Sunday, October 14, 2012

Can Microsoft be saved?

Steve Ballmer’s last weeks’s annoucement makes it clear: Microsoft is transformed into a hardware company. It is however also a very risky decision, as Microsoft now becomes direct competitor with its biggest OEM allies, like Dell, HP, or Acer, which are essential for its Windows related business that brings the company nearly all its profits.

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In his annual letter to the shareholders Ballmer specifically mentioned that Microsoft will focus on market development around its Xbox game console and the newly announced tablet Surface, and it will also develop other devices running Windows as needed (speculations are mainly about mobile phones). It will also continue developing its online services such as Xbox Music, Video, Games, and applications such as SmartGlass that interacts with these services and allows you to control the Xbox game console from mobile phones and tablets, so it is possible, for example start watching a movie on the phone and then switcih it to the big screen of the TV.
This announcement represents a major change of Microsoft’s strategy. So far, Microsoft focused on software development, while it left the hardware market to its OEM partners, in particular the giant companies such as HP, DELL and IBM (now Lenovo, to which IBM sold its PC division). These partners have actually managed to push Windows as the de facto standard in the market by selling their computers that came preinstalled with Windows. It is mainly thanks to its excellent partner strategy, that Microsoft became the largest IT company of its time in the world.

But if Microsoft will now enter the hardware market, it instantly becomes one of the key competitor of its vitally important partners, thereby threatening its core profitable segment that feeds him. Step that was now made by Microsoft by its announcement of Surface tablet and Ballmer’s letter of last week is thus not easy. Microsoft enters path with no return, if it goes wrong.

The journey is all the more risky, that Microsoft is already trying to move into new market segments for a long time, but till now with very poor results. For example, its Internet services (including search engine Bing) are long-term subsidized by income from Windows and Office. Thus, if such income dries up now and the transition to hardware market fails, Microsoft will no longer have any backup plan that would save him.

What is the main problem of Microsoft?

But times have changed, and Microsoft must make a change now. It is pushed by the relative decline in the size of its core market - the market of commercial software for the PC. Personal computer on which the Microsoft dominates is no more the only or even the most important IT market. As a result of the gradual transition of the IT industry towards Internet (cloud) services and the increasing role of consumer electronics, the importance of PC decreases and with it decreases also the market for commercial software for the PC on which Microsoft makes almost all its profits. Microsoft now simply has to move away from the declining PC market towards the markets that grow, otherwise it will only watch how its core business disappear, without having been able to create another one. But although Microsoft is already trying for many years to invest in the transition to new markets, with the exception of the Xbox game console, he's still failed.
Microsoft's problem can be thus defined as follows:

  1. Firstly, the exclusivity of PCs, where Microsoft has its dominance, expires; hardware market no longer consists solely from a PC, but now its majority is constituted by a variety of other devices (mainly smartphones and tablets), where Microsoft has only a negligible share.
  2. Second, the whole market of the commercial software is declining and will terminate - even on the PC. It is now newly challenged by competing Internet services that are cheaper (often free) and offer better performance, especially in the area of ​​communication and data sharing. Thanks to the Internet (or cloud) services users do not need any more to buy software to obtain the functionality they need.
Let us now describe Microsoft’s both problems in detail, and then we look at possible steps, how could Microsoft solve the situation.

PC exclusivity ends

Since 2010, when Apple introduced its successful iPod, the PC market is declining (in two years it declined according to research company Gartner by 8% and now it quarterly sells 87.5 million PCs), compared to the smartphone market which is on the other hand growing rapidly. Over the last year the smartphone market increased by 42.7% and quarterly sells 154 million units. Another fast growing market is, according to Gartner, market of tablets, which this year is to sell 119 million units, up 98 percent compared to 2011. In the same report, Gartner expects Microsoft tablets will constitute only 4.1% of this number .
From these figures we clearly see that the share of PC in the IT market is dramatically declining. PC (where Microsoft has the dominant market share) is no longer synonymous with computers, more and more users are accessing Internet services from other devices, particularly from mobile phones and tablets, where the market share of Microsoft is negligible. Microsoft therefore loses the market in which it is dominant with its Windows operating system share of 92% and where it also makes most of the money on Windows and on its office suite Microsoft Office. The market is shifting to areas where Microsoft is not successful at all. And this is a serious situation indeed.

Which emerging markets are thus available?

Let us summarize, then, that in the "Post PC" era (the time of consumer electronics, or the time of cloud) PC exclusivity ends along with the market of commercial software. On the other hand, there are two new giant markets emerging: market of Internet (cloud) services that will replace not only today’s market of software, but also market of media, advertising, music, games, entertainment and selected professional services, and mass market of consumer electronics, which will serve as terminals for the use of these services. Both markets may be the target of Microsoft. Both are huge, we can even say the greatest ever created by mankind. Consumer electronics market will have the size in the tens of billions of devices, while the market for services will serve this giant market and through it also to almost every person on the planet, and among other things will absorb the advertising market, which will also become the main pillar of its business model. So Steve Ballmer in his report to shareholders does not say anything radically new. Microsoft needs to move from areas which it dominates, but which are gradually disappearing, into new markets of hardware and services that grow.

Now that we have explained the nature of the problem Microsoft faces due to external changes in the IT market, let's look also at the second problem - we can call it an internal problem of Microsoft. It consists from the fact that Microsoft has long been trying to enter both these markets (in some cases even for over twenty years), and yet it has not yet been successful, with the exception of Xbox.

Attempt No. 1: mobile operating system

Among the first attempts of Microsoft was a natural effort to transfer its dominance in the market for PC operating systems to the market of operating systems for mobile devices. Today, after 22 years of development, is a worldwide market share of Microsoft’s mobile operating systems only 3.2%. Compared with 16.4% share of iOS, which came on the market only 5 years ago in 2007, or 68.1% share of Android, which came on the market even a year later, it is certainly not a success. In recent years, Microsoft position is even worsening, as can be seen from the graph below (source):

Attempt No. 2: online services

With regard to the Internet (or cloud) services, in this area, Microsoft has been involved, from August 1995. In 2011 server ZD Net calculated that for 9 years, Microsoft online division has lost $8,5 bn. In addition, the trend is not positive. This July, this division turned Microsoft the first time in Microsoft's history into the overall quarterly loss when writing off unsuccessful acquisition of advertising firm aQuantive in the amount of 6.2 billion USD. Over the past 5 years Microsoft Online Services Division has lost more than $ 10 billion.

Attempt No. 3: Search

The most visible effort in the field of Microsoft online services is its search engine, let us therefore discuss it specifically. In the course of development it had a number of names. The first search engine called MSN Search launched in the fall of 1998, incidentally the same year when the company Google was founded (which, however, began as a research project in 1996). This time Microsoft used third party search algorithm provided by Inktomi. In November 2004, Microsoft began using its own search. In 2006 the name was changed to Windows Live Search, and a year later to Live Search. In 2009, it changed the name last time to Bing. Thus we see that Microsoft offers its search service for the entire time as Google.
Now our traditional question: how successful is its search? As regards the global market share, the specific numbers vary by source, but, for example according to the company StatCounter, global share of Google search is 91% (September 2012), while Bing's share is just 3.1% and Yahoo with which Microsoft entered in July 2009 a ten-year contract in which they Yahoo pledged to use Bing, other 2.9%. This sums to 6% of Microsoft against 91% of Google.
Recall that search engine Bing has massive support of Microsoft’s top management: In 2009, Steve Ballmer said that during a period of up to five years, Microsoft is willing to invest in its search engine 5 to 10 percent of its operating profit, for a total of up to $ 11 billion.
And so we come to the financial side of things, which reveals an even bigger problem. Just in the last three years, from the time of renaming the search engine to Bing, Microsoft's search engine Bing has lost 5.5 billion USD. Can we thus consider the current 6% share in the global search after 14 years of service and a truly giant billion-dollar investments a success?

Game consoles - market success, but financial problem

Now we come to the segment in which Microsoft managed to settle down and become a world leader. It is a market of game consoles, which Microsoft dominates with his Xbox. But even here there is a catch. Just because something is popular does not mean that it is also financially successful.
Let us answer the question of whether Microsoft suceeded on the market of gaming consoles. In terms of dominating the market, yes, but if we look at the total investment by Microsoft to promote gaming consoles on the market, it unfortunately greatly exceed current revenues from this segment, and probably also possible revenue of this segment in the future. Both the original Xbox and the Xbox 360 were sold by the company for many years with the loss of about 125 USD on one device. Xbox total sales till the first quarter of 2012 were 67.2 million. Server The Motley Fool server calculated that the cumulative loss in the history of Microsoft Xbox till the first quarter of 2012 is $ 4.1 billion.
It is therefore questionable whether this segment of the market will last enough to at least recuperate that loss back. This question is very valid, by the way, because the general trend of the transition to the cloud services does not leave space on the market for the device where you install your games because these games will be indeed available online (using services like OnLive or Gaikai or today’s virtual worlds). Such equipment is not needed aven for storing on them recorded music and movies, and then from the home server sharing them in our iPads, tablets or smart phones. This functionality is a vital functionality of online media libraries that are as a matter of principle (because it is an internet service) available from any device in the world, without having to run your home server. At home, we really only need to have enough terminals (smartphones, tablets, televisions), plus internet access. Everything else will be arranged by relevant Internet services. How long will be Microsoft able to keep home entertainment server in our homes in the time of cloud?

What can thus Microsoft do?

Bottom line, Microsoft can actually enter two growing markets: the market for Internet services, and the market of consumer electronics. With the Internet service market is the problem that Microsoft has already entered it, and although he gives due priority to it and invests truly enormous sums in the tens of billions of dollars here, yet still failed to get significant share.
That leaves the hardware market as the only viable option, which is with an exception of video game consoles (and some PC peripherals) untouched by Microsoft. This market was taboo for Microsoft, because Microsoft did not want to offend its core hardware partners, on which depends its main business with operating system Windows.
But Microsoft is aware that it can wait no longer. PC market declines not only in relative but even in absolute terms, while in the segments that are growing rapidly (especially smartphones and tablets), Microsoft is "missing the boat". His partner policy doesn’t work here and share of Microsoft's operating system is in units of percent only. Even Microsoft’s alliance with Nokia failed, and didn’t help Microsoft to grow its smartphone OS market share. Everything therefore points to the fact that all options have been exhausted, and Microsoft has no choice but to enter this market alone.
Microsoft made one more trick. It united its successful Windows operating system for PCs with its failed operating system for mobile devices into one product. Even this is a risky way, it may in fact turn out both ways. Windows PC can transfer its popularity on Windows Phone, but it can also for example happen, that major modifications made to the user interface of Microsoft Windows will be too radical for existing standard Windows users, and the new Windows version will not take up.

Will Microsoft Surface tablets salvage Microsoft?

It seems that Microsoft now bet everything on one card - on its Microsoft Surface tablet. Technically, it is really nicely designed product. It has an innovative design (according to some opinions, even better than Apple), impressive build quality and interesting features (stand and keyboard cover), and also offers compatibility with the previous PC world. It will enter the market on 26th October this year. The question is whether or not it can reverse the situation on today’s tablet market dominated by iOS and Android.
A lot will depend on the price. There are many speculation on the internet on this topic. Some opinions say that Microsoft does not leave anything to chance and cheaper tablet model called Surface RT will be sold at a subsidized price of around $ 199, that is, the price at which Google sells its small tablet Nexus 7. If that were true, Surface RT would become the cheapest full size tablet on the market (for comparison, Apple sells the latest iPad for $ 499, Samsung Galaxy Tab 2 10.1 starts at $ 400, the Kindle Fire HD+ starts at 299 dollars and Barnes & Noble Nook HD+ starts at 269 dollars).
In this case Microsoft would then lose about $ 100 on each piece (with the increasing volume of production it will be less would reduce), so that if it has to sell 30 million units, which would provide a visible market share for it, it would need roughly $ 3 billion. It is a large sum, but for a company that has $ 56 billion of cash, this is not the biggest problem (as we have already mentioned, a bigger problem is the risk of loss of its key hardware partners). Although this speculative plan is really aggressive, these $ 3 billion would probably have been better invested than, say, the  $ 8.5 billion that Microsoft paid in May 2011 for the purchase of Skype. In addition, Microsoft has already subsidized hardware ($ 125 per Xbox) with a good result: then he actually managed to successfully dominate the gaming consoles market.
We will see soon. On the 25th October Microsoft planned a press conference that will end the speculations.

Risky gamble

Personally, I think Microsoft has no other way but to invest all its energy to succeed in the field of consumer electronics hardware, even at the cost of subsidized production. The road is a risky gamble, but other routes have been already tried and failed. Microsoft must invest everything to break through in the field of hardware. This would not only open the new segment it so desperately needs, but also will give meaning to its ecosystem of online services, including search engine Bing.


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