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Microsoft's Second Assault on Smartphones

Bill Gates describes Microsoft as "the most optimistic company in the technology business." Instead of obsessing about the slowdown in its core market for PC software, the Redmond giant is refocusing on new opportunities, such as the market for advanced cell-phone software.

That still-small market is growing at 20% to 40% per quarter, and Microsoft (MSFT) hopes to stake its claim. About 18 months ago, it announced that by 2005, 2% of its revenues would come from cell-phone-related sales and that 25% of souped-up cell phones would carry its software platform. The latter goal was particularly ambitious, given that Microsoft had exactly 0% of the market at the time of the announcement.

WINDOWS LOOK. Analysts view Microsoft's optimism as wishful thinking -- and, so far, they've been proven right. The software's first versions crawled with programming bugs, earning Microsoft heavy criticism. Its partner, British cell-phone maker Sendo, defected last fall and sued the software giant for allegedly stealing its ideas (a claim Microsoft denies). Meanwhile, Gates & Co. has grabbed less than 1% of the market in "smartphones," which are a cross between a cell phone and a personal digital assistant (PDA). In 2002, Microsoft booked a measly $20 million in revenue from the effort, says Brendan Barnicle, an analyst with Pacific Crest Securities.

The market for smartphones is expected to reach 36 million units this year, says Michael King, an analyst with research consultancy Gartner. And while most of Wall Street has decreed that Microsoft would be lucky to achieve even a fifth of its original market-share goal -- about 5% by 2005 -- some analysts say Microsoft might do much better.

A slew of service providers have just signed up to introduce Windows-based smartphones, which offer the traditional Windows look as well as access to Microsoft applications. The software giant has lined up top-tier handset maker Samsung, and the products will be introduced in the U.S. by either Sprint PCS (PCS) or Verizon Wireless. And rumor has it that another major cell-phone maker -- possibly No. 2 Motorola (MOT) -- might start producing Windows-based phones. (Motorola declined to comment.) Another possible partner, says King, is Sony Ericsson, which has been rapidly losing market share in this brutally competitive market.

MORE OPTIONS. Despite its early stumbles, Microsoft is ramping up its efforts. On June 23, it announced a new brand, Windows Mobile, for smartphones and pocket PC PDA platforms. Such aggressive moves are necessary as Microsoft will face formidable competition in this emerging market from the likes of Nokia (NOK), which is one of several major cell-phone makers supporting a rival operating system, Symbian, which is starting to gain traction in Europe.

Another tough foe is Palm (PALM), which offers its own operating system (OS) used in products from Samsung, Kyocera (KYO), and especially Handspring (HAND). A big unknown is whether customers will prefer products with dialpads (phones) or mini-keyboards (PDAs).

Windows Mobile is Microsoft's attempt to leverage its success in the PDA market, where its market share has jumped to 30% in just a few years, says Matt Rosoff, lead analyst with consultancy Directions on Microsoft. As PDAs sprout voice capabilities and smartphones become smarter (today's handsets already boast 20 times the power of original PCs), Microsoft wants to capitalize on this convergence and offer business travelers -- key users -- more options. In the smartphone and voice-capable Pocket PC PDA market, Microsoft held a 7% share in the first quarter, up from zero a year ago, estimates Neil Strother, an analyst with Cahners In-Stat. He expects that share to creep up to 9% by yearend.

NAME GAME. The new brand -- the old name was Windows-Based Smartphone OS -- should allow Microsoft to distance itself from its badly reviewed earlier versions. The first iterations tended to lock up, preventing users from making calls, says David Hayden, CEO of wireless consultancy MobileWeek in Palo Alto, Calif. The phones' new name reflect their improved functionality, he says. "Windows Mobile is going to be a front-and-center brand," says Ed Suwanjindar, Microsoft's lead product manager for mobile devices.

Microsoft has made headway signing up service providers to carry its smartphones, especially overseas. Traditionally, carriers have been reluctant to do business with Microsoft because of its reputation for playing hardball with its customers and partners. But they're critical to its success since they're the gateway into the market, especially in the U.S., Japan, and Korea.

Carriers see some advantages in going with Microsoft. Some Windows-based smartphones don't carry the brands of cell-phone manufacturers, so the service providers can put their own names on the devices. That's a major selling point at a time when competition between wireless-service providers seems to ratchet up daily, so every bit of differentiation counts. Plus, such branding can improve a carrier's name recognition with customers and boost retention.

PLAYING NICE. Since last year, European operator Orange has sold 70,000 Microsoft-based smartphones. In May, Swedish carrier TeliaSonera agreed to sell them. The same month, retailer Synergy Technologies said it would sell a Microsoft-platform smartphone in Hong Kong. And a Portuguese service provider has agreed to offer carry one as well.

Bigger fish close to home are also slowly swimming toward Microsoft's net, including No. 1 U.S. provider Verizon Wireless, British operator T-Mobile, and AT&T Wireless (AWE). All plan to roll out Windows-based smartphones this year. Verizon (VZ) and a number of other major carriers already sell Windows-based Pocket PCs.

Still, Microsoft needs to find more cell-phone manufacturers to make its phones and more service providers to carry them. Microsoft defector Sendo is developing a smartphone based on Symbian and should release it later this year. And competition in smartphones will intensify as PDAs get smaller and voice-enabled. The key questions are: Just how big will the smartphone market get and and will they be what consumers want?

MISSING PIECES? More important, Microsoft has to overcome its reputation as a bully. Sendo found that the giant didn't let Sendo modify the code to tailor the software to suit customer requirements, says Ron Schaeffer, head of Sendo's product strategy and planning. Suwanjidar counters that Microsoft has to ensure that the platform isn't modified too much and remains stable and consistent across different carriers.

Microsoft's platform also doesn't have some of the features carriers want, Schaeffer says, such as support for multimedia messaging. According to Suwanjindar, Microsoft figures that cell-phone makers and carriers can easily work that in. Microsoft hasn't announced when it'll release the its next smartphone platform version, but he says that software will allow for more flexibility when integrating additional features than the current operating system does.

Schaeffer concedes that Microsoft's platform still works better than those of many of its rivals for remotely connecting to Microsoft Office applications -- a major plus for many users. "You'd be foolish to count Microsoft out," he says.

With $46 billion in cash and short-term investments, the Colossus of Redmond can afford to be patient. "We have a history of doing hard things and seeing them through," says Suwanjindar. If that holds true again, this could be the decisive year for Microsoft's smartphone efforts -- and vindication of its optimism. By Olga Kharif in Portland, Ore.

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