When Microsoft (MSFT 6.16%) made Windows 10 a free upgrade for Windows 7, 8, and 8.1 users last year, many investors and consumers questioned the tech giant's long-term intentions. Some tech pundits suspected that Microsoft would eventually convert the "free" OS into a subscription-based one, while others believed that it could use "universal app" revenues to offset lost license revenues. However, few people initially thought that Microsoft would turn Windows 10 into an advertising platform.
Yet that's exactly what happened over the past few months. Last October, Microsoft quietly added a "suggested" apps section, which resembles the app-install ads used by bigger Internet advertising companies, to its Start Menu. In the beginning of the year, it started displaying ads for Minions and Rise of the Tomb Raider on users' lock screens. Although both features can be turned off, they suggest that Microsoft is at least mulling the idea of using ad revenues to replace licensing fees. Is this a smart move, or would it be a huge step in the wrong direction?
The evolution of Windows
To understand why Microsoft would insert ads into Windows, we should first discuss how the market for operating systems has evolved. Microsoft CEO Satya Nadella seems to grasp what his predecessor, Steve Ballmer, failed to comprehend -- that Alphabet's (GOOG 6.30%) (GOOGL 6.09%) Google and Apple (AAPL 4.86%) had conditioned consumers to expect operating systems to be free. Instead, Google and Apple respectively monetize Android and iOS by taking a cut of app store sales. Google also uses Android to mine data to craft better targeted ads across its ecosystem.
Due to this market shift, Microsoft couldn't expect mainstream users to pay license fees every few years to upgrade their operating systems. That's why the Windows ecosystem remains fragmented among multiple versions of Windows -- Net Market Share reports that 11% of PC users still use Windows XP, 52% still use Windows 7, 12% use Windows 8/8.1, and just 13% use Windows 10. To get all those users back on the same page, Microsoft offered free upgrades to Windows 10.
Pulling more users to Windows 10 tethers them to newer cloud-based services like Bing search, OneDrive, Cortana, and Azure. That move widens Microsoft's moat against Google, and the accumulated user data can eventually be used for advertising and personalization purposes. Research firm eMarketer estimates that Microsoft's online ad revenues rose 18.5% annually to $3.45 billion in 2015 -- a notable slowdown from 48.7% growth in 2013 and 33.3% growth in 2014. However, Microsoft also handed over its display ad business to Verizon's AOL last year, indicating that it no longer wanted to directly compete against heavyweights like Google.
Adopting Amazon's approach
That's why Microsoft is now testing a more subtle advertising strategy with embedded ads in its own Start Menu and lock screen. This approach has two major advantages. First, those ads can drive revenue to other parts of Microsoft's business. For example, app-install ads inserted into the Start Menu can generate advertising and app store revenues for Microsoft. The new lock screen ad for Rise of the Tomb Raider, a timed exclusive game for the Xbox One, promotes its gaming business. Second, those ads can reach a lot of eyeballs -- Microsoft reported that 200 million devices were already running Windows 10 as of January.
This is the same strategy which Amazon (AMZN 4.46%) used when it introduced lock screen ads to the Kindle several years ago. Amazon launched these ads to subsidize the cost of the Kindle tablets, which were mostly sold at a loss to generate long-term digital sales. Microsoft is essentially testing out the same strategy with its Start Menu and lock screen ads. However, Amazon actually charges users to opt out of its ads, while Microsoft lets users disable them for free.
Why this move could backfire
Unfortunately, inserting ads into Windows 10 could lead Microsoft down a slippery slope. If Microsoft truly believes that Windows 10 ads could drive revenue into its app store or gaming businesses, it will need to prevent users from removing them. But if it does so, or charges users to remove them, it could face a big PR backlash for "baiting and switching" users. Although developers often encourage customers to upgrade their free apps to paid ad-free versions, Microsoft doesn't attract the same level of empathy as individual developers or small studios.
Therefore, I don't really think that investors should see Microsoft's Start Menu and lock screen ads as a serious advertising push just yet. Instead, it's likely just a test to gauge the public's overall response.