Windows slump shows Microsoft’s transformation is taking hold

Windows slump shows Microsoft’s transformation is taking hold

Microsoft CEO Satya Nadella

Yesterday brought bad news for Microsoft’s shareholders, but the company’s leadership won’t be unduly concerned that its share price fell by 9 percent on Tuesday afternoon, shortly after announcing its fiscal second-quarter results and accompanying outlook.

A first glance suggests Microsoft is trundling along rather nicely, with the $26.5 billion in revenues and $0.71 in earnings per share well in line with previous expectations. So what’s all the fuss about?

Well, shareholders aren’t particularly happy that Microsoft is indicating it expects growth to slow down to between just four and five percent. Add to that the poor performance of its major cash cow, Windows, which saw sales tumble by 13 percent for the quarter, and it’s easy to see why investors are getting nervous.

But it’s unlikely that Satya Nadella feels the same way. It’s almost a year since the former Server and Tools Business president took charge of Microsoft, and in that time its shares have rallied by just over 20 percent, even taking into account yesterday’s drop. And while some are claiming “the honeymoon is over” for Nadella, the shareholders were always likely to get upset at some point.

Nadella won’t care in the least. For him, everything is going exactly according to plan. “Microsoft is continuing to transform, executing against our strategic priorities and extending our cloud leadership,” the CEO said in a statement. “We are taking bold steps forward across our business, and specifically with Windows 10, to deliver new experiences, new categories, and new opportunities to our customers.”

Nadella’s vision takes shape

 

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Microsoft can’t keep relying on Windows license sales

For Microsoft’s renaissance to take place, it needs to dismantle its old business model for Windows. Nadella knows the company can no longer keep relying on its operating system to sustain its future growth, and his decision to make Windows 10 free for users of Windows 7 and 8 recognizes that.

“Its two major competitors and essentially every other company now give their software away for free,” writes Jan Dawson, founder and principal analyst at technology research and advisory firm Jackdaw. “This state of affairs will continue to increase pressure on Microsoft to follow the same path over time, and it will either have to succumb to this pressure or see its sales and market share fall significantly.”

Windows won’t be Microsoft’s cash cow anymore, but instead it will become the ‘glue’ that holds the organization together and allows it to complete its shift to the services company that everybody wants to use.

Instead of asking whether or not Windows 10 is worth the money, consumers and enterprises alike will be thinking, “why not upgrade if it means getting all the latest improvements and features for free?”.

Assuming it can get everyone on board with Windows 10 (at least the PC users anyway) Microsoft will try to exploit the situation to lock enterprise customers into its core services, in much the same way that Google has Android users locked into Chrome, Gmail, Maps and Search. And once those customers are locked in, there’s an outside chance some of those users may move to the Windows platform on their non-PC devices too, where the same services they’re accustomed to using will all be natively integrated.

Forsaking Windows’ revenues might seem drastic, but Nadella really doesn’t have much choice. Unlike Google, Microsoft can’t count on billions in annual revenues from its advertising business, and if it’s really to become a services company it has to do everything it possibly can to get people using those services first. Only then can it try to monetize them.

“With consumer services and devices providing a falling contribution to Microsoft’s business over time, the focus has to shift to business services,” noted Jackdaw’s Dawson.

And those business services will almost inevitably fall under a subscription model, as Office 365 already has, believes Holger Mueller, principal analyst & vice president of Constellation Research Inc. So far, Microsoft hasn’t said anything about how (or even if) it intends to monetize Windows after giving it away for free for the first year, but a subscription-based model could well be too enticing to ignore.

“We expect Microsoft to break out subscription revenues sooner than later and show the usual big growth numbers in that area,” said Mueller. “After all, few things are stickier than an OS or an Office suite. What is a user going to do when asked to renew his OS or Email with only a few days left? They’ll probably keep renewing.”

It’s early days yet but there are signs the strategy is working, as evidenced by the number of bright spots in Microsoft’s earnings call. On the hardware side, Surface tablet sales rose by 24 percent in the quarter, eclipsing $1 billion in revenue for the first time. As for services, its cloud business more than doubled its revenue, and is on pace to become a more-than $5 billion business for the company; Office 365 saw a 30 percent rise in subscribers, and now counts 9.2 million customers; and even Bing saw a 23 percent rise in ad sales.

The potential of Microsoft’s cloud unit is particularly enticing, as it now accounts for almost a fifth of the company’s total revenues. “[But] what’s more important is its growth rate (114%) and the fact that most of it is recurring revenues,” said Rebecca Wettemann of Nucleus Research Inc.

Despite these bright spots, Microsoft’s total profits fell by almost 11 percent to $5.9 billion for the quarter, which shows it still has some way to go before it completes its transition. It’s an open question as to whether or not the new Microsoft will ever be as profitable as it was during Window’s heyday, but Nadella has made it clear he’s prepared to do whatever it takes to see his transition plans through. Microsoft is well on its way to becoming a “services” company, and there’s no turning back now.

It may not be kind on the shareholders, but when the only alternative is to stand still, there really isn’t a whole lot of choice.

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