Microsoft gives Windows Phone away for free - and hopes to get much more in return

Tools

Phil Goldstein

SAN FRANCISCO--It was almost an aside that did not elicit much reaction from the thousands in the room during a three-hour keynote here at Microsoft's (NASDAQ:MSFT) Build developer conference: The company would start giving its Windows platform away for free to device makers making smartphones and tablets with screens under nine inches.

The shift is a radical one considering Microsoft's long history of making money by licensing its software, and I think it could finally provide the spark that Windows Phone needs to accelerate its market share growth nearly three and a half years after Microsoft took the wraps off its first Windows Phones. In 2013, Windows Phone garnered 3.2 percent of the global smartphone market, according to research firm Gartner. This could finally be the move that gets Windows Phone to that elusive goal of at least 10 percent market share.

It's a strategy that carries risks (which I'll get to in a moment), but it also reflects the notion that "when you got nothing, you got nothing to lose." Jackdaw Research analyst Jan Dawson estimated Microsoft makes less than $1 billion per year from Windows Phone licensing, compared with the $4 billion to $5 billion a year Nokia (NYSE:NOK) is making from selling Lumia devices. He noted that since Nokia's Lumia phones have represented around 80 percent of Windows Phone sales anyway, "much of the licensing fee revenue was about to become an internal transfer anyway" as Microsoft is about to close its $7.5 billion deal to acquire Nokia's handset unit.

"It's much better served by reducing the cost of selling Windows Phone hardware, and then making greater revenue there," he said. "The key to making money in devices is scale, so they have to do what they can to goose Windows Phone device sales. Stripping the licensing fee out of the price should help with that. With Nokia as part of Microsoft, there would have been suspicion from other OEMs that Microsoft was favoring Nokia commercially anyway, so this removes that concern."

Others agreed: "In the past, Windows' licensing fee of $5-$15 has been a major factor for manufacturers choosing Google's free Android system, and has been reflected in Android's massive market share globally," noted Hendrik Malan, operations director for Frost & Sullivan Africa. "Developers, on the other hand, typically focus on creating apps for the most popular operating system to ensure maximum coverage for their apps, and thus most apps have been developed primarily for Android and iOS platforms. This shift, however, will attract more developers as the Windows Mobile OS increases in popularity, further increasing the attractiveness of this OS to the end-user."

Microsoft isn't saying much about its strategy, but it's clear that the move is part of a series of actions the software giant has made in recent months to make Windows Phone more appealing to OEMs and ODMs.

"This offering also enables hardware partners to provide their customers a one-year subscription to Office 365. These steps will help our partners to deliver the rich experience of Windows plus best-in-class hardware, software and services to consumers at affordable prices," Terry Myerson, Microsoft's executive vice president of operating systems, wrote in a blog post. "For partners, this makes it easier to bring more compelling devices to market. For developers, this means more endpoints for their apps in a store that's already growing at about 50% a year. And for consumers, it will mean a broader range of great smartphones and tablets at prices that will be competitive with anything on the market."

Some believe that this might be too little, too late. CCS Insight analyst Geoff Blaber said it's "frustrating they didn't do this three years ago" because "they could have been in a fundamentally different position." However, the way Microsoft executives see it (and I buy their logic) is that it couldn't have happened until now.

Microsoft needed to expand its presence around the world with Windows Phone and also needed to make it desirable for more OEMs to join the Windows Phone team. And the success of the low-end Nokia Lumia 520 last year showed them that they could successfully sell an entry-level smartphone. So at Mobile World Congress Microsoft greatly expanded its hardware partner roster, especially for China and India. Microsoft also is now using Qualcomm's (NASDAQ:QCOM) Snapdragon 200 and 400 chipsets and the Qualcomm Reference Design program to make it easier for OEMs and ODMs to make inexpensive hardware.

Those pieces all needed to be in place for the software shift to happen. Microsoft needed to expand the number of partners targeting the low-end smartphone market. It didn't make sense for Microsoft to give away its software without first expanding the addressable market and lowering barriers to entry on the hardware side.

As I mentioned, there are risks. This is relatively unchartered territory for Microsoft. How will it make money on the Windows devices other companies are making? It still will be collecting royalty fees from around two-dozen device makers that use Google's (NASDAQ:GOOG) Android and need to license Microsoft patents. But Microsoft's big bet is now on services, and that's where things get hazy.

Blaber said that Microsoft could hope to drive greater volumes and make more money via advertising from its Bing search engine, the way Google does with Android. Cortana, the digital assistant at the heart of Windows Phone 8.1, is powered by Bing, so that seems somewhat plausible. Yet the real cash cow would be in subscription services like Xbox Live and Office 365. I'm not sure Microsoft will be able to get users to pay for services en masse to generate consistent revenue streams, especially for something like Office, which users have come to expect for free when they upgrade a Windows PC. Blaber noted there are lots of moving pieces to the equation, most notably how owning a hardware company will play out. "At least they are making the difficult decision to ensure" they have a path to maintaining growth, he said.

Moving away from a costly licensing model is definitely a major step for Microsoft. It should finally make it more attractive than ever before for handset makers to support Windows Phone. That could ensure that all of those new hardware partners offer more than just token support for the platform. It was a quiet announcement here, but it could shake the world.--Phil