Apple Just Quietly Destroyed Microsoft’s Future

by Brad Moon | October 23, 2013 2:54 pm

When Apple (AAPL[1]) trotted out updated iPads at yesterday’s media event[2], it was expected the company might take a few potshots at tablets running Android. After all, Google’s (GOOG[3]) mobile operating system is powering the wave of low-cost devices that have cost Apple its lead in the tablet market. What wasn’t expected was the targeting of Microsoft (MSFT[4]) with the bombshell announcement that OSX Mavericks — the Mac equivalent of Microsoft’s Windows PC operating system — will be a free release.

If you thought the iPad cannibalizing PC sales was a threat to Microsoft, what do you suppose the possibility of having to give up Windows revenue altogether might do to the company’s bottom line?

Even though it’s giving away a Windows 8.1 upgrade at no charge (to users already running Windows 8), Microsoft remains highly dependent on Windows revenue. It sells lucrative Windows licenses to the OEM hardware vendors who build PCs. If you own a computer currently running an earlier version of the operating system — say XP, Vista or Windows 7 — Microsoft charges between $119.99 and $199.99[5] if you decide to make the jump to its newest version.

Contrast that with Apple, which will let anyone download OSX Mavericks at no charge. To make it a potential one-two punch, Apple is also offering its iWork productivity apps — which compete with Microsoft Office — for free with new Mac and iOS device purchases (upgrades to the latest versions are also free to existing iWork owners).

Apple used to charge for its operating system too, although the price has been on the decline (from $129.99 for 2003’s OSX Panther to $19.99 for last year’s Mountain Lion). In its 2012 annual report, Apple spikes out $3.5 billion in software sales[6]. That’s only 2% or so of total revenue and includes Apple’s cut of third-party software sold through its Mac App Store. In other words, forgoing revenue from selling OSX and iWork has almost no impact on Apple. At the same time, by offering free OS upgrades and Office-compatible productivity apps — complete with cloud versions and online collaboration — Apple is making a play for more enterprise customers to shore up sliding sales of its Mac computers.

Microsoft, on the other hand, cannot afford to give Windows away.

Looking back to its fiscal year 2008, Microsoft booked $16.9 billion in revenue ($13.1 billion in operating income) directly attributable to Windows client sales, either through OEM licenses, upgrades or retail sales. That’s 28% of the company’s total revenue for that year and a whopping 58% of its $22.5 billion earnings. Taking the most recent data, the FY13 Q4 report[7], fiscal 2013 saw earnings of $26.8 billion. Of that, the Windows division accounted for $9.5 billion of income, or nearly 36% of Microsoft’s earnings for the year.

In other words, during the past five years Microsoft has reduced its reliance on Windows as a profit center, but it remains extremely important. Add in the Office productivity suite and you basically have Microsoft’s business. A Forbes piece from earlier this year points out the company still makes 75% of its profits on the Windows and Office combination[8].

Wired’s Ryan Tate thinks the move to free operating systems is a permanent one, writing “the desktop operating system is dead as a major profit center[9], and Apple just delivered the obituary.” The move to offer free computer and mobile versions of iWork doesn’t put the same degree of pressure on Microsoft — new users with existing Macs still pay, and Microsoft can make the case that Office is a more feature-rich product — but it certainly doesn’t help either.

Outgoing CEO Steve Ballmer has made a frequent point of telling us that Microsoft is reinventing itself as a devices and services company[10]. A recent corporate reorganization, plans to purchase smartphone maker[11] Nokia (NOK[12]), its Azure web platform, Bing, the latest Surface tablet releases and the upcoming Xbox One release are all signs of the company moving in that direction. Apple’s announcements — and the corresponding threat to Windows (and Office) revenue — will only add fuel to the fire of transforming from a software company.

The question is, if Microsoft is forced into playing the free operating system game sooner rather than later, how can it make up that revenue shortfall? It took six years to reduce Windows from 58% to 36% of annual profits, so what happens now that the pressure is on to stop charging for Windows altogether … and Office is also threatened?

The move is extraordinarily low-risk for Apple (with considerable possible upside) with grim implications for Microsoft. Again quoting the Wired analysis, Apple’s move to kick off the era of free PC operating systems will look “very scary” to Microsoft shareholders. I have to agree.

As of this writing, Brad Moon did not hold a position in any of the aforementioned securities.

Endnotes:
  1. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  2. yesterday’s media event: http://investorplace.com/2013/10/aapl-apple-event-ipad-air/
  3. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG
  4. MSFT: http://studio-5.financialcontent.com/investplace/quote?Symbol=MSFT
  5. Microsoft charges between $119.99 and $199.99: http://www.microsoftstore.com/store/msusa/en_US/cat/categoryID.62684800?WT.mc_id=MSCOM_EN_US_HP_Products_Windows
  6. Apple spikes out $3.5 billion in software sales: http://files.shareholder.com/downloads/AAPL/2738492025x0xS1193125-12-444068/320193/filing.pdf
  7. FY13 Q4 report: http://www.microsoft.com/investor/EarningsAndFinancials/Financials/FY13/Q4/SegmentRevenues.aspx
  8. the company still makes 75% of its profits on the Windows and Office combination: http://www.forbes.com/sites/adamhartung/2013/01/20/sell-microsoft-now-game-over-ballmer-loses/
  9. the desktop operating system is dead as a major profit center: http://www.wired.com/business/2013/10/apple-ends-paid-oses/
  10. Microsoft is reinventing itself as a devices and services company: http://www.theverge.com/2013/9/20/4749574/microsoft-business-model-mix-of-google-and-apple
  11. plans to purchase smartphone maker: http://investorplace.com/2013/09/can-microsoft-and-nokia-make-phones-that-people-actually-want/
  12. NOK: http://studio-5.financialcontent.com/investplace/quote?Symbol=NOK

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