Microsoft's Billion-Dollar Question

It's kind of funny when you can write about a company's "billion-dollar question" and have it seem trivial, but such is the case for Microsoft (Nasdaq: MSFT  ) and its larger high-tech peers. Still, news that Microsoft plans to spend $1 billion on the launch of its new Windows Phone 7 deserves a closer look. Is it too late for Microsoft to get back in the game, even with a massive marketing push?

Buying friends
A lengthy TechCrunch article quoting a Deutsche Bank analyst who spoke with company executives says Microsoft plans to spend about $500 million on marketing and give $500 million to developers and phone makers to subsidize app and handset development. That's just costs for the launch, too; over the course of the year Microsoft and its partners plan to spend "billions." For context, the company spent $13.2 billion on sales and marketing last fiscal year. Of that $13.2 billion, only $1.6 was direct advertising expenses.

The surge of money is needed to give Windows Phone 7 a fighting chance and keep handset makers rapidly coalescing around Google's (Nasdaq: GOOG  ) Android committed to the platform. After announcing an impressive slate of launch partners, Microsoft has lost support throughout the year. An especially troubling loss was Hewlett-Packard (NYSE: HPQ  ) , which shifted away from Windows Phone 7 and Windows on its tablets after buying Palm.

Lies, damn lies, and statistics
Of course, Microsoft will say it's still early in the game and the company can come back with a strong Windows Phone 7 launch. According to Greg Sullivan, a product manager quoted by TechCrunch:

We have a long-term view and Microsoft has been in this position before in other businesses where we've had to take a long-term view. … The mobile phone market is growing by leaps and bounds, but it's still in the early stages.

Rule No. 1 of the mobile world: Don't believe anyone who says it's still "early." North American and European smartphone penetration rates are over 30%. While that leaves plenty of growth, a set number of users don't want to pay for data plans, so the penetration rate of "available" smartphone users is actually higher.

Second, smartphone users download software (apps) to support their phones, which presents a switching cost. Once someone has loaded their smartphone with tools and games, do they really want to start over on a new operating system? Plus, they get used to the user interface and functionality of their phones. Stealing smartphone buyers from other platforms is difficult; 89% of Apple's (Nasdaq: AAPL  ) iPhone users and 71% of Android users plan to stick with their current operating system on their next upgrade. I know it's Greg Sullivan's job to wax optimistic, so I don't blame him -- but don't buy the optimism.

Bottom line
I hate to sound dismissive of Windows Phone 7 before it even hits stores, but the deck is stacked against it. Regardless of Windows Phone 7's features, it's just too late in the game. While Microsoft's massive scale gives it the advantage of being able to seed development and handset maker support with its large cash pile, the fact that several partners are pulling away (despite the massive incentives) is troubling.

The smartphone market seems to have hit a tipping point where support for a couple platforms (Android and the iPhone) is snowballing. The two platforms are seeing exponential developer support while Research In Motion (Nasdaq: RIMM  ) fails over and over again to come up with a competitive high-end phone and Nokia (NYSE: NOK  ) stays lost in the woods.

However, there are some bright spots for Microsoft. I like what the company is doing with its Xbox Live integration. One of the key reasons Apple has been so successful is how well its software scales (its iOS runs on iPods, the iPhone, and the iPad), and the common theme of iTunes linking up digital media. In the process of creating Windows Phone 7, Microsoft connected Xbox Live -- which has powerful media as well as social elements -- with its operating system. This kind of clean, seamless integration between several consumer devices is an improvement for Microsoft, a company notorious for business units that operate in silos.

It's not that Apple has better innovation talent or outspends Microsoft (Microsoft's R&D budget is over five times as large), it's that Apple has always had a tight focus and a unified experience that appeals to consumers.

Microsoft is trading at a P/E of about 9, net of cash. That suggests that the market isn't expecting much success from Microsoft outside Windows, Office, and its Server and Tools businesses. All the reports of Microsoft's fumbling of the mobile market serve to obscure its innovation in other areas, like cloud computing.

When you're more than three years late to the smartphone game, you take whatever good news you can get. The vital signs on Microsoft's mobile efforts look grim, but that doesn't mean the company's not a good buy at today's prices.

Eric Bleeker owns shares of no companies listed above. Google, Microsoft, and Nokia are Motley Fool Inside Value recommendations. Google is a Rule Breakers selection. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Google. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 05, 2010, at 3:26 AM, AlexanderAkhavan wrote:

    To be honest, I do not see alot of people at work using Blackberrys. Its anecotal of course, but most people I know have switched to the IPhone.

  • Report this Comment On September 05, 2010, at 3:49 AM, iamtiger wrote:

    When you are talking hi tech its never too late... People upgrade their phones every year.... I know people who jump from one OS to another on a regular basis.. You need to check the forums and youtube... People are clearly getting impatient waiting for this WP7 OS... With the XBox integration alone, this phone would have been successful.. What does XBox Live have like 250 million members... Also dont underestimate the Zune Pass service.... And I didnt even mention the min. specs required for this phone.. The iOS is buggy as hell, it hasnt been out for 3 months and it already had to be updated(fixed)... the android is so slentered people dont even know what version they have, some apps work on certain phones and not others... The google app store is full of porn and apps that zap your batteries, the apple app store is full of thousands of apps that all do the same things... Considering that, I would say no its not too late... If fact its right on time...

  • Report this Comment On September 05, 2010, at 8:05 AM, laramr1 wrote:

    Corporate America is still dominated by Blackberry.

  • Report this Comment On September 05, 2010, at 2:54 PM, uc22 wrote:

    Funny how Win Phone 7 is too late but all of you so called ananysts think every Tom, Dick and Harry that writes a basic OS is going to take WIndows down.

  • Report this Comment On September 05, 2010, at 3:07 PM, TMFRhino wrote:

    uc22,

    I don't think anyone has predicted Windows is going down.

    iamtiger,

    Have to to disagree. It can be too late. People could have said it wasn't "too late" to usurp Microsoft's OS lead back in the late 80's but market dynamics had pretty much assured the company's success. Also, while I like the Xbox Live integration (and wrote positive things about it above), there's been about 40 million Xbox 360's sold... So the 250 million figure is a bit high.

    Best,

    Eric Bleeker (TMFRhino)

  • Report this Comment On September 05, 2010, at 8:18 PM, AngelTread wrote:

    The article says that Apple's appeal is because of its unified experience that scales across multiple devices (pad, pod, phone).

    This is where Windows Phone 7 fails. It runs on a phone only. Slates must use a different OS.

    Samsung is one of the OEMs getting cold feet about Windows Phone 7. Samsung's Galaxy phone and Galaxy Tab will now both run Android.

    HP will run WebOS on phone and slate.

    Confusion comes to companies that try to use Windows Phone 7, as they cannot keep that unified experience that people want.

    LG will release an Optimus phone running Windows Phone 7, but because WP7 doesn't run on a slate, LG will run Android on its Optimus Pad. Different user interface. Different experience. No unified interface. Consumer confusion.

    Windows Phone 7 is a sure failure, and Microsoft still does not understand why Apple's portable devices appeal to consumers.

  • Report this Comment On September 06, 2010, at 1:00 AM, uc22 wrote:

    Eric,

    The media has been talking all year about Chrome OS and how it will take down Windows. I hear many still talking about Linux taking down Windows and every time OSX gains 0.001 percent of the market I hear how the days of Windows are numbered. Don't get me wrong, I use and love all of those (except Chrome which is not ready for primetime) OS varients. I am just not insane enought to think they will bring Windows to its knees. If you like I can post links to at least 20 articles that predict the fall of WIndows, many of those written in the last year. Basically what I am saying is, if any ole OS can take down the dominate OS on the market, why is it that Win Phone 7 is too late considering that no one smartphone OS really dominates the market?

  • Report this Comment On September 06, 2010, at 2:38 AM, AngelTread wrote:

    Has anyone asked Sony Ericsson and Toshiba why they abandoned Windows Phone, after initially signing up to it?

  • Report this Comment On September 06, 2010, at 2:48 AM, uc22 wrote:

    @Angeltread,

    I don't know about Toshiba but it appears Sony has a WP7 phone coming. It will not be at initial launch though.

  • Report this Comment On September 07, 2010, at 10:07 AM, DaveGruska wrote:

    I keep hearing about iOS's high switching costs. I've bought maybe 6 or 7 apps that at most cost $2.99 - the rest are either free or are free for a day or so through FreeAppADay, etc.

    At most, all the quality cheap/free apps may present a higher barrier to entry for a new player to catch up, but as a user, I wouldn't have a problem leaving my ~$15 investment in apps to switch if something better came along.

  • Report this Comment On September 08, 2010, at 9:15 PM, TheDumbMoney wrote:

    I think MSFT will continue to be a success as a company (Windows, Bing, Explorer, Office, Cloud, medical applications, etc.), but I'm not buying more shares because I have any high expectations for Windows Phone 7. I tend to agree the ship has sailed, at least domestically.

    I do think MSFT's competition in this space is virtually solely Android and RIM and Nokia, not Apple. Apple is the luxury provider. And it has dropped in market share of the smart phone market in the last year. Apple would much rather make bookoo profits off of over-paying hipsters and have a low market share. Android and the others are the lower-cost, open providers, and Google is most likely to become the MSFT of the smartphone market. Android has recently equalled or surpassed iphone in market share, and is growing much faster. Remember that Apple once led in desktop software, too, many years ago, in a galaxy far, far away (and at about the time those words were originally scrolling up movie screens). Its closed loop is its strength and its achilles heel as well.

    But, as always, I should note that I probably don't know what I'm talking about, and only have a CAPS score in the 30s.

  • Report this Comment On September 10, 2010, at 12:19 PM, exeter17 wrote:

    Yes your corp drones use RIM BB devices. I'm leaning more toward the Droid platforms. And the BB OS is java based and clunky and slow. OS6 is rumored to not be any better. I'd give Win7 with Active Synch a shot.

  • Report this Comment On September 10, 2010, at 2:51 PM, SevenOneHands wrote:

    Microsoft wants to perform well on mobile devices and on your TV. Compared to competitors it is very strong in these respects.

    The strategy seems to be the one I would favor - to control the point of initial contact wherever software is used and then to only venture into the actual application or content side of the business where it is highly profitable to do so. In video games it will be highly profitable. In other areas it is less likely to be very profitable.

    I expect to see more generic, web-based applications. These will be less profitable for everyone. Office should hold up well, but not as well as Windows. Basically, Microsoft needs to take what it has in PCs and import that to TVs, Handheld Devices, Consoles, and the Web.

    That should be the strategy. I think that is the strategy. These aren't unrelated businesses that need to be broken up to unlock creativity (as some have suggested). Rather, the profit potential for each is greatly enhanced by being part of Microsoft. If you take these pieces apart they are worth very little. There would only be the three businesses I started off talking about and the console / games business.

    Internationally, there is going to be natural growth for Microsoft's dominant businesses. It won't be a tremendous growth rate, but it will be strong and will require virtually no additional investment to secure.

    Overall, I like the future for software a lot more than hardware, because the marginal gains in the quality of hardware will slow greatly in the years ahead.

    The question isn't what can be done mathematically in terms of increasing specs; it's what that translates to for the user. We are reaching a point where the individual user will not directly see the benefits of increased hardware performance as clearly as he did in the past.

    Much of the research that goes in to this area will only serve to bring down prices and benefit memory intensive businesses - it will not provide as much of a "wow" factor for the user anymore.

    ----------------------------------

    Money without intelligence is like a car without a road.

    http://www.intelligentinvestingtips.com

  • Report this Comment On September 11, 2010, at 4:52 AM, Babble100 wrote:

    Coming late to the game, the only way MSFT can win is if they have some dramatic 'killer' app or service advantage over what's already on the market. I haven't seen what that is yet. Maybe its a secret plan... But the price of coming late to the game is that a "me too" just good enough W7 phone product just won't make it. No matter how expensively it's marketed.

    Ballmer should be fired for the massive wasting of shareholder equity that he has presided over.

  • Report this Comment On September 11, 2010, at 12:46 PM, wiggster1 wrote:

    Microsoft has missed the boat on this in a big way and the chances are that their phone will suffer the same fate that Zune has in the digital world. There only hope is that they can displace the Blackberry in the Corporate Market - which should be possible given that most companies are running Exchange, Office and increasingly Sharepoint. Google is the new Microsoft of the Smart Device world, while Apple is Apple. As before with Mac vs PC Apple was the innovator, but eventually Microsoft dominated because it had a more open and agnostic philosophy. I'm guessing that the same will happen with Android but that doesn't mean there won't continue to be a huge market for Apple's products.

    For Microsoft to have missed this shows some real problems with their corporate culture in my opinion - and a big reason not to invest in the company.

  • Report this Comment On September 11, 2010, at 11:52 PM, exileonmainst wrote:

    From batteries to having to become entrapped in the all things Apple, Apple products are too expensive and controlling.

    MS products are buggy. I reckon users of their new phone software will set aside every second Tuesday of each month to download patches.

    RIM is reliable but static. Just like most corporate bureaucracies who use 'em.

    Android is inexpensive, wide open, actually works and is rapidly evolving.

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