still isn’t there.

Overall, I think Microsoft has to stick with both Windows Phone and the smartphones it makes itself. I’ve been an advocate of ditching the Surface, but OEMs seem to have softened in their opposition to it, and at the same time it’s beginning to approach profitability, so I’m not as committed to that stance as I have been (it’d be far harder for Nadella to justify doing that now as well). But I think for Microsoft — as for Amazon — the focus in first-party hardware should be on what it can do uniquely well. The HoloLens hardware and to some extent the Surface Hub are examples in that category and I’m looking forward to seeing more detail on those in the coming months.

Business services won’t make up all the difference

With consumer services and devices providing a falling contribution to Microsoft’s business over time, the focus has to shift to business services. Office and Windows don’t face quite the same headwinds in the enterprise as they do in the consumer market, for a variety of reasons, but both will see declining revenues over time anyway as:

• More businesses turn to alternatives to Office, such as Google Apps
• Businesses shift from legacy Office versions to Office 365
• Businesses update Windows PCs less often or move to (as yet unannounced) new pricing models for Windows which generate lower revenue
• Businesses issue some employees who once had Windows PCs with other devices not running Windows, such as iPads or Chromebooks.

Given this decline and the much more significant decline in consumer licensing, Microsoft has to grow other business services significantly. Cloud services are the really positive story here, and they crossed $1 billion per quarter for the first time in calendar Q3 2014, and eclipsed Enterprise Services revenue for the first time in Q4. But that’s a drop in the bucket in the context of $26 billion overall revenues per quarter and a potential loss of $4 billion consumer revenue and more besides. I simply don’t believe that Microsoft has enough growth in the rest of its business to offset the various declines underway, and as such I believe Microsoft’s overall revenues will decline over time, possibly indefinitely but at least in the next few quarters. This is already happening, but the effect is masked in reported results by the inclusion of the Nokia devices business, which of course wasn’t present last year at this time.

Because much of the revenue decline will come in the licensing businesses, which generated 93% gross margins in Q4, while much of the growth will come in other businesses with much lower margins, this revenue decline will also lead to significant margin erosion over time.

In conclusion: a smaller, less profitable Microsoft

Ultimately, then, what I’m predicting is a smaller and less profitable Microsoft over time. But what I’m not doing is jumping on the “Microsoft is irrelevant”, “Microsoft is doomed” or other similar bandwagons. I don’t believe Microsoft is either of those things. As long as its key products are being used by over a billion people, as long as it continues to churn out compelling new apps (be they free or paid for), and as long as it continues to reinvent itself as it currently appears to be doing, I see a reasonably bright future ahead for Microsoft. No, I don’t see Windows Phone becoming a significant platform in the mobile market any time soon, and I don’t see the Surface being anything other than an also-ran in tablets. But I do see Microsoft continuing to be a very relevant platform in the enterprise market across PCs, tablets, mobile devices and cloud computing, while I see its apps and services being very significant in the consumer market, albeit not generating much revenue. I’ve had some great exchanges with readers in the comments section on recent posts, and I’d love to hear your thoughts on all this too, so please feel free to chime in.

Other posts on Microsoft

Microsoft is one of the companies I write about most frequently, both here and at Techpinions, where I write columns twice weekly. Here are some links to previous posts on Microsoft in those two places, and you can see the full archive of Microsoft-related posts on this blog here:

• Why Windows 10 can’t fix Windows Phone
• The Windows Phone app gap
• Quick Thoughts: Microsoft’s Office Moves
• Breaking down Microsoft’s business
• Nadella’s Manifesto
• What is Microsoft uniquely good at?
• Calculating Microsoft’s Windows Phone revenue
• Microsoft’s intertwined consumer and enterprise businesses
• From Needing Windows to Loving Windows (Techpinions)
• Microsoft in 2015 (Techpinions)
• The state of Windows Phone (Techpinions)
• Windows 10: fixing the Windows 8 mistake (Techpinions)
• What does cloud-first, mobile-first mean for Microsoft? (Techpinions)
• The Windows 8 mistake (Techpinions)