• Sidebar: Key Consumer Technologies

To weather the current slump in IT spending and make sure it can maintain growth through business down-cycles in the future, Microsoft needs to generate more revenue from the consumer sector. To meet this end, the company has devised a consumer strategy guided by three imperatives: increase PC sales to consumers, expand into consumer electronics, and earn money from networked services. To succeed, Microsoft will have to coordinate efforts among many product groups, beat powerful entrenched competitors, and enlist new types of partners to support a quest that is even more ambitious and far-reaching than "a PC on every desktop."

Long-Term Vision: Microsoft (and Its Partners) Everywhere

Chief Software Architect Bill Gates has often discussed his long-term vision for consumers: by the end of this decade, which Gates sometimes calls the "digital decade" or the "PC-plus" era, consumers will have multiple devices in their home and on their person, all of which will be able to connect to one another and to various networked services. The PC will play a central role as a kind of command-and-control center—a place for storing, manipulating, and distributing data to these other devices and services.

This vision is demonstrated in the Microsoft Home, an on-campus showplace that is meant to represent a typical home in 10 years. For instance, visitors to the Home are shown how a family's daily calendar could be stored in a network-connected repository, then accessed from various locations in the home (such as a PC in the den, TV in the living room, and terminal in the kitchen), and outside the home (with a work PC, Pocket PC, Auto PC, and data-enabled wireless phone, for instance). This calendar could then be integrated with presence and communications applications, so users could determine whether other family members were currently online and which devices and applications they were using, and then conduct instant messaging, voice, or video sessions about a particular event on the calendar.

In this vision of the future, Microsoft would make money by selling the software that runs in these networked devices. As with the PC business, Microsoft would rely mostly on hardware partners to manufacture and distribute these devices, except when a partner could not be persuaded to take the financial risk necessary to compete against entrenched competitors (the situation that Microsoft faced with Xbox) or when the market is moving too slowly for Microsoft's strategic purposes (home networking). In addition, Microsoft would build or operate profitable networked services, such as a hosted calendar or Voice over IP (VoIP) service, splitting revenues with partners that have key assets or expertise Microsoft lacks, such as broadband infrastructure (Verizon, Charter) or digital audio content (Pressplay). This would help the company diversify beyond desktop PC software, which today provides more than half of its revenue and nearly all of its profits.

With this long-term goal in mind, Microsoft's consumer strategy today is based on the following three imperatives:

• Keep the consumer PC business growing
• Become a major player in the consumer electronics space
• Create profitable networked services for which consumers will pay a regular fee.

Imperative 1: Grow Consumer PC Business

Of Microsoft's seven business units, Windows Client, which includes all versions of the desktop OS, is the biggest revenue earner, accounting for about 30% of all revenues, and the most profitable, with margins of more than 80%.

According to market researcher Gartner Dataquest, worldwide PC unit sales were up only 2.7% in 2002, and this growth was mainly driven by consumers, as businesses kept a tight rein on IT spending. Microsoft is aware of this trend and has recently changed the Windows organization to increase its focus on consumers. Will Poole, who used to oversee the digital media division—a consumer-oriented business—was recently promoted to lead the entire Windows Client team. In addition, Rick Thompson, who oversaw consumer hardware such as keyboards and mice until leaving Microsoft in 2000, has rejoined the company to take a newly created role in the Windows Division: vice president of extended platforms. There, he will oversee many aspects of the consumer PC business, including Windows versions for special-purpose PCs such as the Media Center (which allows consumers to watch and record TV shows, play DVDs, and perform other media-related functions), and ensuring that peripherals work well with the PC (the "hardware experience").

Under the leadership of Poole, Thompson, and others, the Windows Client business unit will attempt to increase consumer revenues by encouraging consumers to replace their current PC or buy additional PCs.

Drive PC Upgrades

Every time a consumer buys a new PC, Microsoft sells a new version of Windows. Improvements to the OS itself, such as a new UI and better security and reliability, are often not enough to spur these upgrades—many consumers will only buy a new PC if they need it to use new applications or peripherals. With this in mind, Microsoft has begun releasing consumer software, such as the threedegrees instant messaging client and Movie Maker 2.0 digital video editor, and consumer hardware, such as its Bluetooth-based wireless keyboard and Windows-Powered Smart Display portable monitor, that only work with Windows XP.

The company is also trying to position the PC as the best device to record, edit, and store digital media. Working with digital media files (particularly video) is disk- and memory-intensive, so consumers will need the most recent hardware to participate in these scenarios. To encourage consumers to use the PC for digital media, Microsoft has bundled appropriate programs, such as Media Player and Movie Maker, with the OS, and has invested considerable resources in improving the compression and quality of the default format used by these programs (the Windows Media Format, or WMF).

Multiple PCs per Home

Microsoft also hopes to encourage consumers to buy additional PCs for their home. One way to do this is to encourage home networking: although several Microsoft partners, notably LinkSys (recently purchased by Cisco) and Netgear, already provided home networking kits, Microsoft entered the market itself in late 2002, hoping that the presence of the familiar Microsoft brand could convince previously reluctant consumers to experiment with home networking.

As part of this effort, Microsoft has built several key networking technologies into Windows XP. For instance, the Remote Desktop Protocol (RDP) allows a PC to serve as a "host" for other PCs or terminals (such as the Smart Display) to access data and applications. And because few consumers want to run network cable through their houses, Windows XP introduced support for wireless technologies such as 802.11 and Bluetooth.

(For more details on technologies that are important to Microsoft's consumer strategy, see the sidebar "Key Consumer Technologies".)

Finally, Microsoft hopes to further its goal of multiple PC ownership by creating special-purpose PCs in nontraditional form factors, such as the Media Center PC for viewing and recording digital media and the Tablet PC (a high-end laptop with a touch-sensitive screen that accepts pen-based input). Other special-purpose PCs are likely to follow—one likely possibility is a communications-oriented PC that features the necessary hardware and software for VoIP and video calls.

Imperative 2: Get into Consumer Electronics

Competing in the consumer electronics space is necessary for Microsoft to reach its long-term goal of having its software in a wide range of interconnected devices. The financial opportunity in this market is significant: according to statistics from the Consumer Electronics Association, an advocacy group, and market researcher NPD, U.S. sales of all consumer electronics devices topped US$96 billion in 2002. About US$11 billion of this total came from personal computers (most of which are sold with Windows); retail PC software added another US$5.7 billion to the mix. Meanwhile, game consoles, software, and accessories—one of many consumer electronics segments—accounted for US$10.3 billion in sales in the same time period. In other words, a successful consumer electronics business could help Microsoft weather flat or declining PC and PC software sales.

To some extent, Microsoft was forced to enter the consumer electronics space to protect its most profitable business: the PC. Consumer electronics companies (particularly Sony) and network service providers (cable, telephone, and wireless companies) have talked about game consoles and set-top boxes serving as the gateways to the Internet or other data networks. Allowing another device to steal this important function from the PC could deal a serious blow to the Windows revenue stream.

Microsoft's efforts in the consumer electronics space can be split into two areas: home devices and portable devices.

In the Home

Since nearly all consumers have a TV in their home, one way for Microsoft to become a consumer electronics company is to create devices that connect to the TV. This is a major goal of Robbie Bach's Home and Entertainment business unit, which oversees Xbox. Bach also recently took control of Microsoft's TV platform, which suggests some future coordination between the two product lines: Bill Gates, for instance, has talked about a future version of Xbox connecting to an electronic program guide and recording TV shows.

In addition, a new team in Rick Thompson's Extended Platforms Group is working to create an audio/video "node" for the home. Although Microsoft has not yet released details about this project, these devices will presumably receive digital media streams from a PC over a home network, and then play these streams on traditional consumer electronics equipment, such as a TV or stereo.

The Windows Media Group also plays an important role by convincing consumer electronics companies to adopt Microsoft's digital media technologies. For instance, Microsoft has convinced several chip makers, including Texas Instruments and National Semiconductor, to license the WMF. Consumer electronics companies, such as Apex, JVC, Panasonic, Pioneer, Toshiba, and Zenith, are now using these chips to build CD players and DVD players that support the format.

In addition to earning direct license fees from licensing the WMF, the Windows Media Group is also creating enabling technologies that make it easier and more convenient for consumers to transfer digital media from their PC to devices. For instance, Microsoft and Matsushita (Panasonic) have introduced the HighMAT format, which provides a standard way for consumer electronics devices to recognize the digital media data on a recordable CD or DVD.

On the Go

Although some of Microsoft's reference platforms for portable devices, particularly Pocket PC, are selling well among business users, many of them are too expensive—US$500 or more—to appeal to consumers. So Microsoft is introducing new reference platforms for less-expensive devices that perform a smaller subset of consumer-specific functions.

In Jan. 2003, the company announced Media2Go, a reference platform that hardware companies can use to build portable video and audio players that can easily download digital media files from a PC. Creative, iRiver, Samsung, Sanyo, and ViewSonic have agreed to build the devices, which should hit the market by the end of 2003 at prices between US$200 and US$400.

Microsoft has also developed Smart Personal Objects Technologies (SPOT), a new platform for mobile devices that will download simple data (such as traffic reports) over a low-bandwidth FM-based radio spectrum. Three companies, Citizen, Fossil, and Suunto, have agreed to build SPOT watches at price points between US$100 and US$300, and Microsoft hopes the platform will find its way into other types of home devices, such as alarm clocks.

Imperative 3: Profit from Networked Services

In addition to earning money from software in PCs and in a wide range of other consumer devices, Microsoft also hopes to earn money from networked services—that is, services delivered to consumers over the Internet or some other type of data network.

Networked services offer a constant, predictable revenue stream, unlike the consumer software business, which generates periodic one-time payments of anywhere from 20 to several hundred dollars. Microsoft has an annuity revenue stream with business customers who have signed multiyear licensing agreements, but has not been as successful creating a similar business with consumers. For instance, the .NET My Services—a proposed Microsoft-hosted repository of consumer data, such as calendar and contact information—was terminated before it ever reached market because of an unclear business plan and an inability to sign up the necessary partners to support it.

Latest Plan: MSN Client, Advertising

Creating profitable networked services has been MSN's goal since its inception in 1995. MSN's preferred business model has always been to get consumers to pay MSN a monthly fee, but the company has also had some success with an advertising-based model, in which the services are free but advertisers pay MSN to reach these users.

Unfortunately for MSN, profitability has remained elusive—the MSN business unit lost US$157 million in its last reported quarter (ended Dec. 31, 2002), and has probably lost several billion dollars since its inception.

In its latest effort to stem these losses, MSN is deemphasizing its ISP business, which relies on expensive promotions to gain users and suffers from high churn rates. Instead, it will concentrate on creating client software that not only allows users to connect to the Internet but also includes additional software functions and exclusive content. Then, it will try to convince broadband ISPs to distribute this software to customers and split the monthly proceeds from these customers, or convince users to download it themselves and pay Microsoft a monthly fee (the latter is often called the "bring-your-own-access," or BYOA, model).

The company began this strategy in Oct. 2002 with the release of MSN 8, a desktop client that offers parental controls, spam filtering, graphical e-mail, and links to online content and services from Encarta and Money, among other features. But so far, MSN 8 has not led to a significant increase in MSN subscribers or revenues. To attract broadband users, future versions of MSN could involve better Web search functionality; downloadable or streaming digital media, similar to the RealOne service offered by RealNetworks; enhanced real-time communications services, such as VoIP and video; or online gaming, where the success of Xbox Live (250,000 subscribers in its first two months) has shown significant consumer demand.

In addition, Microsoft will try to increase advertising revenues from free sites and services, possibly by bringing some paid search functionality (in which advertisers pay for placement in search results) in-house. (See "MSN Embracing Paid Search".)

Easier Said than Done

Although Microsoft is no stranger to ambitious business plans, its consumer strategy faces some significant barriers.

Who's driving? Today, Microsoft's consumer businesses are in different divisions within the company, rather than consolidated under a single leader with a consistent vision. These divisions often have different and conflicting business goals, and political infighting and duplicate efforts threaten to confuse both consumers and the partners that Microsoft relies on to bring products to market. For instance, the TV Division built support for digital video recording (DVR) into the Microsoft TV platform, and could conceivably use this feature to sell advanced set-top boxes to cable operators; adding DVR to the next generation of Xbox could also help sell more consoles. But these initiatives would compete with the Media Center PC and related products from the Windows Extended Platforms team.

Entrenched consumer electronics competitors. Previously, when Microsoft entered new markets—PC operating systems, productivity applications, even the ISP business—those markets were still young, with lots of growth potential and few entrenched competitors. In contrast, the consumer electronics market is dominated by multibillion-dollar players with well-known brands, such as Nokia and Sony. As these companies see Microsoft encroaching on their core business, they will set up roadblocks whenever possible. Likely tactics include adopting Linux or other non-Windows OSs for their devices; incorporating or creating non-Microsoft formats or protocols, such as MPEG or proprietary digital rights management (DRM) schemes; pursuing exclusive deals with network operators, such as wireless phone carriers, that Microsoft needs to get its technology into consumers' hands; and taking legal action—for instance, Philips and Sony recently purchased Intertrust, a company that has filed hundreds of patent infringement lawsuits against Microsoft in the area of DRM technology.

Uncertain demand. Although Bill Gates and other executives at Microsoft have expressed excitement about a world of interconnected devices connecting to networked services, it's not clear that consumers are crying out for such products. Launching consumer products without clear customer demand can be risky and expensive, and can make it almost impossible to sign up partners, as the company's experience with .NET My Services proved.

Technological and legal barriers. Finally, various technological and legal issues must be resolved before many of the consumer scenarios Microsoft envisions will become possible. For instance, the price of broadband Internet access will probably remain high unless incumbent telephone and cable providers are forced to open their "last mile" to competitors. DRM is another barrier—consumers will not use protected content when so much unprotected content is available through file-sharing networks such as Kazaa, and content owners have been reluctant to make much of their material available online, fearing widespread copying and intellectual property violations.

Although Microsoft has succeeded in taking big risks in the past ("a PC on every desktop" was remarkably ambitious when first proposed), it might have to subsidize new consumer businesses, such as MSN and Xbox, to the tune of billions of dollars before seeing any significant success.

Resources

For more on the new roles of Will Poole and Rick Thompson, see "Ayala to Lead New Sales Force" on page 27 of the Apr. 2003 Update.

For background on the Media Center PC, see "Media Center PC Launches" on page 18 of the Dec. 2002 Update, and the official site at www.microsoft.com/windowsxp/mediacenter/.

For more on the threedegrees instant messaging client, see "NetGen Team Targets Youth" on page 25 of the Apr. 2003 Update; the client is available at www.threedegrees.com.

For more on Movie Maker 2.0 and HighMAT, see "New Media Publishing Format, Movie Maker 2.0" on page 10 of the Dec. 2002 Update.

For more on the Windows-Powered Smart Display, see "Smart Displays Launch" on page 21 of the Feb. 2003 Update, and the official site at www.microsoft.com/windows/smartdisplay/.

For more on Microsoft's entry into the home networking business, see "Hardware to Promote Home Nets" on page 20 of the Nov. 2002 Update.

For more on the Media2Go platform, see "New Clients for Windows Media" on page 19 of the Feb. 2003 Update.

For more on SPOT devices, see "SPOT Devices to Use FM-Based Network" on page 20 of the Feb. 2003 Update, and the official site at www.microsoft.com/resources/spot.

For the latest news on the TV Division, see "TV Division: Back to Basics" on page 22 of the June 2002 Update.

For more information on .NET My Services, see "New Strategy Devised for .NET My Services" on page 20 of the Apr. 2002 Update.

For background on MSN 8, see "MSN Refocuses on Client Software" on page 24 of the Sept. 2002 Update.

For more on the barriers to Microsoft's consumer strategy, see "Broadband Crucial to Consumer Strategy" on page 17 of the May 2002 Update.