Microsoft (NASDAQ:MSFT) CEO Satya Nadella signaled a changed direction for the company in March when he announced that a version of the company's signature Office software would be released for Apple's (NASDAQ:AAPL) iPad. That move has been a runaway success with over 40 million downloads, according to company blog, and Microsoft is now going even further to make Office available on every device no matter what operating system it uses.
The company announced last week that it will bring Office to Android tablets, and Word, Excel, and PowerPoint to iPhone. More importantly, Microsoft has made a major shift in strategy as it will now allow the free version of its iOS and Android apps to do much more. This has the potential to disrupt the company's business model: More people will certainly use Office and the Office apps, but many will have much less incentive to pay for it.
"Starting today, people can create and edit Office content on iPhones, iPads, and soon, Android tablets using Office apps without an Office 365 subscription," John Case, corporate vice president for Microsoft Office, said in the blog post, though he did try to make the case for why people would still want to upgrade from the free version to the paid. "Of course Office 365 subscribers will continue to benefit from the full Office experience across devices with advanced editing and collaboration capabilities, unlimited OneDrive storage, Dropbox integration and a number of other benefits."
The previous version of the free Office apps were read-only. Users could open and view documents, but could not make changes to them. Adding the editing capability makes the Office world a whole lot bigger, but it removes incentive to pay for the product. It's a bold, risky strategy that puts in doubt a big piece of what has been a key part of a $24 billion business annually for Microsoft.
How much does Office make?
Microsoft does not directly report results for its various iterations of the Office and the Office 365 subscription service. Instead it offers financial results for the Microsoft Business Division, which includes Office, Exchange, SharePoint, Lync, Yammer, Microsoft Dynamics business solutions, and Office 365. That division had $24 billion in revenue in 2013, the same in 2012, and $22 billion in 2011. The division is also the company's largest business segment, topping the Windows division, which brought in over $18 billion for each of the last three years.
Although just how much revenue Microsoft makes from Office, and how much it risks by allowing editing in the free version, remain in question, we can make some assumptions. In 2014, the company changed how it reports earnings, breaking revenue down by broad categories and separating consumer and commercial customers.
ZDNet earlier this year analyzed the company's 2014 finances and reported that commercial licensing, which makes up nearly half of Microsoft's revenue, includes Windows Server products and volume licensing editions of Windows, along with Office for business. Consumer licensing, which includes Office for home and small business users, among other things, made up 23% of the company's 2013 business.
If we assume that few business users will drop paid versions of Office for a free one, and the ratio of commercial to consumer users stays true when it comes to Office sales, then Microsoft is risking whatever portion of 23% of $24 billion (roughly $5.5 billion) comes from Office. That's a really rough number, and we still don't know what percentage of the $24 billion in business division sales comes from Office, but it's reasonable to assume Microsoft is making a multibillion-dollar bet that customers who now begrudgingly pay for Office won't just elect to use a limited version of the system for free on their tablets.
There's also the possibility that some people forgo annual Office 365 subscriptions, which were made more enticing by the ability to have fully functioning versions on tablets and phones, and use an older copy of Office on a PC supplemented by the free apps on a tablet.
Why is this money in jeopardy?
People using Office on a Windows machine won't be affected by this change, as Microsoft's tablets, aside from the Surface RT (which comes with Office preinstalled), run the full Windows OS. Meanwhile, Apple has a separate OS for its tablets and phones, and Android is a tablet and phone OS. The risk for Microsoft is that offering a free version of Office on Apple iOS and Android devices gives PC users another reason to leave. That leads to the potential double-whammy in which the company not only loses an Office sale, but also loses a customer completely.
Microsoft is betting heavily that its move won't send more customers to Apple and Android products. It's also making a counterintuitive assumption that giving away a perfectly usable, but not fully functional, version of Office will lead to more paying customers.
That's a gamble when marketing to a generation, the so-called millennials, that is used to getting something for free and is more willing to put up with a mediocre product rather than shell out a few bucks for a good one. Microsoft is hoping people won't choose to not renew their Office 365 subscription or choose to never buy a new version of the software outright in favor of just using the free apps.
The company is threading a very thin needle in which it must convince enough new users on Apple iOS or Android devices to pay for Office to offset the ones it loses who elect to not pay because the free apps are good enough.
Daniel Kline owns shares of Apple and Microsoft. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and 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.