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Facing Irrelevance, Microsoft Tries to Reinvent Everything

This article is more than 10 years old.

Fourth in a series on the tablet wars.

It's hardly news to say that Microsoft's dominance of the PC era is one of the great business success stories of all time. That said, if you bought the stock midway through Bill Clinton's second term, your shares are worth about what you paid for them. And just as it seemed the Redmond, Wash. software giant had gotten over that 14-year valuation hangover -- the forward P/E is just above 8 -- Microsoft found itself in a world where the PC was no longer the center of the information universe. As Eric Savitz reported the other day, PC sales are falling, and are likely to do so as far as the eye can see.

This is what they call an "existential threat" in the MBA texts, where your very business is threatened by tectonic shifts in the landscape around you. For all the success of their server, database and gaming products, more than half the company's revenue comes from the Windows and Business divisions (the latter of which is nearly all Microsoft Office). Even while the stock has gone nowhere, the one certainty has been those divisions have continued to grow through good (Windows 7) and bad (Windows Vista).

But PC replacement cycles have been growing longer for quite awhile as real-world performance improvements of Intel's chips has slowed, the global economy has been beaten up more than once, and the marginal benefit of each upgrade cycle has gotten smaller compared to the prior one.

In and of itself, that might not be a huge problem were it not for the mobile revolution. First, in the form of smartphones as Blackberry gave way to iPhone and Android. And now, via tablets, which threaten not to eliminate the PC, but rather to displace it for the majority of people, the majority of the time.

Bill Gates understood this moment was going to arrive before most people. In fact, he held up a prototype tablet at the now-defunct Comdex trade show back in 2001 and boldly proclaimed:  "The tablet is a PC that is virtually without limits -- and within five years I predict it will be the most popular form of PC sold in America."

Of course, that didn't happen, but Microsoft was undaunted. The company was at it again before Apple launched the gigantically successful iPad in 2010. Microsoft's project, called Courier, was slated to ship before iPad and might have blunted Apple's success. Instead, infighting at Microsoft led to delays and eventually to the cancellation of Courier. So instead of leading from the front, Microsoft now comes from behind with the Surface tablet, which launched to much fanfare October 25, to coincide with the debut of Windows 8.

Surface represents a huge bet for Microsoft as it is branded hardware that effectively competes with products from Dell, HP, Acer, Lenovo, Samsung, et al. -- the very companies Microsoft has relied on for the past decade to sell Windows. And these OEMs aren't entirely happy about it. Acer CEO JT Wang even warned Microsoft back in the summer:  "We have said [to Microsoft] think it over. Think twice. It will create a huge negative impact for the ecosystem and other brands may take a negative reaction. It is not something you are good at so please think twice."

And the nastiness hasn't stopped since the Surface's arrival. HP's PC chief Todd Bradley had this to say: He'd "hardly call Surface competition. It tends to be slow and a little kludgey as you use it....It's expensive. Holistically, the press has made a bigger deal out of Surface than what the world has chosen to believe."

Methinks they doth protest too much!

Because what these guys know is that if Microsoft is successful selling its own computers -- and look, tablets are computers -- then computer makers are irrelevant. And so far, the only tablets that have gained any traction at all since iPad invented the market have been "full ecosystem" products like Amazon's Kindle Fire and to a lesser extent Google's Nexus. Microsoft is building the same kind of ecosystem around Surface with attractive hardware, an optimized operating system and a store where you can seamlessly download apps, music, videos and the like.

The important thing to understand here is that for a long time, Microsoft got paid for Windows and Office, and together those might be worth around $100. The PC makers, selling $1000 systems, might have made a similar markup on the hardware. These are approximations, but if there was $200 to be made on a PC, it went roughly half and half to Microsoft and, say, Dell. Compare that to a $500 iPad with a 40% gross margin, typically sold directly by Apple to the consumer. Again, you're looking at $200 of margin on something half as expensive.

It's math like that that's made Apple the most valuable company on earth and doubtless made Microsoft take a long hard look at what it means to be in the hardware business. In the short run, Microsoft is taking baby steps. Surface is only sold in Microsoft's retail stores (of which there are only a couple dozen so far) and direct via its website. In the longer term, it seems inevitable that if the product is successful, Microsoft will dive in all the way. And if we want to return to those MBA texts mentioned above, a case study should serve as to illustrate the point:

Google currently licenses the Android operating system to more than a half dozen companies who produce dozens of models of phones. While many of them seem attractive and offer similar features, the only Android OEM making any money at all is Samsung and the vast majority (all?) of its profits are coming from the flagship Galaxy S3 phone. If tablets follow a similar path, Microsoft has to be thinking, Surface could be the big winner, even in a world where lots of Windows tablets exist. Microsoft may not yet be in any position to build a hundred million Surface tablets. But it doesn't have to right now, either.

Instead, it's got to get the product established and gain credibility in a market that largely equates iPads with tablets. One stiff headwind is that Android or Apple tablet users can get an almost identical experience across their tablet and smartphone while Microsoft's Windows Phone has yet to gain any real traction. On Monday, I'll take a deeper dive into the Surface and try to put this challenge into a broader context.