According to Shakespeare, some are born great, some achieve greatness and some have greatness thrust upon them. Notwithstanding the intelligence of its employees, past and present, Microsoft fits mostly in that third category. Microsoft got its head-start in the monopoly operating software business from IBM, who, presumably, did not realize what it was giving away.

In 1980, IBM, the Rolls Royce of the computer industry, purveyor of mainframes sold by an exalted internal sales force for nothing less than $15,000 a pop, decided to enter the “microcomputer” market dominated by such riff raff as Commodore, Atari, Tandy and Apple.

According to legend (corroborated by Wikipedia, although different versions of what went down exist – this is the most Shakespearean), IBM was planning to build a microcomputer around Intel’s 8086 processor, a chip that just so happened to be incompatible with the most popular operating system software of the day, CP/M. So IBM approached Gary Kildall of Digital Research, the maker of CP/M, for a tweaked version his software. Tragically, a Digital Research executive, Kildall’s wife, objected to IBM’s standard non-disclosure agreement and got upset over pricing so contract negotiations failed. IBM turned to Bill Gates who was already providing the ROM BASIC interpreter software for the new machine. Gates contacted Tim Paterson who had developed, using the CP/M-80 manual as a reference, an alternate version of CP/M called 86-DOS for use with Intel’s 8086 processor. Microsoft bought the rights to 86-DOS, IBM renamed it PC-DOS for use in its brand new microcomputer, newly christened the IBM PC, and the rest is history.

Thus, Microsoft was handed the PC operating system software monopoly by IBM for a product its engineers had not even developed themselves. No-one responsible for the creation and popularization of PC-DOS (also known as MS-DOS), Paterson, Kildall, even IBM, subsequently made anything like money Microsoft made as the middleman. Life often isn’t fair.

But the industry moved on. In 1987, Microsoft, repeating a successful past strategy, copied Apple’s graphical user interface to extend its operating system monopoly with Windows 2.0. The ubiquitous nature of the PC bestowed a related monopoly upon the lucky Microsoft in office productivity software – the sainted Microsoft Office. PC sales grew to over 350 million units in 2011 and Microsoft generated revenues of $93bn in their latest fiscal year – a record.

Which brings us to today. A lot has changed in the last 35 years but the world has really changed for Microsoft in the last ten. First off, the PC is not the indispensable computing and internet connection tool it once was. Ten years ago, just over 200 million individual computing devices were shipped world-wide. 100% of these devices were PCs and around 85% of them were graced with the Windows operating system.

This year, 2.5bn individual computing devices will be shipped but only 12% of them will be PCs. And while Windows still clings to its 85% market share of PC operating systems, it has been trounced in the new markets. Overall, Windows will be in charge of operating just 14% of the 2.5bn devices shipped this year (most of the PCs and a sliver of the tablets). Android, created by Google (a recent IPO ten years ago) will be in charge of over half – 53%. And the surviving member of the riff raff, Apple, will be operating the most expensive 12%.

The smartphone is now the world’s favourite computing and internet connection tool (75% of this year’s 2.5bn devices will be phones) and Windows is operating just 2.6% of them world-wide. In the US, Windows phones have been even more roundly rejected. Windows has a negligible 1.5% of the phone market in the US.

Naturally enough, the PC market is not really growing any more. (Retail sales clerks, marketing executives, engineers in the field all walk around with tablets now). PC sales peaked in 2011 and have been drifting down ever since. This year is especially dire – units were down 9% in Q2. Sales in the next couple of years should not be quite so bad. Expiring support for older versions of Windows should inspire some purchases in 2017-2019 and certainly the installed base is getting older. Draw down of inventory for the launch of Windows 10 this year also argues for a rebound in sales in Q4 and into next year. Nevertheless, it is hard to see the iconic, but passé, IBM PC recover its status as a growth product.

In a nutshell, Microsoft’s software products are on the things folks are not really buying any more. And they are not on the things folks are buying now.

The ex-growth characterization of the PC market means a lot to Microsoft. Although the company makes it as hard as possible to figure out what percentage of its sales and profits comes from which products, ball park figures can be pieced together from its financial statements. In fiscal 2015, about 51% of Microsoft’s gross profits came from PC software – Windows operating system and the Office suite both for commercial and consumer markets. And over the last year, revenue from PC software fell about 9%.

The management team over at Microsoft, after thinking long and hard about what to do about their problems with PC software, again turned to their trusted strategy and decided to copy what everyone else was doing. For about two years now, Microsoft has been selling us their Office suite of software as a service.

So how have things been going? Well, let’s look at the consumer market first. Astutely concluding that if they cannot sell more units, the only way to increase revenue is to raise prices, Office 365 is on offer for $7/month (single computer) with a terabyte of storage thrown in for free. Compared with buying Office 2013 at list ($150 – although it can be had all over the web for $86), Office 365 only makes sense if you are the sort of person who feels the need to upgrade their version of Word every 18 months. Or someone who cannot live without Outlook which was inexplicably left out of Office 13. As of the end of June, (and we were surprised), there were 15.2m such persons.

While this is an impressive number of subscribers, we have doubts about how many more such persons are out there. In order to get these customers, Microsoft has already cut their realized price in half over the last twelve months. Because not only is Microsoft competing with itself (Office 2013 at $86 is $1.4/month if you can live with your computer and its version of Word for five years and a free simplified version of Office is available online), but also with the myriad of competing but compatible products now available – also for free. In this competitive environment, it is inevitable that prices for Office 365 continue to fall. At $30/year, Microsoft would have a very competitive product. But at that price, Microsoft would need to have 120m subscribers (more than 7x its current subscriber base) or roughly 40% of the estimated installed base of consumer PCs world-wide to just get back to the $3.6bn in revenues Office Consumer generated last year.

So, the consumer market is a bust. What about the commercial market? The deal Microsoft is offering its commercial customers with Office 365 is considerably more attractive than the deal being offered to consumers – which is just as well because Office Commercial is a much bigger business, generating 29% of gross profits compared to just 4% for Office Consumer. On top of the Office software suite, Office 365 Commercial includes access to Exchange (calendaring and mail server software), Sharepoint (intranet, extranet, content management, enterprise social networking, business intelligence and work-flow management software) and Lync (instant messaging) plus your very own domain.

To match the features provided in an Office 365 commercial subscription, a company would have to buy, install, configure and run an Exchange server, Sharepoint server and Lync server, purchase client access licenses and hire an IT guy to look after it all. Companies are moving to Office 365 just so they can move their email systems out of their own data centers and on to Microsoft’s cloud. The new arrangement gives companies flexibility (so smaller companies can access Sharepoint applications they were previously too small to purchase by themselves) and better security. Microsoft also handles back-up. The economics seem to work for the customer base. Revenues from Office 365 Commercial were up 120% in the year ended June 2015 and accounted for almost a quarter of total Office commercial revenues.

Of course, Office 365 Commercial is cannibalizing sales of licensed software – most obviously Office licenses but also licenses of server products which include Exchange and Sharepoint. But overall sales of Office in the commercial market, Office 365 and regular licenses combined, squeaked out a gain in 2015 of 1.3%. Revenue from Office 365 more than made up for the decline in revenue as a result of fewer licenses sold. And this was so even though the run rate for Office 365 is higher than the reported revenues in 2015 and PC sales were down over the period.

The main reason for this overall sales increase is, of course, that Microsoft raised prices. Unfortunately, comprehensive price comparisons between Office 365 and licensed Office are beyond the scope of this commentary. However, Microsoft’s own CFO has contended that Office 365 represents a 30% increase in price relative to the relevant portion of current IT budgets. This is certainly a price increase but it pales in comparison with the 5-fold increase thought appropriate by the folks over at Office 365 Consumer. Moreover, we do not know what this analysis includes. Maybe it does not include all the costs involved in running a standalone database less efficiently than Microsoft. Maybe clients are happy to pay a 30% premium for less hassle and the ability to tailor their use precisely.

The second reason for the increase is that not all the revenue generated by Office 365 is cannibalized revenue. Some of it comes from new services – rent-a-server and rent-an-IT-professional. Office 365 commercial has widened Microsoft’s addressable market. How large these new markets are and how much extra revenue these new services could bring in are difficult things to estimate. But we venture to say that they are big. And only going to get bigger. And Microsoft can add all sorts of other software and services to its list of offerings with Office 365 in the future.

So by raising prices a bit and bundling in new services, converting the commercial Office customer base (c. 30% of gross profits) from licenses to software as a service is a modest growth business for Microsoft. Hooray.

(To be continued)