Microsoft (NASDAQ:MSFT) recently announced that Windows 10 will be free for Windows 7, Windows 8.1, and Windows Phone 8.1 users, so long as they upgrade their devices within the first year. The upgrade will cost money after the offer expires, but the free upgrades will remain active.
Terry Myerson, Microsoft's Executive VP of Operating Systems, mentioned the use of Windows 10 "as a service" during the company's Windows 10 event on Jan. 21, fueling speculation that it could turn Windows 10 into a subscription-based OS. However, Myerson later told PC Gamer that Microsoft had no intentions to do so, and that it simply meant Microsoft would update the OS with smaller and more frequent updates, as opposed to the big Service Packs of the past. Moreover, Myerson stated that Microsoft would update Windows 10 "at no cost" for a device's lifetime.
Those bold moves clearly indicate that Microsoft plans to sacrifice its Windows license revenue to gain more users and consolidate the fragmented Windows market. Will this gutsy gamble work?
Why Microsoft is giving away Windows 10
Microsoft Windows is installed on over 90% of the world's computers, but it's a highly fragmented market. According to Net Market Share, 56% of PCs worldwide run on Windows 7, 14% run on Windows 8/8.1, 18% are clinging on to Windows XP, and 3% are stuck on Windows Vista.
Those numbers indicate that many consumers simply stop upgrading at a "good enough" operating system, and keep using it after Microsoft halts security updates. This fragmentation means that many of Microsoft's newer initiatives, like "universal apps" which straddle PCs, tablets, phones, and Xbox One consoles, simply don't work on most Windows PCs.
But if all of Microsoft's Windows 7 and 8 users upgrade to Windows 10, the new OS will immediately claim 70% of the PC market. This would give Microsoft a much firmer foundation on which to build its cloud and productivity ecosystem.
This runs parallel to Microsoft's new Office strategy. Like the Windows market, the Office one is also fragmented among older versions. An Oct. 2013 survey by Forrester Research found that 28% of businesses were still using Office 2003 or earlier. To encourage more users to upgrade to the subscription and cloud-based Office 365, Microsoft started bundling free one year memberships to the service with new Windows PCs, laptops, and tablets.
Both Microsoft's Windows and Office strategies are designed to counter Google (NASDAQ:GOOG) (NASDAQ:GOOGL), which has rapidly expanded its presence in operating systems and productivity software by giving away its products for free.
Why giving away Windows 10 could be the wrong play
However, Microsoft's plan has one big flaw -- it can't reasonably beat Google in a long-term race to the bottom.
Windows and Office account for large parts of Microsoft's top line, while the majority of Google's revenue comes from search and advertising. Google merely uses Android, Chrome OS, and Google Drive to tether more users to its ecosystem and drive them through its search engine, which convinces more marketers to buy its display ads. That strategy disrupted Microsoft's business, because Google lowered price expectations so much that many consumers now expect operating systems and productivity software to be free.
Last year, Microsoft already made Windows licenses free for phones and small tablets, and introduced Windows 8.1 with Bing, a low-cost version of Windows for OEMs to compete against Chromebooks. Therefore, making Windows 10 a free upgrade might cause Windows revenue from both consumers and OEMs to dry up.
A delicate balancing act
Microsoft has to pull off a tough balancing act for its Windows 10 gamble to work.
Microsoft must make sure that revenue at its commercial cloud business -- which includes Office 365, Azure, and Dynamics CRM -- keeps growing to offset declining revenue from new Windows licenses. It must resist the temptation to pull a "bait and switch" by turning Windows 10 into a subscription-based OS. Lastly, the company must cohesively merge phones, tablets, and PCs into its "One Windows" system with a solid library of cross-platform apps.
Microsoft investors should remember that the company's current priorities aren't top or bottom line growth. Instead, Microsoft is consolidating its operating systems and growing its user base -- two areas that CEO Satya Nadella's predecessor, Steve Ballmer, arguably ignored.
Giving away Windows 10 for free is a necessary but risky move. It was needed to break the unpredictable cycle of Windows upgrades, which fragmented its own market with every new release, but it could also permanently cripple its Windows cash cow.