It wasn't long ago popular opinion dictated Microsoft's (Nasdaq: MSFT) best days were behind it. The threat of the federal government breaking up its business supported that assertion, but its product strategy also appeared stale. Like IBM (NYSE: IBM), which dominated the mainframe arena and later stumbled during the PC revolution, many investors thought Microsoft would miss the Internet express.
Early peeks at new products and services have since dispelled that notion. The company's Windows XP operating system and Xbox video game console are due to be released later this year. Then, there are Microsoft's Internet initiatives, which the Rule Maker Portfolio touched on earlier this year in the columns Microsoft's Future, which discussed .NET, and Microsoft's HailStorm. Lastly, the company plans to enter the device market.
.NET provides access to software applications over the Internet, and offers developers tools and services to build applications. HailStorm, an early component of .NET, offers Web-based services including a calendar, address book, credit card information, and messaging capabilities. The catch is that you can access these services "anywhere, anytime, on any device" with a Web browser.
The common denominator among these products and services is that each will be available through subscription. That's a significant shift that will provide a more predictable and annuity-like stream of income for Microsoft. Because most computers do not come with Office preloaded, for example, consumers could rent it for a flat fee and gain additional services, such as Internet access and technical support.
Microsoft has other subscription-based services, such as MSN Internet access and bCentral Internet site for small business. Starting at $25 a month, the latter offering includes a website, email services, a shopping cart for e-commerce transactions, credit card services, and customer service capabilities. That small monthly fee is ideal for small businesses that don't have the luxury of purchasing expensive enterprise applications from companies like SAP (NSYE: SAP) and Oracle (Nasdaq: ORCL).
Investors should applaud this move to a subscription-based model. Historically, software companies have earned the bulk of their revenue from upfront fees and upgrades -- resulting in an unpredictable stream of revenue. A subscription model, on the other hand, gives greater insight into future results. The risk, of course, is that there are no guarantees new software will be widely adopted throughout an organization, but given the mind share of Microsoft's applications, this is hardly a significant danger.
The subscription model should also have a positive impact on sales. Office, for example, dominates the market, contributing about $9 billion in revenue annually. The problem is that nearly every business already uses it and sees little reason to upgrade. The company has encountered the same trouble with Windows XP -- many businesses have yet to upgrade to Windows 2000, and the ones that have are so satisfied they don't see a compelling reason to upgrade.
With the market saturated and upgrades no longer a given, the subscription model could be the cure. Customers are lazy and though they might not be inclined to spend more on new software, they'll most likely continue paying a monthly fee to access Microsoft's applications whether they're new or not. Of course, it will still be important for Microsoft to make its offerings sexy with new products, but it certainly won't be under the same pressure to spur demand for its latest versions.
AOL Time Warner (NYSE: AOL) is one company that continues to benefit from subscription sales. It has more than 130 million subscriptions to a variety of offerings that include America Online, Time Warner Cable, HBO, and magazines. Last year, $14.7 billion (41% of its top line) came from subscriptions, and that doesn't include the incremental ad and commerce sales. While many businesses are hurting from slowing spending because of difficult economic conditions, AOL Time Warner is weathering the storm with much of its business already locked up.
Like Warren Buffett, we look for Rule Makers that can generate tremendous amounts of recurring cash flow with very little additional investment, while sustaining lasting competitive advantages. It's difficult to find technology companies that can display these characteristics because the competitive advantage periods are relatively short given the rapid pace of technological change, which forces businesses to constantly reinvent themselves. This has been one of the biggest knocks on Microsoft, versus some of our other holdings like Coca-Cola (NYSE: KO)
With more than $30 billion dollars on its balance sheet and annual R&D spending of $3 billion, Microsoft has the resources to continue reinventing its products. The problem is that the company has been forced to come up with upgrades to increase sales, and to spend millions on marketing. In certain cases, new products displayed very few advantages over previous versions. The market has become saturated, and by getting customers to subscribe the company won't be under such pressure to develop new versions that in many cases customers never really demanded. That should cut Microsoft's costs and lead to even more profits.