Microsoft: Beyond 'Software Plus Services'

For 30 years after Bill Gates and Paul Allen founded Microsoft in 1975, the tech world revolved around making their dream—a PC on every desk—a reality. But over the past few years the Internet has given rise to a new guiding principle: using the Web to more efficiently dole out software to reach almost anyone, any time, on nearly any device from a smartphone to supercomputer. If someone has to deal with the hassles of buying, running, and updating complex software programs, why not let so-called cloud-computing suppliers like Google (GOOG), Amazon (AMZN), or (CRM) be the ones to reach for the aspirin, rather than force every consumer and business to deal with these headaches?

It's a message Microsoft (MSFT) has struggled to counter. In recent years the software giant has pursued a kind of middle-ground approach through its "software plus services" strategy. The idea is that almost any job is best accomplished using a combination of the two methods. In some cases, work can be done by software residing on a powerful electronic device, with limited assistance from Web services—say, a periodic update to deliver a patch for the latest computer virus or to add a twist to your favorite video game. Or, the heavy lifting can be handled by the computers of an Internet company that delivers an online service to a broad array of devices, from high-powered PCs to "dumb" machines with far less smarts.

In truth, Microsoft's position reflects the current reality in many cases. Consider Apple (AAPL). Its hugely popular iTunes is not a destination on the Web, but software you install onto the hard drive of your Mac or PC. All of those 50,000 apps that run on your iPhone are just that: apps, not Web sites. Even Google, one of the biggest proponents of cloud computing, makes software that resides on PCs and other devices. Google Earth, its powerful mapping tool, is a program you download. Says Stephen Elop, president of Microsoft's Business Div.: "These companies would never say it, but actions speak louder than words. They're doing software plus services, too."

Cloud Computing Coming Slowly

Customers also recognize that cloud computing is still in its infancy. "The industry isn't moving at a pace that everything is going in any one direction," says Anthony Nuzzo, vice-president for deployment of applications at Coca-Cola Enterprises (CCE). "The cloud isn't mature enough for many applications."

The problem for Microsoft is that its "software plus services" message hasn't resonated with customers or Wall Street. The company's stock remains at the same level, around 24 a share, as it was when Google (GOOG) was founded in 1998.

Now, Microsoft is poised to put far more behind its software-plus-services approach. The software giant has been working on a new "Web operating system" called Azure that will let other software developers sell their programs either in the traditional way—on CDs in shrink-wrapped packages—or deliver them as a service from Microsoft's sprawling network of data centers. Microsoft is expected to release more details on pricing and the rollout plans for Azure on July 13-16 in New Orleans at its annual meeting with business partners.

Office 2010 on the Way

At the same conference, Elop will unveil for the first time details of the Office 2010 suite, which will ship in the first half of next year and will include Web versions of the popular Word, Excel, and PowerPoint programs. Consumers will be able to get free, ad-supported copies of these applications, minus some of the features available in the version Microsoft will charge customers to buy outright. For example, the Web version of Word won't have a wide selection of fonts, mail merge to easily do mass mailings, or the ability to automatically handle footnotes. And the Web version of PowerPoint won't allow user put audio or video clips in their presentations.

Microsoft executives say the primary reason for the slimmed-down Web versions isn't to attract thrifty consumers but to enhance the overall Office experience—particularly for corporations. For example, road warriors will be able to gain access to documents or take part in meetings via a Web conference, even if they're on a borrowed cell phone, laptop, or Net kiosk in an airport.

Elop says he made sure Microsoft was committed to the Net before taking the helm of the $18 billion Business Div. in early 2008. "The No. 1 thing I told him is that we've got to drive harder to embrace the cloud," says CEO Steve Ballmer. "We have to do it profitably and sensibly, and in a way that has some integration with the rest of the company. But we can't let up on the pedal even for a second."

Lower-Margin Business

Elop has accelerated the rollout of an online suite of programs including Exchange and SharePoint, a server program used by corporations to share documents and host Wikis. (Once Office 2010 ships, the Web versions of that suite will be added to this online service.) The company claims that some 10 million employees at hundreds of companies now have their e-mail and SharePoint sites served up from Microsoft's data centers rather than from a server at their office. And the company is signing up its traditional software distributors and resellers that want to offer the service, known as the Business Productivity Online Suite. Corporate Vice-President Allison Watson, who runs Microsoft's distribution channels, says 40 such customers, including Dallas-based CompuCom, worked with Microsoft for a year before the launch last November. Microsoft admits revenues from this business are small today, but Office marketing chief Chris Capposella thinks 50% of all Exchange users will be getting their e-mails via the cloud, rather than courtesy of their employer's computers.

The risk for Microsoft is that delivering such a service is by definition a lower margin business. Since Microsoft is covering all the costs associated with running the software, it currently charges customers roughly $12 for each employee using the program each month. Had the customer done a typical deal, where Exchange and the other programs are lumped into a three-year license agreement, it would pay a lump sum fee upfront for these programs, depending on the number of employees using the software. Microsoft estimates that if it converts that typical licensing deal to a subscription model, it would have received $3 for each employee per month, instead of the $12 it currently charges. But under the subscription-based business model, Microsoft will have to spend about half of that $12 it plans to charge just to run the servers and pay the IT workers and customer service reps associated with that customer, says Ron Markezich, vice president of Microsoft Online. Throw in the cost of developing the software in the first place, and the profit margin falls far off the gaudy 80%-plus software margins Microsoft is accustomed to, say analysts.

Ballmer says the hit to profit margins is worth the risk, since Microsoft theoretically ends up with more absolute dollars of profit at the end of the day. Rather than make $3 a month per user through a traditional sale, it might bring in $6 through the subscription. The fact that Microsoft had to incur margin-sapping costs to land that $6 misses the point, says Ballmer. Actual dollars of profit—not the margin number on the quarterly balance sheet—is what pays the bills and helps give a return to long-suffering shareholders. "I like to explain to people that you don't pay dividends or buy back stock [two key ways companies can boost earnings for shareholders] with [profit] margins," he says. "That takes real dollars."

Little Impact from Office Live

Merrill Lynch analyst Kash Rangan thinks Microsoft's various cloud-services initiatives could mean $5 billion to $10 billion in additional sales over the next few years. He figures the profit margin on these sales will be about 20%, far less than Microsoft's traditional margin of around 45%. (While the company makes nearly pure profit off Windows and Office, it has lost billions in Internet search, consumer electronics, and other markets.) All told, this could bring Microsoft's total operating margin down to around 31%. "It's not the worst thing in the world for them," he says, since Microsofit clearly will never enjoy the profitability it had when the PC was king. "Microsoft will never be the Microsoft of 2000 again," he says.

Many of Microsoft's competitors say they doubt the company is ready to push forward with this risky bet. "They're not out aggressively pitching their cloud computing story—except to companies that have made it clear they are moving in that direction and evaluating our offerings," says Google's Girouard, who runs Google Apps, an Office-like suite of online applications that, he says, is Google's fastest growing business.

This isn't the first time the company has professed to be cloud-friendly. In 2000 it rolled out a Web hosting service called bCentral, only to scrap it in 2004. It then introduced Office Live in 2007, providing a place Office users could store their documents, spreadsheets, and such. Office Live has made so little impact that it's now being folded in with Windows Live, a portal consumers can use to see their e-mail, instant messages, Facebook feeds, and other Net fare. And despite the increasing number of announcements, most customers still don't have a clear understanding of the broader "software plus services" message, says ISI Group analyst Bill Whyman. "It's too complicated. Nobody understands it."

Elop says he's fine with the doubts surrounding Microsoft's efforts. "This is one of the most successful businesses in the history of the world, so we can't screw that up," he says of his efforts to shake up Office. "But I think a lot of people are going to be surprised at the degree to which we're really going for it."

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