Microsoft’s most important sales channel, the OEMs and PC builders who ship Windows preinstalled on desktop PCs, is experiencing significant change. The proposed settlement in the antitrust case limits what Microsoft can demand of OEMs. Tough economic times have caused OEMs to look for ways to make more money on PCs by replacing Microsoft programs with those from competitors. On the other hand, the value of an industry standard desktop is so high for so many customers—including corporate purchasers, ISVs, and the OEMs themselves—that they may be loathe to depart from it.

Microsoft and OEMs

The OEM channel is the source of Microsoft’s strength in the PC software market. More than 90% of new Intel-compatible PCs are shipped to customers with Windows preinstalled on them, giving Microsoft an extraordinary advantage over competitors when it bundles programs with Windows: at virtually no cost, it can seed the market with more than 100 million copies of a new program within a year. Furthermore, these programs are already installed on the PC when the customer starts it up.

Competitors, in contrast, must sell their products through retail channels or offer Internet downloads, which are beyond the skill level of many novice computer users. Given that users already have Microsoft programs on their computer that can, for example, browse the Web, edit movies, exchange instant messages, or play digital audio or video files contained on a Web site, novice PC users have little incentive to purchase or download a non-Microsoft product, and may even be unaware of alternatives. Rapid dissemination of Microsoft’s client software ensures that many popular Web sites and third-party applications will adopt features or services compatible with the Microsoft de facto standard, such as Web sites designed specifically for Internet Explorer (IE) or media files compatible with Windows Media Player.

During the Microsoft antitrust trial, the courts found that Microsoft acted illegally by forbidding OEMs to remove icons for its products, such as the IE browser, and that it penalized OEMs, including Apple, who considered using competing products, such as Netscape. One of the issues in the trial was whether these measures gave Microsoft the ability to out-distribute and out-install competitors.

The Changing Legal Landscape

The proposed antitrust settlement between Microsoft and the Department of Justice (DoJ) would give OEMs both the right and the necessary tools to remove links to what the court calls Microsoft's "middleware" (defined as the browser, e-mail client, instant messaging client, media player, Java Virtual Machine, and, possibly, certain future programs) and to set non-Microsoft middleware as the default for particular file and data types. The tools do not actually remove the middleware, nor do they remove links to bundled non-middleware programs, such as Movie Maker, from the PC desktop. Removal of links to Microsoft middleware is intended to provide greater opportunities for ISVs to get competing middleware onto the preinstalled PC desktop, territory that in the past has been Microsoft’s alone. Although the proposed settlement has not yet been approved, Microsoft is currently testing tools for removing its middleware in a Windows service pack.

Yet, even if the settlement is upheld in its current form, ISVs will remain at a disadvantage: if they want an OEM to include their software on the PC desktop, they will have to negotiate and likely pay the OEM a consideration for that privilege. Microsoft does not pay OEMs to ensure that they will distribute its browser or multimedia player. Also, removing the Microsoft links requires OEMs to take additional configuration and testing steps that increase their costs.

Nevertheless, the proposed settlement will give OEMs and ISVs more opportunities than they had before the antitrust trial: ISVs and ISPs can more freely negotiate with OEMs to preinstall their software on the OEM’s PCs, and OEMs have a potential new revenue stream from such deals. AOL, for example, has aggressively pursued deals with OEMs, offering to pay them for placement on the Windows XP desktop (Microsoft and AOL could not come to an agreement to ship AOL software with Windows XP OEM versions), or to pay a bounty for each subscriber AOL gains as a result of placement on the OEM’s PC.

OEMs will also have more freedom to modify the desktop and to add or subtract software to create a more distinct desktop, which will help them differentiate their offerings from the competition on features rather than price alone.

The Changing OEM Market

These new opportunities arrive at a critical time in the OEM market. After booming for most of the 1990s, PC sales hit a wall in 2001, reflecting both the fact that many organizations upgraded older PCs to make them compliant with year 2000 calendars, and a general slowdown in the U.S. economy.

According to IDC, only the largest vendor, Dell, shipped more PCs in 2001 than in 2000 (its sales were up 16%). The next four largest vendors—Compaq, Fujitsu Siemens, Hewlett-Packard (HP), and IBM—saw decreases of 8.5% to 16%. In the same time period, many OEMs began experiencing life-threatening financial difficulties (Packard Bell, Gateway) or have reduced their PC focus to concentrate on other businesses (Micron, IBM). Market difficulties have led to the merger of two major players, HP and Compaq.

This consolidation in the OEM market means that Microsoft has fewer OEMs to negotiate with, allowing the largest OEMs to exercise more clout over how they will and will not do business with the company. The new HP-Compaq combination, for example, accounted for about 43% of sales by the top five OEMs in 2001.

The HP-Compaq merger might also affect Microsoft's tight relationship with Compaq, generally considered to be Microsoft’s closest OEM partner. Although HP is likely to continue many aspects of that relationship, it is also the largest Unix vendor, and its divided loyalty could reduce Microsoft’s influence with the company.

Although consolidation might help the OEMs regain some of their clout with Microsoft, and might help ISVs find a place on the desktop, this advantage is mitigated by the increasing strength of "white box" manufacturers, which sell PCs with lesser-known brands or no brand at all. According to IDC, these manufacturers, which now often have access to the same high-quality motherboards and components as larger OEMs, accounted for more than 58% of PC sales in 2001, and their sales dropped only 3.4% that year, suggesting better market performance than the larger OEMs.

White box manufacturers, many of whom participate in Microsoft’s OEM and System Builder programs, are less attractive to major ISVs who compete with Microsoft middleware, and therefore make it easier for Microsoft to promote its preferred technologies. To push their products through the white-box channel, ISVs would have to locate and deal with thousands of individual manufacturers—Microsoft knows of about 20,000 white box manufacturers around the world, but estimates the real number could be double that. Also, white box manufacturers ship smaller numbers of boxes and differentiate their systems more strongly on cost than major OEMs do, and so have less reason to do costly integration work to replace Microsoft middleware with an ISV’s alternative.

Microsoft’s Responses

Microsoft has not signaled any significant changes in its OEM relationships, other than preparing to ship a Windows XP service pack to implement the proposed settlement. Nonetheless, changes in the OEM legal and market landscape could cause the company to protect its desktop position by "resetting" the desktop back to a Microsoft-friendly configuration through the Windows Update online service, leveraging other popular products in the retail channel, or by steering customers to volume licensing for its operating system.

Resetting the Desktop

One of Microsoft’s key technologies for dealing with viruses and bugs is Windows Update, a Web site and client technology that allows users to keep their computers up to date by automatically downloading and installing software updates over the Internet. But Windows Update also gives Microsoft a chance to see what middleware customers are using, prompt them to try a Microsoft alternative, and even reinstate hidden Microsoft middleware. For example, a recent "critical update" for the Windows Messenger instant messaging client reinstalls that software on PCs from which users have removed it.

Retail Opportunities

Another option for Microsoft is to leverage its popular application products by distributing middleware with them. Buyers of games, for example, might be prompted during installation to restore Microsoft’s media player, browser, or instant messaging software as the default, replacing competitive middleware, to support network game features.

Microsoft has an advantage over competitors in this field because its product line is much more diverse and it sells a wider range of products that can be used to cross-promote Microsoft middleware as the default.

Volume Licensing Channels

Another course open to Microsoft is to change volume licensing rules to reduce its dependence on PC OEMs to distribute Windows.

Microsoft does not currently sell full versions of Windows through its volume licensing programs. All desktop computers that run software licensed through a volume licensing program must be purchased with a full (not an upgrade) version of Windows, obtained from the PC OEM or at retail. Microsoft could amend this longstanding practice and encourage customers to purchase and install the operating system through volume licensing programs, where many of the DoJ-inspired rules for dealing with OEMs do not apply.

In the past, Microsoft has discouraged sales of "bare boxes" (PCs without an installed operating system) because of its fear of piracy: users could simply take a CD-ROM containing an OEM version of the OS and install it on a bare box. However, new antipiracy technology, such as activation (which prevents one copy of the OS from being loaded on more than two PCs), has reduced the scale of this problem. Customers involved in volume licensing programs are also less likely to be engaged in widespread piracy.

Market Inertia Might Limit Impact

In spite of the DoJ’s efforts, and in spite of shifting OEM allegiances, it's possible that very little will happen to Microsoft’s ability to control the default programs and technologies on desktop PCs, because that ability is, in the minds of many, a beneficial force.

OEM Resistance

The proposed remedy has a significant weakness from a competitor’s point of view: it does not require that Microsoft middleware actually be removed. In particular, OEMs or end users who conceal a Microsoft program and put another in its place face the risk of "interface shock," because Microsoft middleware can jump into the foreground at any time. For example, Microsoft’s IE browser will appear whenever users invoke HTML-based help screens in Microsoft applications, even if the user has set Netscape Navigator as the default program for handling HTML files. Similarly, a user who selects the RealOne player as the default streaming media application will still end up viewing some video files with the Windows Media Player.

More generally, customers, software developers, and OEMs recognize that a return to the very early days of the PC, when software was often specific to a particular brand and model of PC, would create a software management nightmare, fragment software markets, and confuse customers. OEMs especially value consistency because they are responsible for supporting Windows on the machines they sell, and two or three support calls can erase their profits on a PC.

Finally, although OEMs could take advantage of the proposed settlement to create more distinctive desktops, most are focused on more fundamental problems, such as reducing costs and managing inventories. Many are experiencing "Dell envy" and are examining ways to imitate the market leader through direct sales to customers over the Internet without sacrificing their retail channels. Dell, notably, is better known for its efficient manufacturing and business processes than for software innovation, and for now, replacing Microsoft’s desktop with something more distinctive appears to be a lower priority.

Resources

The AOL-Microsoft dispute about shipping the AOL client was described in "AOL and Microsoft: Nothing to Talk About," on page 28 of the Aug. 2001 Update.

The settlement between Microsoft and the DoJ is described in "Effects of the Antitrust Settlement" on page 13 of the Jan. 2002 Update.

Microsoft’s site for system builders is at www.microsoft.com/oem.

Terms of the proposed settlement between Microsoft and the DoJ are at www.microsoft.com/presspass/trial/nov01/11-06revised.asp.