Everyone's excited about the forthcoming Windows Phone 7 software, which Microsoft bulls are hoping will mark Microsoft's return to relevance in the mobile industry.

Reviews of the software have been good, and the only major complaint is that it's a year behind the rest of the industry--namely Apple's iPhone OS and Google's Android.

In the rapidly evolving smartphone world, being a year behind is a recipe for trouble. If Microsoft focused huge resources on the problem, however, it might be able to close the gap.

But Microsoft actually has a bigger problem in mobile, one that threatens to turn Windows Phone 7 into the mobile equivalent of the $2+ billion-a-year cash incinerator known as Bing.

Microsoft's mobile software business model is fatally flawed.

Why?

Microsoft is still trying to jam the square peg of the old PC-based operating system software model into the round hole of mobile. And that game is over for good.

Specifically, Microsoft is trying to charge handset providers a software license fee for every Windows-based smartphone they sell, the same way Microsoft charges PC manufacturers a software license fee for every Windows machine they sell.

Five years ago, before the iPhone and Android, when Windows Mobile still had a reasonable share of the market, this model made sense. Windows Mobile was still a tiny business for Microsoft--hundreds of millions of dollars on a revenue base of $50+ billion--but the concept of handset manufacturers paying for OS software was intact.

Now, however, Google has blown that concept out of the water.

Google gives its smartphone software, Android, away for free. Free is a good price, which is one of the reasons Android is rapidly taking over the smartphone world. Free is also ~$15 less per copy than Microsoft is reportedly planning to charge per unit of Windows Phone 7.

But $15 is only $15, you say. It's not like it's hundreds of dollars per unit.

Yes, it's only $15--but it's $15 that either has to come out of the handset manufacturers' bottom line or get passed on to the consumer or carrier. And given the competitive pricing pressure in this business, it will almost certainly come out of the handset manufacturer's bottom line.

Carriers certainly aren't going to pay higher subsidies for Windows Phone 7 phones than they'll pay for iPhones and Android phones, especially if the software isn't state of the art. And consumers almost certainly won't pay, say, $214.99 for a Windows phone when they can get the latest iPhone or Android phone for $199.

So that means handset manufacturers will have to eat the cost. And when you take $15 a unit and spray it across hundreds of millions of units, pretty soon you're talking about real money. At least as far as the handset manufacturers are concerned (it will still be a rounding error for Microsoft).

Meanwhile, the other smartphone model that is working these days is the integrated hardware-and-software model, a la Apple and RIM.

Consumers and carriers DO pay for RIM and Apple software, but not explicitly, because it's included in the price of the phone. And because Apple and RIM have developed the software themselves, they don't have to cover someone else's profit margin in the sale.

In other words, Microsoft's mobile business is now stuck in the middle--caught between free software on the one hand (Android) and integrated hardware-and-software units on the other (Apple and RIM).

A few years ago, when the iPhone launched, Steve Ballmer ridiculed it as being the most expensive phone in history (oops). Then, when Android launched, Steve Ballmer ridiculed it, too, saying that he had no idea how Google possibly expected to make any money giving the software away for free (oops).

Steve's no fool, so we expect that the latter remark was probably just an attempt to get the rest of the world ridiculing Google rather than an actual misunderstanding of what Google was trying to do.

But now Google has done it. And now smartphone handset manufacturers have the opportunity to build their phones around a state-of-the-art mobile operating system that is completely customizable, has a large and growing base of app developers, and is available for free.

And that means that charging $15 a copy for Windows Phone 7 software has become a non-starter.

Meanwhile, Microsoft doesn't want to sell integrated hardware-and-software units because that would inhibit its ability to become a ubiquitous platform (like Android and, more importantly, like Microsoft Windows) that every developer wants to build upon. So the Apple and RIM mobile model is also a non-starter--at least until Microsoft realizes its predicament, throws in the towel, and buys RIM.

Put it all together, and Microsoft no longer has a business in mobile. Which makes its Windows 7 Phone strategy little more than a dream.

(How will this play out? We suspect it will play out by Microsoft deciding to give Windows 7 Phone software away for free. As noted, the business is a rounding error, and charging for a product that the market leader is giving away for free is just a non-starter. Microsoft has already demonstrated its willingness to flush billions of dollars a year down the rat hole of search, so we suspect it will just decide to throw a few billion down the mobile rat hole as well.

Unlike Google, however, Microsoft doesn't have another business that can subsidize the cost of Windows Phone 7. Giving Android away for free works for Google, because the incremental search revenue and profits pay for the investment. Giving Windows Phone 7 away for free won't cause consumers to buy more copies of Windows or Office. And Microsoft can't make the money back on search because its search business is already losing $2+ billion a year.

So this is indeed a predicament...).

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