Microsoft’s New Strategy Could Undermine the Most Profitable Part of Its Business

Microsoft 's (MSFT) recent reorganization aims to orient the company around devices and services. In the past, Microsoft was simply a software company. It sold the Windows operating system, but it played little role in the production of Windows hardware.

Times have changed. Now, Microsoft wants to have a hand in the entire process, producing its own devices that run its own software and services. Given such a big shift in strategy, some in the industry have questioned Microsoft's move.

Unfortunately, Microsoft is risking far more than Windows. Microsoft's most profitable division -- its business division led by Office -- could be on the line.

Microsoft's Mexican standoff
In film, the term "Mexican standoff" denotes a particular type of scene. Three gunfighters stand with pistols raised, ready to shoot at their adversaries -- but because each gunfighter is staring down the barrel of one of his opponent's guns, he dare not pull the trigger.

Microsoft's situation with Office and Windows is a bit like that.

On the one hand, Microsoft could chose to port Office to tablets running Google 's (GOOG) Android and Apple 's (AAPL) iOS. Analysts agree that if it were to do this, it would take in billions of dollars of new revenue, as Office-starved mobile users pony up the cash for Microsoft's popular software.

But if Microsoft went down this route, it would be, in many ways, dooming Windows long term. Office is perhaps the single biggest reason for a user to consider buying a Windows 8 tablet. Bringing Office to iOS and Android would destroy that incentive entirely.

Yet, at the same time, the more Windows' market share continues to erode, the more Office risks becoming irrelevant. Office, like Windows itself, benefits from network effects. The more businesses use Office, the more useful Office becomes. Office file formats have become commonplace throughout corporate America, while proficiency with Excel and PowerPoint are common job requirements.

Obviously, there are immense switching costs to ditching Office, and thus, it isn't likely to happen overnight. Still, the longer Microsoft keeps Office to itself, the more likely it is that its competitors could take its place.

Apple's iWork, Google's Docs and Box's Notes
Primarily, that competition comes from Microsoft's two chief rivals and an innovative new start-up.

Apple's Office competitor, iWork, has been around since 2005. Yet, it's never come close to taking off, probably because Apple has kept it restricted to its own operating systems, OS X and iOS. However, a radical new pricing decision could soon make iWork much more popular.

Starting this month, when iOS device owners upgrade to iOS 7 (the latest version of Apple's mobile operating system), they'll get a free copy of iWork. Admittedly, that sounds a lot more impressive than what it is. Previously, Apple was charging only $10 for the app. However, by making it free, it's likely that most iPad owners will at least try it out. As with Office, iWork could come to benefit from network effects. A growing number of businesses have begun to adopt the iPad; by getting them on iWork, Apple could start to chip away at Office's empire.

Google's Apps have been free to Gmail users since inception, but businesses that want to use them still have to pay a nominal fee. Despite this, Google's management believes that, over time, it can rob Microsoft of many of its Office users -- as much as 90%.

That's the figure Google's enterprise head Amit Singh gave AllThingsD last December . Singh admits that Google Apps continue to lag Office in features (and will likely never fully catch up), but for most users, Google's slightly stripped-down, but much cheaper, version will suffice.

But that's just Apple and Google. Given the ongoing shakeup in the industry, it's not surprising that new start-ups would emerge to try to fill the gap.

Box, a cloud-based storage provider, recently announced Box Notes, an online alternative to Microsoft Word. Like Google, Box admits that its application is not nearly as powerful as Microsoft's, but for the majority of users, all those extra features just aren't necessary.

The importance of Office
Windows, Xbox, and Azure may grab the headlines, but investors shouldn't lose sight of Office. Last quarter, Microsoft's business division was by far its most profitable, accounting for about 80% of its operating income and about one-third of quarterly revenue. Given that Office brings in more than 90% of the division's revenue, the software suite is immensely important to Microsoft.

For now, Office continues to be instrumental to business users. In the longer term, the situation could be a bit more complex. If Microsoft continues to keep Office away from Android and iOS tablets, then newer, cheaper alternatives like Google Apps, iWork and Box Notes could slowly chip away at the Office empire.

Who Will Win The Standoff?
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