Microsoft Is Pinning Its Hopes on Windows Phone 7

In an interview shortly after he unveiled Microsoft's (MSFT) new Windows Phone 7 mobile software on Oct. 11, Chief Executive Officer Steve Ballmer declared a new era for Microsoft. "This is a big launch for us—a big, big launch," he boomed.

Ballmer, never known for understatement, may be lowballing this one. Gartner (IT) expects smartphone sales to surpass PCs in 2012. Microsoft remains immensely profitable thanks to its aging PC monopoly, and it will remain so even if it never figures out the smartphone market. Yet the stakes go beyond numbers—it's about staying at the center of computing while the world's information moves away from PCs and into the cloud.

People get e-mail, music, and Season Two of Mad Men on smartphones and other mobile devices—essentially pocket computers—and that information is warehoused at and delivered from far-off data centers, not PC hard drives. "If Microsoft gets this right, the stock is really, really cheap," says Michael F. Holland, founder of investment firm Holland & Co. "It would be an indication they've been able to evolve into a 21st century company."

By almost any measure, Microsoft is nearly out of the mobile game. Its market share fell to 5 percent from 22 percent in 2004, says Gartner. Customer satisfaction of Windows smartphones is 24 percent, according to ChangeWave Research; it's 74 percent for iPhones and 65 percent for handsets powered by Google's (GOOG) Android. There are a few hundred apps for Windows mobile, vs. 250,000 for Apple (AAPL) and 70,000 for Android. Asked about Windows Phone 7's chances, Google Android chief Andy Rubin has said: "The world doesn't need another platform."

Unless, of course, Windows Phone 7 handsets, on sale Oct. 21 in Europe and Nov. 8 in the U.S., blow away consumers as the iPhone did back in 2007. Today, consumers load their smartphones with apps. Rather than tap between separate programs, Windows Phone 7 users will choose from a few larger icons—Microsoft calls them tiles—that aggregate information from related apps. For example, a "People" tile lets users contact friends via phone, text, or Facebook without having to click on any of those apps. An "Office" tile opens a screen to edit and send a PowerPoint deck or Word file, no attachments necessary. This is the biggest step forward since Android, says Jonathan Sasse, senior marketing vice-president of Internet music company Slacker.

Microsoft mobile chief Andy Lees says Windows Phone 7 reflects his group's new approach to design. In the past, the company wrote the software and left it to licensees to ensure great products. This time, Microsoft set strict rules. All Windows Phone 7 handsets must come with three buttons (home, search, and back) and a camera with at least five megapixels of resolution. "In some cases that meant saying no to some of our largest partners, says Lees. He adds that Microsoft doesn't need to have as many apps as Apple or Android, just the most popular ones. That way Microsoft can assure the quality of Windows handsets. Ours is a structured ecosystem," says Lees.

Building an ecosystem—there's the rub. The tech world usually jumps behind Microsoft's initiatives. That hasn't happened in mobile. With Apple and Google each activating more than 200,000 customers a day, according to those companies, handset makers, carriers, and app makers have far larger audiences than Microsoft offers. While Dell (DELL), HTC, LG, and Samsung make Windows Phone 7 devices, longtime Microsoft partners Motorola (MOT) and Hewlett-Packard (HPQ) (by far the largest licensee of Microsoft's PC software) don't.

Although Microsoft wants to deemphasize apps, it still needs them. That's why it's paying some software makers to write apps for Windows Phone 7. While eBay (EBAY) and Netflix (NFLX) have obliged, many others won't until they see brisk Windows Phone 7 sales. Tim Westergren, founder of the popular online radio app Pandora, says he has no plans for a Windows Phone 7 app. We'll go wherever we see the volume, he says.

Other factors could prevent Microsoft from having the debut many experts say it needs. Owners will not be able to cut and paste text or simultaneously run multiple apps as they can on most smartphones. While AT&T (T) and T-Mobile will offer Windows Phone 7 devices, the software won't work with Sprint (S) or Verizon Wireless (VZ) until next year. (Apple's AT&T-only iPhone may be on Verizon by then.) Even AT&T, which co-hosted the launch event on Oct. 11, won't say how much it will invest to promote Windows devices. "It would be good to see carriers thinking they can differentiate themselves by heavily marketing Windows Phone 7, says Loomis Sayles analyst Tony Ursillo, noting Verizon's spending on Motorola's Droid phones.

Holding share in such a fast-growing market could require sales of about 20 million units in 2011, no easy feat. That's how many iPhones Apple sold in its debut year. Ursillo estimates Apple will sell 75 million in 2012. Even if consumers were to somehow buy 37 million Windows handsets the same year, that would add just 3 cents per share in profit, says Ursillo. Sasa Zorovic, an analyst with Janney Montgomery Scott (who cut the stock to neutral from buy on Oct. 5), wants to see the company double market share by the end of next year.

Microsoft's to-do list doesn't end with Windows Phone 7. It has no tablet software that can match the iPad. Failing in smartphones would be bad. Failing in tablets, which users expect to run office software, would be catastrophic, says Elevation Partners co-founder Roger McNamee, who brings up once-proud computing names as worst-case scenarios. If Microsoft misses the market for tablets, he says, the collapse in their relevance to consumers will remind people of Digital Equipment and Wang 20 years ago.

The bottom line: Microsoft's smartphone market share has fallen to 5 percent. It needs Windows Phone 7 to get it back into the game.

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