Windows has long been a cash cow for Microsoft (NASDAQ:MSFT), with nearly every PC sold to both consumers and businesses coming with a license for the operating system. But the rise of tablets, smartphones, and the cloud has put pressure on Microsoft's venerable OS, and the way that people interact with computing devices has fundamentally changed. Recent reports that Microsoft is considering offering a free or low-cost version of Windows 8, along with a cut to the Windows license fee for devices that retail for less than $250, is a step toward the company's goal of shifting from a software company to a devices and services specialist. But with Windows making up a big chunk of Microsoft's profit, and with Google's (NASDAQ:GOOGL) Android and Chrome OS operating systems representing the first real threat to Windows in years, should Microsoft investors be worried?
Why is Microsoft doing this?
Chromebooks, laptops that use Google's Web-based Chrome OS, make up a tiny fraction of the total PC market. In 2013, just 2.5 million Chromebooks were sold, representing about 1% of the global PC market. Windows still has a lock on the market, but the problem is that the market is contracting.
The low end of the PC market is being cannibalized by low-cost tablets and, to a lesser extent, Chromebooks, and the fact that the Android operating system is free means a comparable Windows-based device will be priced at a premium. While there's no real threat of Microsoft losing the personal computer market as a whole anytime soon, the first computing device for many people is no longer a Windows PC. If Microsoft lets this continue, the long-term implications could be disastrous.
Part of the purpose for Microsoft considering a free or low-cost version of Windows 8.1 is to make low-end Windows devices price-competitive with Android devices and Chromebooks. Since Microsoft derives most of its profit from the enterprise, not the consumer, the loss of licensing revenue shouldn't be all that meaningful, as I suspect the low-cost version of Windows 8.1 will offered only for consumer devices. The benefit likely outweighs the cost, bringing Windows laptops into the $200 range that Chromebooks sell for, as well as making Windows-based tablets and convertibles more attractive.
It's no secret that Windows 8 has been a tough sell, with the 8 and 8.1 versions only representing about 10% of all PCs using Microsoft operating systems. Windows 7 still accounts for 47% of Windows PCs, while the aging Windows XP claims nearly 30%. As consumers and businesses move on from Windows XP, there's a very good reason for Microsoft to want them to choose Windows 8 instead of Windows 7. In one word: services.
The future of Microsoft depends not on selling one-off licenses, but on monetizing its myriad of services. Office 365, the subscription-based version of Microsoft Office, in one example of this trend, and increasing the number of people dependent on Microsoft services is likely the real point behind lowering the cost of Windows 8.
A good example is Microsoft OneDrive, formerly known as SkyDrive, Microsoft's cloud storage and syncing service. OneDrive offers the same functionality as services such as Dropbox and Google Drive, and it's built into the Windows 8 file system, making it convenient for users of that OS. There's little reason to use it without a Windows 8 device, even though Android and iOS OneDrive apps are available. It's clear that boosting the number of Windows 8 users will also drive people toward Microsoft services, and achieving this is probably worth the short-term revenue hit.
Along with a lower-cost version of Windows, Microsoft also aims to boost the number of users of its services by offering benefits to those using more than one service. OneDrive offers seven gigabytes of storage for free, more than Dropbox's 2 GB, but an another 20 GB of space is given to Office 365 subscribers. Additional storage can be purchased at significantly lower rates compared to Dropbox, with 100 GB on OneDrive costing half as much as 100 GB on Dropbox.
Boosting the number of Windows 8 users is the key to Microsoft's long-term strategy of monetizing its services, and a low-cost version should help drive upgrades from Windows 7 and Windows XP. Since Microsoft derives most of its profit from the enterprise segment, this move shouldn't have much of an effect on the bottom line, and the benefits will likely greatly outweigh the costs. Investors should be happy that Microsoft is getting serious about boosting Windows 8 adoption, not worried about the short-term effects.