In January, Microsoft (NASDAQ:MSFT) announced that Windows 10 would be a free upgrade for consumer versions of Windows 7, Windows 8.1, and Windows Phone within the first year. At the time, OS chief Terry Myerson stated that Windows 10 would be "a service," fueling speculation that the "free" OS could require a subscription in the future. Myerson later clarified that the "service" referred to incremental OS updates which would replace bulky service packs, and that no additional fees would be attached to Windows 10.
But at the end of January, Microsoft quietly filed a trademark for "Windows 365," which sounds a lot like Office 365, its subscription-based productivity suite. Is Microsoft planning to pull a "bait and switch" on Windows 10 users, or does it have other subscription-based plans for Windows?
Two possible explanations
In my opinion, there are two possible reasons that Microsoft trademarked "Windows 365." First, Microsoft might backtrack over Myerson's comments and charge Windows 10 users for updates after the first year. However, that probably won't happen due to the inevitable backlash.
A more likely scenario is that Microsoft will combine Office 365 and Windows 10 into a single package tethered to its cloud service, Azure. Since users would require a subscription to access Office 365, the entire package could be marketed as "Windows 365." Therefore, the OS itself would be free, but users would be encouraged to subscribe to additional productivity and cloud services.
Why subscription-based Windows is inevitable
In my opinion, Microsoft will eventually add subscription options to Windows. Offering Windows 10 for "free" is a defensive move against Google (NASDAQ:GOOG) (NASDAQ:GOOGL), which encourages OEMs to install Android and Chrome OS, which are both free.
Google can afford to do this for years, since its top line is mainly dependent on ad revenues. The consumers it gains with Android and Chrome OS get tethered to its ecosystem, where they help generate search, ad, and app revenues. Microsoft's top line is heavily dependent on sales of Windows licenses, so it can't afford to race Google to the bottom of the market.
Therefore, Microsoft will need to either start charging subscriptions to OS updates, or use the free OS as a base for peddling subscription-based software and services like Office 365.
Making Windows subscription-based would solve two other big problems. First, it would stabilize the company's top-heavy dependence on hit-and-miss Windows upgrades while reducing OS fragmentation. Second, it would reduce the need to support dying operating systems, like Windows XP, well past their prime.
Sacrificing profits for market share
Over the past year, Microsoft has repeatedly sacrificed profits to gain market share.
Last year, it eliminated Windows license fees for phones and small tablets, then reduced license fees for larger tablets and select laptops. It encouraged OEMs to bundle free Office 365 and One Drive memberships with new Windows devices. Offering Windows 10 for free is a clear continuation of that strategy.
But all those initiatives are weighing down its top and bottom lines. Last quarter, Windows Pro and non-Pro revenue both fell 13% year-over-year, contributing to a 10.6% decline in net income. Wall Street expects Microsoft's fiscal 2015 earnings to fall 9% year-over-year to $2.39 per share.
After Microsoft reduces OS fragmentation and streamlines its ecosystem with its Windows 10 strategy, it will need to pivot its OS strategy to grow its bottom line again.
How much revenue could subscriptions generate?
In late February, TechRepublic's Greg Schultz speculated that if Microsoft charged $99 per year for a "Windows 365" subscription, it would "more than make up for the free year of Windows 10."
For example, a new copy of Windows 8.1 currently costs around $100 on Amazon (NASDAQ:AMZN). Considering that consumers only buy new versions of Windows every few years, $99 annual subscriptions could generate a higher and more consistent stream of revenue.
Schultz also estimated that at $99 per year, the OS would generate $693 million in sales in the first year based on 7 million paying customers -- a fairly conservative target considering that Microsoft sold 200 million Windows 8 licenses within the first 15 months of its initial release.
Let's not get ahead of ourselves yet...
Subscription plans for Windows could certainly be in the works, but investors should remember that Microsoft hasn't said much on the issue yet. For all we know, Microsoft might have simply trademarked "Windows 365" to cover its patent bases and avoid litigation from patent trolls.
Nonetheless, investors should keep a close eye on Microsoft's "free" Windows 10 strategy, and how it intends to generate revenue from the new OS.