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The payoff could set Microsoft up well to take on the multidevice market it missed out on initially.
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Windows 10 will be a free upgrade for the first year after it's made available. Source: Microsoft
There's a reason developers typically make apps for Apple's (AAPL +0.01%) iOS first. The majority of the iPhone and iPad user base all use the most recent version of iOS. Android, comparatively, is highly fragmented.
The problem is just as bad for Microsoft (MSFT +0.01%) and its Windows OS for desktops, laptops, and tablets. Windows 8 was a flop, with only 13.5% of PCs running the OS more than two years after its release. When Microsoft ended support for Windows XP last spring, longtime users upgraded to Windows 7 instead of Windows 8.
As Microsoft attempts to extend its operating system across all types of devices -- desktops, laptops, tablets, phones -- it's of the utmost importance to have mass adoption of its newest OS, Windows 10. That makes it easier for developers to target a large audience with their apps, and that's why Microsoft is offering Windows 10 for free to Windows 7, Windows 8.1, and Windows Phone 8.1 users.
Windows 10 must succeed
Windows licenses account for nearly one-third of Microsoft's total revenue. If the company is unable to build momentum behind Windows 10, rejuvenate the PC market, and stop the platform shift to Mac, it's going to hurt one of its biggest cash cows.
In 2011, Windows generated over $19 billion in revenue and $12.3 billion in operating income. While Microsoft reached those levels again in 2013 with the release of Windows 8 and the Surface, operating income fell significantly to just $9.5 billion. Last year, the expiration of Windows XP support couldn't prevent Windows sales from declining again.
As mentioned, most Windows XP upgraders chose Windows 7 over the newer versions of Windows. But Windows 7 doesn't support a key component of Microsoft's new cloud and device strategy: the Windows Store.
The Windows Store is Microsoft's answer to iTunes and Google Play. It's the first step in unifying Microsoft's old single-device system to the cloud-connected, multidevice world we live in now. Getting more users on a version of Windows that supports the Windows Store is key to attracting developers to the platform. With most upgraders electing Windows 7 over Windows 8.x, Microsoft is falling further behind Apple and Google with its app store.
Windows 10 extends the cloud strategy by integrating closely with other Microsoft services such as OneDrive and of course Office 365 -- both of which operate seamlessly across multiple Windows devices with a user's Microsoft account.
A short-term hit
Microsoft is sure to feel at least some short-term pain from providing free upgrades to a large percentage of current PC users. When Apple started providing upgrades of OS X for free, it lost an estimated $1 billion in revenue. With a much higher percentage of PC users running Windows 7 or later, the impact could be much more severe for Microsoft.
It could also impact new PC sales, which directly impacts Microsoft's Windows licensing revenue. If a Windows 7 user can simply upgrade the OS for free, he's likely to put off buying a new computer longer. Part of the reason businesses maintained their Windows XP machines was the cost associated with upgrading hardware to use Windows 7. Microsoft's offer to upgrade Windows 7 machines for free indicates its belief that a hardware upgrade is unnecessary to run the new OS.
Betting big
Giving away Windows 10 is a gamble that Microsoft is willing to take because the payoff sets it up well to take on the multidevice market it missed out on initially. Giving away Windows 10 should allow it to grow its market share quickly, which will attract more developers to its app store, where Microsoft can make some money on the back end. Additionally, mass adoption makes it easier to sell users on Microsoft's cloud services.
The impact of giving away Windows 10 will be hard to hide on Microsoft's earnings reports, however, considering Windows accounts for more than $18 billion in annual revenue. In the long run the company clearly believes strong adoption of Windows 10 will allow it to sell more Windows devices and generate more revenue from its app store.
After all, Apple grew iTunes into an $18 billion business. Why can't Microsoft leverage its 1.5 billion Windows devices into another $18 billion business of its own?