Imagine a company that has been licensing its operating system to third party companies so they can build hardware to run it. Imagine that company falls on hard times but sees itself tied to that model as essential to market share growth. Now imagine this company deciding that it will focus its energies on its own devices and, as a result, throw its third party integrators under the bus.

If it’s 1997 and that company is called Apple, the action is now seen as a genius move that allowed the company to be reborn. However, if it’s 2012 and the company is called Microsoft, pundits have decided that it is the worst idea a company could ever have and a guarantee of failure. Are the pundits right? Will Microsoft fail? Does it have a choice? Let’s investigate.

An expected move

For the past five years, the discussion around the future of computing has shifted drastically from one where Microsoft had the thought leadership to one where Apple appears to be leading the way. With the introduction of the iPhone, an iPod with phone capabilities, Apple plugged a potential challenge to its dominance in the mobile music space and launched a new era of competition in the phone space: at the time, companies like Sony and Nokia were starting to add music playing features to their phone so Apple effectively shut down those threats by entering their field. The success of the iPhone eventually led to the development of the app store and eventually the launch of the iPad, heralding a new era of tablet computing.

Meanwhile, Microsoft had tried long and hard to be a player in those markets. In 2002, Microsoft used its existing compact edition of Windows (named Windows CE) to create what it called windows smartphones. Manufactured by third party integrators and using an interface that looked a lot like that of a traditional PC, Microsoft’s offering allowed its users to make phone calls, run some light version of Microsoft’s Office suite, use a web browser, and send text messages, instant messages, and emails. But after almost a decade of attempts, the company had few people buying phones with those capabilities.

With the launch of the iPhone, the market shifted drastically as Apple provided an elegant way with a wholly different approach to the mobile device experience. This eventually forced Microsoft to realize that the mobile experience was drastically different from the PC one and to get rid of the old approach: born from these newfound insights was Windows Phone, a new operating system that entered a market where Apple was dominant in terms of thinking and where Google was dominant in terms of device penetration. Thus Windows Phone was born.

But by that point, a lot of the market had already shifted; By the time Microsoft started to play catch-up in the mobile phone business, Apple had started rewriting the rules of the computing world by introducing the iPad, a tablet that did most of what the majority of people used a computer for, and did it with the same panache as the iPhone did things in the mobile phone space.

Microsoft just had to respond and it was long rumored that Microsoft would need to do something in the tablet space (another area it had pioneered with the introduction of the Tablet PC in 2001, a device that had a lukewarm reception) in order to remain competitive.

This week, Microsoft announced its move, with the unveiling of an integrated strategy that takes the Windows OS it will offer on PC devices in the fall (Windows 8) and makes it available in a tablet form (called the Surface) as well as in a reduced form factor (Windows Phone 8).

Software is Free

To understand why Microsoft is having something close to a panic state at this point, one has to think of a number of warning signs. For starters, customers are moving off the traditional PC, where Microsoft has long dominated, and on to tablets, where Apple is clearly dominant. Along with that move, a substantial portion of Microsoft’s revenue are evaporating as fewer copies of Windows are being shipped by third parties. Fewer copies being shipped mean a first strike against the existing revenue model.

At the same time, there has been worries about pricing. Because Apple does not have to license anything when it offers a new Ipad or iPhone on the market, and because it is underwriting the R&D costs of new version of its iOS operating systems by selling newer hardware, Apple has essentially pegged the price of an operating system at $0 (remember that upgrades to iOS are free as long as your device can support them). Meanwhile, Google has been offering copies of Android to third party manufacturers for a price close to free (the common conception is that they are giving it away for free but software licensing and patent issues has moved the price of Android from $0 to somewhere in the sub-$10 range). Compared to the $50 or so Microsoft used to charge for licenses of its PC operating system, this is a radical market change and third party integrators are starting to complain.

So the increasing perception (and this is one that will affect anyone in the business of selling software) is that software is free or close to it. Just look at the prices on most software packages aimed at consumer and you will see some substantial drops. For example, if we look at the price of several well known application to complete similar tasks on a computer, tablet, or via a web browser, we end up with something like this:

Category Computer Tablet Web Word Processing Word $40-50 Pages $9.99 Google Docs Free Spreadsheet Excel $40-50 Numbers $9.99 Google Docs Free Presentation Powerpoint $40-50 Keynote $9.99 Google Presentation Free AAA Game Civilization V: Gods and Kings $30 Asphalt 7 $0.99 Bubble Safari Free

In each case, the computer offering is several orders of magnitude larger than similar offerings on the tablet and most have free equivalents on the web. Looking at similar data, it is not too hard to extrapolate that the consumer market will continue to demand lower prices for software as it makes the transition to new device type.

Meanwhile, the trend of consumer behavior being an early indicator for what will eventually happen in the business world has to be another warning sign for Microsoft, which invented and managed to leverage substantial profit from being one of the largest software vendors in the world. So what is true today in the consumer market (a substantial drop in price and equivalent psychological expectation as to the value of software) may translate in what will be true in the enterprise space.

Along the way, the move to cloud infrastructures is reducing the need for software from Microsoft when it comes to enterprise grade systems. Today, many software as a service vendors offer products that are competitive to some of Microsoft’s more complex offerings at a substantially lower price.

The burning platform

Microsoft is finding itself on the edge of a burning platform. Two of its biggest cash cows, Windows and Office, are about to be value ata substantial discount over what they were valued at in the past. And the rest of their business may end up suffering the same fate in the future.

In the meantime, however, it also finds itself in the enviable position of generating and sitting on mountains of cash. So what’s a company in that position to do? If it were a lean startup, someone would advise them to pivot. And THAT is exactly what Microsoft is starting to do.

This week, beyond announcing Surface (which, let’s face it, still looks a little rough around the edges), the company also jettisoned its early adopters on the Windows Phone platform by announcing that it was radically changing the core in the new Windows Phone OS and thus was not providing any upgrade path to current users. A painful decision to make as it is bound to hurt sales of the current devices and will probably create frostier relationships with current partners (especially Nokia) but a necessary one to move forward. Just as Apple did when it essentially decided to stop licensing its operating system to third parties, Microsoft is concentrating on doing what is right for its own future and what is right in terms of giving it control over direction in that future. By concentrating on a single operating system core (in this case, Windows Phone 8 shares the same core as Windows 8), the company is reducing its costs and creating a valuable offering for developers as code that runs on one platform (eg. the PC or Xbox) can relatively easily be ported to another (eg. phone or tablet).

But while it seems to have finally gotten its software house in order, the company still needs to do something drastic on the hardware side. With over $50 billion in cash on hands, Microsoft could buy its place at the table on the hardware side. While everyone sees Nokia as an obvious integration partner (and at under $9 billion, it seems to be well on its way to becoming an acquisition target), there are others Microsoft could look into.

For example, Microsoft should consider Lenovo as a potential target to beef up its hardware side. The company has a long tradition of solid hardware and hasn’t expanded into the software business, as companies like HP have. It is also a company that has learned to integrate cultures rapidly, as a substantial part of its business was born from the acquisition of IBM’s old PC business. Alternately, it could acquire a company like Flextronics, which is a competitor to Apple’s Foxconn partnership and may be a cheap way to acquire supply chain experience.

Along the way, however, it also needs to start thinking about subsidizing its entry in the tablet market. Surface, the product the company introduced to great fanfare this past week, doesn’t appear to be ready for prime time yet. And the lack of actual pricing will continue to make it a non-contender until it has been offered. But let’s look at different pricing scenarios for the company.

How much for a Surface?

Once again, we have to look here at the market in order to see where the Surface needs to land from a pricing standpoint. There are two products to consider: the tablet (ie. the ARM version of Surface) and the PC (ie. the Intel version of Surface). Each product is different: the tablet is low powered and will hopefully have a longer battery life, and the PC is a more powerful machine but comes at a cost and weight loss.

So if we were to truly consider where they sit, the tablet is a competitor to the iPad and the PC is a competitor to the Macbook Air. This would seem to dictate price points that top out at $499 and $999 but the math gets more complicated when the features come in. For starters, why would I buy a tablet from Microsoft if it is priced at the same level as an iPad? Or why would I buy a tablet from Microsoft when I can get a Kindle Fire for $199? In the same fashion, why would I buy a Surface PC for $999 when I can get a macbook Air? Or why would I pay that price when I can get an ultrabook for $700?

Each of those questions weigh on the pricing and the pricing will impact the future of Microsoft’s surface. But what if Microsoft decided that it would look at those markets in the same fashion as it did the Xbox? For years, Microsoft subsidized the cost of the Xbox, eventually sinking $4 billion in it before turning its first profit.

Let’s remember here that Microsoft has over $50 billion in cash. What if it committed one fifth of that to the new platform ($10 billion) and decided that its attack on the market would be on build quality and pricing. Doing so could push the tablet in the $100-200 range and the PC into the $400-500 range, making it substantially more competitive (messaging: you can get a tablet from Apple or you can get a PC AND a tablet from Microsoft).

Doing so would radically change the economics in the marketplace. The casualty list would be long: HP, Dell, Sony, and probably Lenovo would find themselves out of the PC business. Google would end up having a harder time convincing anyone to build a tablet using Android. And Apple would have to increase the level of innovation (and thus potentially reduce its margins) in order to retain its control in those categories.

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