Windows and the Race to the Bottom

Microsoft has confirmed the broad strokes of a report that it is dropping the licensing cost for Windows. But it's only doing so for PCs and devices that retail for less than $250. To be clear, there is currently no market for such devices. So Microsoft isn't so much lowering the licensing cost of Windows as it is making it feasible for hardware makers to use Windows with a new category of super-cheap PCs and devices.

There's an ugly side effect to this licensing change that hasn't been highlighted enough. Those PCs and devices that do qualify for the cheaper licensing—$15 per unit compared with about $50 per unit on more expensive PCs—will be cheap in literally every way. Hardware makers won't need to undergo a Windows logo certification process. This means that these cheap devices will often be very unreliable out of the box and can't be made more reliable through automatic driver updates on Windows Update.

I'll get to the why's of this new strategy in a moment, but what rankles me here is that Microsoft isn't affording a similar licensing cost savings for other types of PCs and devices. With Windows losing market share to competing devices, perhaps it's time for a broader re-think on licensing. At the very least, a sliding scale is in order, with licensing costs rising with the cost of the device and then hitting a ceiling. That $50-per-unit cost should be at the very upper end of the spectrum.

The problem for Microsoft is that lowering costs is the only strategy that makes sense, given how the market is changing. This decision was forced by competitors of the company: Unable to compete with Apple at the high end, Microsoft will now take on Android and Chrome OS for the masses instead.

I've written a lot over the past several months about the market trends that are forcing Microsoft and its hardware partners to push prices as low as they can go. For example, you can read "Windows Phone Price Point: How Low Can It Go?" or "Assessing the Chromebook Threat," in which I discuss how the sudden influx of these low-cost devices is simply the netbook all over again, too-cheap products that have forced Microsoft's hand.

And forced it they have. By dumping its Android and Chrome OS products into the market (and the waiting arms of the ever-thrifty hardware makers) at low, low, low prices, Google has in effect eroded Microsoft's most reliable form of revenues over time: Windows licensing. And so Microsoft has responded in the only way it can. It's lowering the cost of Windows to hardware makers.

You can see this in the recent credible report that PC makers that wish to sell devices for $250 or less can now get Windows dirt cheap. And you can see it in Microsoft's recent Windows Phone hardware partner bonanza: Nine new partners have come on board suddenly—nine!—after each had successfully ignored this product line for years. Why now, you ask? (Or you should be asking.) Because now, finally, Microsoft has clearly lowered the cost of acquiring the Windows Phone OS to a level that meets or undercuts that of Android. It's not like the OS is suddenly more attractive otherwise. Something has changed. And it's not the product.

(Yes, there are Android licensing costs and, as it turns out, restrictions, for those that wish to include Google's apps and services on those devices, and thus provide a "real" Android experience.)

But this is a general conversation that, frankly, should dominate the thoughts of anyone who cares about Windows broadly—that is, Windows for PCs, Windows (Modern) for tablets, and of course Windows Phone for smartphones. And here's how this works.

On the high end, all we see is Apple. This is the firm that makes the most expensive products in every conceivable category. A company that makes laptops that start at $1,000 and go up from there, even though the average selling price of a PC laptop is in the $400-$500 range. A company that makes high-res mini-tablets that start at $400 and go up from there, even though its competition is selling comparable devices that start at $230. A company that makes high-res full-sized tablets that start at $500 and go (dramatically) up from there, to as much as $930 for a fully equipped version, where its competition is playing in the $380 to $450 range, to start.

Apple is unique, for sure. Its margins dwarf any other player in technology. Apple's customers are willing to pay more, and buy more frequently. They perceive a quality there, and it's not entirely unwarranted. They see Apple as the BMW of the technology world, also not entirely unwarranted. Whatever the reason, Apple exists in a bubble and it's a market no other player can touch. There is no Mercedes or Audi to Apple's BMW. There's just Apple.

Microsoft has always wanted to be that Mercedes. Always. Apple envy is arguably the single biggest driving force behind the firm's consumer offerings over the past decade. Maybe the only driving force.

And boy has Microsoft tried. Long before the iPad was a glimmer in Steve Jobs' eye, Microsoft spent years asking, cajoling, even begging PC makers to ship quality products. But PC makers fell for that all-too-easy trap of volume over quality. And as PC sales rose and rose, they responded by lowering prices again and again. Remember the netbook? That little piece of garbage did more to harm the PC market than anything Microsoft's competitors could have dreamt up. It was death from within, embraced wholeheartedly by Microsoft's guileless partners.

Then, as now, Microsoft responded when forced: It provided PC makers with a cheaper Windows version but restricted it to the low-end netbook hardware. They're doing it again right now.

So to save money generally on more expensive mainstream PCs—or, more aptly, to eke out a small profit on each device sold—PC makers bundled crapware. You know the drill on this one: This strategy helped PCs stay sort-of profitable for hardware makers while it killed their relationships with their own customers. Microsoft bristled. Microsoft begged. But it didn't lower prices, except at the low end.

Instead, Microsoft came up with its Signature program, which was designed to show PC makers that a clean version of Windows would provide customers with a better experience and perhaps bump higher-end PC sales. Microsoft made Signature versions of virtually every popular PC sold, showed them to PC makers and tried to get them to sign on, to sell Signature versions of their products side-by-side with the crapware-laden versions. Let customers choose.

Not a single one of them did it. Not one.

And then the iPad happened. And then the PC market started slowing, then declining. And then PC makers scrambled for a fix. Did they adopt Signature? No, and Microsoft, tired of their inaction, moved on and started selling its own Signature-based PCs, called Surface. Through a mixture of hubris and revenge, the PC makers—and literally, this is all of the major PC makers—have since adopted Chrome OS. Netbook, round two. They'll never learn.

To be fair, it's not just the PC makers. Microsoft didn't drop Windows licensing costs for these companies either, because it was unable or unwilling to walk away from that steady revenue stream. Indeed, when you look at what they're finally doing now, the recent licensing savings only applies to low-end devices. They're responding to a threat, not proactively sensing that the market is changing and doing the right thing. They are only lowering prices for cheap PCs. As a result, there will be more of these cheap PCs. Prices will plummet along with the quality.

Windows Phone suffers from the same issue. Unable to create a single hit product at the high end despite some awesome phones—the Nokia Lumia 1020 and 1520 are still the best smartphones I've ever used—Windows Phone has only seen success in one place: The cheapest, third-worldiest part of the market. The Lumia 520 and its siblings dominate the sales and usage charts. Just not in America, where the Apple-crazed population, somewhat uniquely in the world, still thinks iPhones are something special.

Am I worried about this trend? Obviously.

Do I think there's a future here? Yes and no.

Certainly, there's a part of my personality that prefers any product that shoots for the masses and not the elite. That's part of my knee-jerk reaction to everything Apple does: They're so smug and condescending to normal people and their silly, average income levels. In addition, I'm a big fan of what I think of as "just enough" computing, and I think it's easy to overdo it with technology purchases. Somewhat alone among Americans, I'm always trying to downsize.

And while I'm not an economist, I certainly understand that a high-volume/low-margin (PC) market is no less likely to succeed than a low-volume/high-margin (Mac) business. Each has its advantages.

But I'm worried that this race for the bottom is exactly what it sounds like, a zero sum game in which Microsoft and its partners are shooting for big numbers (unit sales) but ultimately end up with little or nothing in the way of actual profits because the only big growth will be in a part of the market where profit is difficult. When PC prices steadily plummet, as they did with the netbook, there's no rebound. You can't convince customers to suddenly start spending more on these things.

So the notion of sub-$250 Windows PCs and devices, and inexpensive Windows Phone handsets aimed at developing markets, is certainly understandable. Is it profitable? I hope so. Will it continue eroding prices at the mid and high ends? I'm sure of it.

Google is in this game with Android and Chrome OS because they profit when people use their products, not when they buy them: These things are laden with Google advertising. Microsoft doesn't make money that way, it makes money by selling software. As a technology enthusiast, I prefer Microsoft's approach, and I tend to like their products better than Google's, too. But when you look at markets in which the products sell for next to nothing and keep going down, you have to worry for the future on the Microsoft side. You just have to.