Microsoft (MSFT -4.34%) is living in a world where operating systems and productivity suites are either given away for free or for a very minimal cost. In the coming decade, these forces will likely put added pressure on Microsoft's bread-and-butter software licensing businesses, Windows and Office, which already face considerable headwinds from the stagnating PC market. The most important question for investors is how Microsoft plans to deal with the threat of cannibalization to these software suites, which make up the majority of its operating profits.
Signs of weakness
Cracks in Microsoft's core licensing businesses began showing up when the smartphone revolution accustomed users to the idea that most software should either be free or cost next to nothing. With well over 1 billion smartphone users upgrading their mobile operating systems free of charge, it certainly sets a nasty precedent for Microsoft's core software licensing businesses. For a basic-needs user, there isn't that much of a difference between a free mobile OS and the $120 starter version of Windows 8.1, a cost that is ultimately passed onto the buyer when they purchase a new PC.
Apple isn't helping matters, either. The company recently announced that it will be giving away its new Mavericks OS for free to existing users. What's more, its iWork productivity suite will come free with all new Mac and iOS device purchases. Add Google into the mix, which gives away the majority of its software for free, including Chrome OS and Android, and it's easy to see how the pressure is slowly building on Mr. Softy's livelihood.
A new and improved vision
Taking into account these external forces and the rapidly evolving computing landscape, it isn't surprising that Microsoft underwent a massive reorganization earlier this year to realign itself as a unified devices-and-services company. It speaks to the long-term importance of its budding hardware business. Ultimately, hardware could become an effective hedge for Microsoft against the threat of software commoditization because the company could potentially make its living by selling devices with a suite of software embedded -- similar to how Apple operates.
Plenty of time to get it right
Judging by Microsoft's recent earnings blowout, the good news is that there's plenty of time for Microsoft to refine its hardware strategy to become more competitive. For the time being, Microsoft investors can rest easy knowing that the threat of software commoditization is still likely far off.
The bad news is that Microsoft still has a lot of work to do if it wants to be a computing devices company first, and a services company second. Last quarter, Microsoft only brought in $400 million in revenue from its Surface tablets -- peanuts compared to the $18.5 billion in total revenue it raked in. Still, the chances are high that hardware will become an increasingly important aspect of Microsoft's business over the next decade, so be sure to watch for how the company improves its competitiveness there.
