Microsoft’s Reason for Being Has Just Been Altered

Microsoft is being forced to change its business model in the wake of disruptive competition from both Apple and Google. But, adapting to this new model will prove easier said than done.

Jun 9, 2014 at 10:05AM

Ever since Apple (NASDAQ:AAPL) stopped charging for updates to its operating system, there has been a lot of speculation about whether Microsoft (NASDAQ:MSFT) will eventually be forced to do the same. For an even longer time, analysts have questioned if Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) free services and software model might dilute the importance of Microsoft's flagship Office Suite.

Speculators were right
From the look of things, Microsoft seems to be heading in that direction. To begin with, Microsoft recently announced that it would give free licenses to Windows Phone and Windows device makers that build smartphones or tablets with screens smaller than nine inches.

But, that's not all. Microsoft will also be giving away Windows 8.1, bundled with Bing as the default search engine within Explorer to lower the cost of these devices, according to management. This is a radical change for Microsoft's business model. The question is, will this new business model add value to Microsoft shares?

This changes Microsoft's reason for being
Originally, Microsoft developed WP8 to derive licence income, because that's what software companies do -- design software and sell user licenses.

For example, Nokia paid as much as $60 per device in licence fees for WP8 before the company's handset division was purchased by Microsoft, and Chinese handset maker ZTE paid between $23-$31 for every WP8 device it sold.

But, WP8 never caught on, partially because of the licensing fee Microsoft charged. Chinese manufacturers can instead build Android devices without paying anything. As such, competing with Google's Android OS and iOS (for other reasons) proved to be almost impossible for Microsoft.

Has Microsoft capitulated to Apple and Google?
The answer is yes. Microsoft capitulated to a changing market, driven by the disruption led by Google's smartphone ecosystem, and by the fact that Apple desktop owners will never have to pay for upgrades. In fact, that's one of the reasons Apple desktop computers have grown in popularity over the past 18 months, even as PC sales have continued to slide.

Will Microsoft ever give its desktop OS for free? That's unlikely because it costs a lot of money to keep Windows up-to-date, and Microsoft is not a charity. However, if Microsoft can find some way to monetize its ecosystem, free distribution might not be a bad idea. But, that's easier said than done, especially considering there are no advertising banners to be found on the company's search engine.

Houston, we have a problem
Microsoft is talking a very big gamble trying to copy the Apple and Google models, primarily because it is a very different company.

Apple does not not make money selling software -- Apple makes money selling hardware. As such, it gives its OS away for free because the company makes more than enough money from hardware sales to compensate for the expense of keeping its OS up to date.

Google has a different model -- it gives away much of its software and and charges nothing for its services because it aims to drive traffic toward its high-margin search and online advertising businesses. There is not a product or service that Google gives away that does not contain at least some kind of advertising that, when clicked, will not earn Google money.

Microsoft, on the other hand, does not make hardware, but software, and it remains to be seen if Nokia will ever become profitable. In addition, Microsoft has, so far, not been able to monetize Bing in the same way Google has monetized its own search. Bing is nowhere near capable of offering Microsoft the advertising and search revenue that Google takes in. In fact, Microsoft has not been able to gain much traction in the advertising space, ever since the company first attempted to crack the space.

Bottom line
Microsoft is being forced to change its business model in the wake of disruptive competition from both Apple and Google. Microsoft is apparently attempting to replicate Google's model, trying to increase the use of its ecosystem to drive traffic and sell services.

But, that will prove very difficult, as Google is well-entrenched in the Internet ad space, and Microsoft's Bing and smartphone penetration is no match for Google. As such, even if Microsoft is successful in the long term, things might get worse for Microsoft before they get better.

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George Kesarios has no position in any stocks mentioned. The Motley Fool recommends Apple and Google (C shares). The Motley Fool owns shares of Apple, Google (C shares), and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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