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Microsoft’s Pricing Power Under Attack

By Margie Nemcick-Cruz - Feb 28, 2014 at 11:00PM

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For a decades Microsoft’s profit centers were surrounded by a giant impenetrable iceberg. As the competition heats up, cracks are starting in this wall of ice.

Microsoft ( MSFT -0.15% ) recently responded to the shifting landscape in personal computing by slashing prices for device makers installing the  Windows 8.1 OS to $15 from $50 for products costing less than $250. Additionally, the Verge reported Microsoft was considering dropping the license fee of Windows Phone entirely, which currently costs $23-$30 to license per device.

No cannibalization
Currently, Microsoft barely operates in the realm of PC's priced under $250, thus the move will not cannibalize profits. Presumably, selling those extra licenses at $15 will add to the bottom line. Shoring up market share at the lower end also helps defend a core profit center of MS Office by getting more consumers in the Microsoft ecosystem. The same goes for mobile, where few Windows Phones are sold that aren't made by Nokia. 

Attracting new device makers
Concentrating first on mobile, equipment makers currently face challenges that put operating margins under pressures. According to bgr.com, Nokia's mobile device operating margin came in at -2%, LG's at -3%, HTC at -7%, Motorola at -28%, and BlackBerry at -55%. The only smartphone manufacturers making money are Apple ( AAPL -0.32% ) and Samsung.

With margins tight for OEMs, Microsoft's lower price will no doubt spur at least some of them to try a Windows-based platform and help initial adopters differentiate themselves from the competition. For Microsoft, adding new partners is certain to have benefits down the road.

Reasons behind the move
For decades, Microsoft had a virtual monopoly on operating systems, which made the company one of the most successful and profitable corporations in history. Today, both Google ( GOOGL -0.60% ) and Apple are providing wonderful alternatives to the traditional PC market with both mobile and PC operating systems. 

Google
Google's strategy of giving away Android and Chrome OS for free to OEM's was seen as a wonderful development by equipment makers like Samsung and HTC, who saved tremendous resources by not having to create their own mobile operating systems. This allowed the companies to more rapidly compete with Apple's iPhone and iPad, and opened the ever-growing market of Chromebooks on the PC end. This was a brilliant move by Google, as the company has garnered tremendous amounts of user data, which is employed to strengthen the moat around search.

Additionally, Google generates more searches and introduces consumers to apps like Gmail and Maps. How successful is the strategy? Android controls 81% of the mobile market.

Apple
Apple no longer charges users for upgrades to operating systems on Macs, providing another reason for consumers to make the switch. Additionally, Apple's office productivity suite, iWorks, is free for all Apple products.

The company captured the world's imagination with its sleek iPhone and iPad, becoming the brand of choice for the affluent. Meanwhile, Microsoft was late to the mobile party and has slid further onto the back burner.

Putting it all together?
From a near-term profit standpoint, this will likely have a beneficial effect for Microsoft, as the move will generate new sales and customers at price points where the company currently has little reach. Profits and sales are likely to increase in the near term.

Long term, however, the prices that Microsoft charges for Windows and Office are unsustainable against the free and rapidly improving versions that Google and Apple offer. PC makers will probably try to negotiate down the current cost for Windows OS as PC sales continue to shrink, using Chrome OS and Microsoft's necessity to maintain market share as leverage.

For decades, Microsoft's profit centers were surrounded by a giant, impenetrable iceberg. As the competition heats up, cracks are starting to show in this wall of ice. What we're seeing today is the start of an irreversible melting of margins, where few will be willing to pay up front for operating systems. If you've accumulated profits in Mr. Softy recently, it's time to take them.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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