Last week, Microsoft (NASDAQ:MSFT) made a radical change to its business model, effectively doing away with the strategy that helped it dominate personal computing: Going forward, it will only charge OEMs for Windows licenses if the device in question has a screen size 9 inches or larger. In other words, Microsoft is now giving away Windows 8.1 and Windows Phone to tablet and phone manufacturers. It will still, however, charge for copies of the operating system installed on traditional PCs and laptops.
At least for now.
It's become abundantly clear that the days of charging for an operating system are rapidly coming to a close: By giving away Android, and to some extent Chrome OS, Google (NASDAQ:GOOG) has forced Microsoft's hand and has slowly destroyed its long-standing business model.
With Android and Windows, history repeats itself
Before the announcement, there had been widespread chatter that Microsoft had made (or was considering making) cuts to its Windows licensing fees. Although Android OEMs have to pay Microsoft royalties, Google doesn't charge for the mobile operating system, giving handset and tablet manufacturers a financial incentive to use it. The same is true for Chrome OS.
That puts Microsoft in a tough spot, as Google's operating systems have risen to dominate the globe. Gartner projects that Android will power more than 1 billion devices shipped this year. In contrast, IDC expects Windows PC shipments to come in at fewer than 300 million.
The whole episode is reminiscent of the browser wars in the mid 1990s, when Microsoft, by giving away Internet Explorer for free with a paid copy of Windows, more or less ran Netscape out of business. Before the introduction of Internet Explorer, Netscape had been charging $49 for a copy of its popular Navigator -- it found it quite difficult to compete with Microsoft's free alternative.
How much longer until Microsoft completely gives Windows away?
Microsoft doesn't plan to give Windows away for traditional PC and laptops users, but it seems inevitable that it will be forced to, at least eventually. There are 8-inch tablets on the market right now that sport full versions of Microsoft's Windows. While a bit less powerful, they could eventually cannibalize sales of competing low-end, Windows-powered laptops and desktops.
By cutting the Windows licensing fee to zero, Microsoft is giving manufacturers more room to price these devices aggressively, which could make them more attractive to consumers who had otherwise planned to buy a traditional laptop or desktop. Lenovo's ThinkPad 8, for example, is an 8-inch tablet with an HDMI-out port and docking capability -- attached to an external monitor, mouse, and keyboard, it could easily replace a traditional PC.
Putting aside potential intra-Windows cannibalization, Google is encroaching on Microsoft's PC dominance in other ways. Chromebooks, for instance, remain a small minority of global PC shipments (less than 1%), but have experienced rapid growth in the last year, particularly among educational institutions who turn to them in place of traditional laptops. Google's Chrome OS powered almost one-fifth of the laptops sold to K-12 schools in 2013, and its growth has been enough to solicit attack ads from Microsoft. At the same time, Android has made the jump from tablets and phones to a few desktop PCs, although this trend remains nascent.
A growing number of users are making smartphones and tablets their primary computing devices, eschewing traditional PCs altogether. With that trend in mind, last year analysts at Gartner predicted that, by 2017, Microsoft's Windows would be virtually irrelevant, replaced almost entirely by Android.
Microsoft without Windows
A free Windows could help to prevent that, but at what cost? Last year, Microsoft reorganized its divisions, obscuring Windows' performance by grouping it with other segments. Microsoft's devices and consumer licensing division includes Windows sales to OEMs, but also includes consumer Office sales and Android royalties. The enterprise licensing division includes Windows licenses sold to businesses, but also includes Windows Server and Office.
The last time Microsoft broke out Windows' performance was the fourth quarter of fiscal year 2013. Back then, Windows was generating about about one-fifth of Microsoft's revenue and one-sixth of its operating income. Presumably, both these figures will decline to zero in the coming years -- that's probably why Microsoft reorganized its divisions in the first place. Microsoft's without a for-profit Windows isn't necessarily a bad thing. If giving away Windows results in more market share, Microsoft can make up the difference by selling other software and services. Bing could finally turn a profit, as it's become more heavily integrated with the Windows operating system.
One thing is for certain: The days of charging for an operating are effectively at an end. With Android, and some to extent Chrome OS, Google has forced Microsoft to fundamentally alter its business model. For most of its history, Microsoft's business was built around selling Windows licenses -- those days are over.
Sam Mattera has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple and Google (C shares). It also owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.