As previously noted, Apple has overtaken Microsoft (and Google) in operating margin percentage. This is an astonishing statistic as Apple is still largely perceived to be a “hardware company” while Microsoft is a “software company” and Google is a “services company.”
To suggest that “hardware” could be more operationally profitable than either software or services is akin to heresy in technology analysis. This reversal is newsworthy indeed. However, even the most casual observer would note that Apple does not derive its market power from hardware alone. It is, in fact, an integrated hardware, software and services company (with a few more roles besides.)
So the emergent successful business architecture in this technologically transitional period is of integration and completeness of solutions.
This shift explains at least at a conceptual level Microsoft’s tectonic Surface shift.
But what about another point of view? What does integration mean for Microsoft’s income, cost and profit structure? Is integration self-disruptive to Microsoft?
Here’s a reminder of Microsoft’s revenues and operating income by division:
The challenge of devices for Microsoft is that the licensing of software for devices is very difficult to sell.
In 2011 Microsoft received about $US18.7 billion in Windows revenues and $US23 billion in Office revenues. The chart shows that this is a fairly steady growth business. According to Gartner, in 2011 there were about 336 million Windows PCs sold and that this too is a fairly stable and mature business.
If we simply divide revenues by PCs sold we get about $US55 Windows revenues per PC and $US68 of Office revenues per PC sold . The total income for Microsoft per PC sold is therefore about $US123. If we divide operating income by PCs as well we get $US35 per Windows license and $US43 per Office license. That’s a total of $US78 of operating profit per PC.
Now let’s think about a post-PC future exemplified by the iPad. Apple sells the iPad with a nearly 33 per cent margin but at a higher average price than Microsoft’s software bundle. Apple gives away the software (and apps are very cheap) but it still gains $US195 in operating profit per iPad sold.
Fine, you say, but Microsoft make up for it in volume. Well, that’s a problem. The tablet volumes are expanding very quickly and are on track to overtake traditional PCs while traditional PCs are likely to be disrupted and decline.
So Microsoft faces a dilemma. Their business model of expensive software on cheap hardware is not sustainable. The future is nearly free software integrated into moderately priced hardware.
For Microsoft to maintain their profitability, they have to find a way of obtaining $US80 of profit per device. Under the current structure, device makers will not pay $US55 per Windows license per device and users will not spend $US68 per Office bundle per tablet. Price competition with Android tablets which have no software licensing costs and with iPad which has very cheap software means that a $US300 tablet with a $US68 software bill will not be competitive or profitable.
However, if Microsoft can sell a $USUS400 (on average) device bundled with its software, and is able to get 20 per cent margins then Microsoft is back to its $US80 profit per device sold. This, I believe, is a large part of the practical motivation behind the Surface product.
The challenge for Microsoft therefore becomes to build hundreds of millions of these devices. Every year. Sounds like they need a Tim Cook to run it.