Microsoft Treading on Thin Ice with Windows 10 Paid Subscriptions

If you have been reading my previous articles on Microsoft (MFST), you may have noticed that I am a big fan of the company and a even bigger fan of CEO Satya Nadella. He had the courage to steer the company from being an all-about-Windows company towards one that ‘also owns’ Windows. I have been recommending the stock since it took a short plunge to under $50 back in February.

What impressed me the most was how the company decided to dump its smartphone dreams and create a company that kept its focus on cloud and mobile initiatives.

But on the Windows front, not all is well for Microsoft.

The Windows 10 Conundrum

Ever since Microsoft announced its decision to end free upgrades for its Windows 10 in July, the company has been receiving flak from all over, and the anger is justifiable. No other company charges for the use of an operating system. Apple’s (AAPL, Financial) OS X for Mac and iOS for mobile devices have always been free, although one could argue that its cost is priced into the device itself. Google (GOOGL, Financial) doesn’t charge for Chrome or Android. In fact, if you look around you won’t find a single operating system - mobile or otherwise - that asks consumers to pay.

Microsoft is the only company that still wants to charge users for using its operating system, Windows 10. Unfortunately for the company, that is how it made billions when it was busy getting a PC into every home. The pre-loaded Windows operating systems of the time were free for consumers, yes, but Windows was making money hand over fist with the OEM licenses. That is why we are seeing the decline in that segment when they report their quarterlies. I have discussed this in a recent article entitled What to Expect from Microsoft beyond 2016:

“Over the past quarter, you will see they are showing positive growth for both OEM and volume licensing, but that is only relative compared to the year before when they incurred heavy losses in both sub-segments. The nearly $3 billion dip in segment revenues for the year shows that recovery is still a few quarters away.”

Whether or not the sale of PCs around the world stabilizes or goes down further, Microsoft Windows OEM is going to take a long time to recover. But the real change is how mobile devices are proliferating around the world. Smartphone sales growth might have slowed down, but the market potential is still huge.

But, Microsoft is going about it the right way. With Windows 10 essentially being a cross-platform operating system, the company now emphasizes the continuum philosophy where a phone or tablet can easily switch roles with a personal computer.

“One of Microsoft’s big announcements at its Build developers conference last week was the ability to turn a smartphone running Windows 10 into a PC. Dubbed Continuum for Phones, it’s designed to take advantage of new universal apps that run across Windows 10 on phones, PCs, tablets, and the Xbox One. If you’re running a mobile version of Excel on your phone it will magically resize and transform into a keyboard- and mouse-friendly version for use on a bigger screen. It feels like the future.” - Verge

The whole idea was to blur the difference between devices through the power of software, which means there is a single operating system that covers the entire breadth of devices, from desktops and laptops to tablets and smartphones.

The universal apps being developed on the Universal Windows Platform will be able to run on any device that is powered by Windows 10. It is part of Microsoft’s strategy to lure developers back to the world of WIndows - the same developers who deserted the company after it lost the smartphone battle against Apple and Google. To that end, Microsoft bought Xamarin, a cross-OS development platform that will eventually give them a rich collection of Windows universal apps. And they are doing it by accepting iOS and Android as rulers of the mobile OS domain, which is why these apps will work on all three operating systems.

So Why is Microsoft Charging for Windows 10?

But if this was the whole idea, why ask people to pay for its operating system and alienate them? It is clear that the masses prefer not to pay for the new software, rather continuing to use the old versions that came free with their PCs.

Source: netmarketshare

As you can clearly see from the graph above, nearly 47% of users are adamantly still sitting on Windows 7, for the simple reason that they are not willing to pay for future upgrades to Windows 10.

But that causes another problem for the company. If there are not enough users, then it stands to reason that developers are not going to flock to create apps for Windows 10 - cross-platform or otherwise. As an analogy, one of the reasons that the iPhone is so popular is that they have a very extensive collection of apps that make the phones “smart.” Otherwise, they would just be nice-looking devices that did not do much.

As such, app developers are a key factor in the growth and acceptance of an operating system. By requiring payment for Windows 10, Microsoft will be restricting the size of its potential market, thereby limiting the download numbers for their apps. That’s bound to put off the bigger app development companies, and Microsoft is hoping that Xamarin will bridge that gap since developers will be creating apps that run on all three operating systems.

That is the lynchpin holding Nadella's master plan together. But if that plan backfires, they are pretty much in the same situation they were in when they bought Nokia (NOK, Financial) to promote the Windows Phone OS.

On the other hand, if his strategy works, it will be the greatest mobile OS coup of all time. Not to mention, they get the added benefit of making predictable revenues from Windows 10 subscriptions.

I do not think the company is unaware of this Catch 22 situation. They had the choice of either giving away Windows 10 for free and letting go of Windows as a revenue earner, or keeping their OS revenues intact and taking a risk with the UWP/Xamarin bet.

They have obviously chosen their fork in the road, and they will have to live with the consequences of that decision. Whether or not they have shot themselves in the foot is a question that will only be answered down the road, but for now, it is safe to say that Microsoft is making an extremely risky bet.

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.

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