Why Software Firms Build Hardware And What Microsoft Is ...

Patents are valuable to any company with a platform and an ecosystem to protect, regardless of
whether they actually produce the software or hardware on which their patents are based. A firm’s
patent portfolio, as well as those of its competitors, are simply additional factors that must be taken
into account in a complex decision-making process of whether, and how, to build hardware.

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Chapter 6: Hardware Strategies at Microsoft

The co-evolution of hardware and software is going to define what’s going to
happen. We have a particular definition of mobile which is perhaps skewed to

the mobile phone. But you take the industrial Internet or the Internet of
everything, everything’s going to be connected to the cloud, and data. So that’s

the world that we are building for.

– Satya Nadella, Microsoft CEO (Hachman 2014)

6.1 Introduction

Beginning in 2014, the “devices and services” strategy espoused by former Microsoft CEO Steve
Ballmer took a back seat to the “mobile-first, cloud-first world” described by Satya Nadella, who
took over the CEO post in February 2014. As a result, building first-party devices took on much
less strategic importance to the company, with the emphasis shifting to cloud services and mobile
applications to enable access to Microsoft’s productivity software and services from any platform
or device. However, Microsoft remained very much committed to building a certain set of
hardware to complement its own ecosystem, including the Surface line of tablets and the mobile
phone business it acquired from Nokia.

Even Microsoft recognizes that its general-purpose software platforms are struggling in the face
of the trend toward more integrated devices, specifically phones and tablets. The following quote
is a message from Microsoft to its investors in its Form 10-Q from January 2014:

Users are increasingly turning to these devices [smartphones and tablet
computers] to perform functions that in the past would have been performed by
personal computers. Even if many users view these devices as complementary

to a personal computer, the prevalence of these devices may make it more
difficult to attract applications developers to our platforms.

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In this chapter, we will discuss Microsoft’s historic approaches to first-party hardware, including
products like Xbox, Zune, Kin, and Surface. We will discuss the successes and failures associated
with these product lines, including major problems like the large write-down from unsold
inventory of the first-generation Surface. We also consider how these approaches compare to
Microsoft’s acquisition and subsequent integration of Nokia’s mobile device unit. Finally, we will
summarize the approaches Microsoft is currently taking in the market and make recommendations
for future strategies based on the framework we have set forth in previous chapters.

6.2 Xbox

Microsoft announced its new Xbox gaming console on March 10, 2000 and officially launched it
on January 6, 2001. Don Coyner, director of marketing for Microsoft Games, described the device
in this way: “The PC and Xbox are complementary devices. Each has very distinct audiences. PC
games are more cerebral, while console games are more visceral” (Microsoft 2000).

The Xbox is one of the primary success stories of Microsoft’s hardware ventures, but it was not
an immediate success from a business perspective. Microsoft has invested in the Xbox for well
over a decade, but only since 2008 has it been a profitable business. It is important to note that
Microsoft has never viewed the Xbox as an end to itself, but rather as a way to expand its Windows
platform, and more recently, its cloud services like Skype and Bing.

Microsoft has long viewed the living room as an important place to have a presence, even going
back to their purchase of WebTV in 1997. These living room devices have traditionally been
specialized, proprietary devices focused on entertainment and a limited set of productivity
scenarios. Norman Young of Morningstar writes of Microsoft’s strategy with Xbox:

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The Xbox console [is] another device to help tie consumers into Microsoft’s
cloud services. As the link to consumers and their living rooms, the Xbox can
help the firm reinforce network effects and increase switching costs through

services such as Xbox Live, Xbox Music, Skype, and Bing. (Young 2014)

So we can see that the Xbox has encompassed, at least to some degree, all of the strategies that we
described in preceding chapters. Microsoft initially conceived of Xbox as a complementary device
to the PC, which implies that they were at least partially viewing it from the “Hardware First” lens
described in Chapter 2 – that is, they wanted their Xbox division to be focused on hardware without
the encumbrances of the divisions of the company that were focused on software and hardware for
the PC. It is also clearly an example of the “Proprietary Devices” strategy. We have already
discussed Xbox through this lens in Section 3.6, and the strategy is also discussed above in relation
to Microsoft’s WebTV acquisition. Finally, Xbox is also a prime example of the “Service Funnels”
strategy, as we discussed in detail in Section 4.4.

6.3 Zune and PlaysForSure

In 2004, as iTunes and iPod began to capture a large part of the market for portable music players,
Microsoft teamed up with OEMs to create a system called PlaysForSure. At the time, Apple’s
music offerings were protected by a proprietary digital rights management (DRM) system, which
prevented users from copying iTunes music to any device other than iPod players, effectively
locking them in. PlaysForSure was an open DRM standard that was intended to allow users to
obtain music from any supported online music reseller and copy the files to any device that
supported the PlaysForSure standard.

By pursuing this strategy, Microsoft was attempting to use an open standard, general-purpose
software, and partly-specialized hardware devices from OEMs to provide a solution in the portable

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music player market. But the problem space and the associated technology, including both portable
device hardware and DRM standards, were far too immature to allow this open system to provide
an end-to-end experience that was competitive with the iPod/iTunes integration offered by Apple.
Compounding the problem for Microsoft, iPod/iTunes had its own proprietary DRM and did not
support PlaysForSure music. To top it all off, the iTunes music store had a stranglehold on the
digital music market in 2007, with a market share around 70 percent (Ahrens and Musgrove 2007)
– and music purchased from iTunes was not usable on a PlaysForSure device primarily because of
the different DRM scheme. As a result, the PlaysForSure standard failed to gain a significant
foothold in the market and was officially discontinued by Microsoft in 20078.

This scenario had the characteristics that would have caused the “Proprietary Devices” strategy to
be a more successful approach, but Microsoft recognized this too late. In 2006, Microsoft released
their Zune portable music player and associated music download service called Zune Marketplace,
directly competing with iPod and iTunes. Again, this was a clear instance of the “Proprietary
Devices” model – Microsoft controlled the entire experience, from the music search and download
process all the way to the music listening experience. But because Apple’s proprietary DRM
prevented iTunes music from playing on any non-Apple devices – and similarly, because Zune’s
DRM system prevented its music from playing on the iPod – Zune utterly failed to overcome the
network effects associated with Apple’s existing market dominance. Somewhat unbelievably,
Zune’s DRM scheme was even incompatible with Microsoft’s own PlaysForSure standard, which
further reduced its attractiveness to consumers with existing music libraries.

8 In fact, DRM for music generally began to disappear around this time as the voice of the market became clearer.
Amazon launched its DRM-free MP3 store in 2007, and more and more music retailers began to abandon DRM.
Apple’s iTunes also began offering some DRM-free songs in 2007, and dropped DRM entirely in 2009.

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So despite a few novel features in the Zune hardware, there was no real differentiation from the
Apple solution, and because the iPod had already become dominant, the Zune failed to gain any
appreciable market share. After only about five years on the market, both the Zune hardware line
and the Zune services were retired. If Microsoft had truly wanted to create differentiation here, it
may have needed to get ahead of the curve and produce a DRM-free solution before Apple could
react – but given the music industry’s attitude toward piracy at the time, this could very well have
been an impossible task.

6.4 Kin

In 2008, Microsoft acquired Danger, a phone manufacturer which had previously produced the
popular Sidekick phone for T-Mobile, and began an in-house project to develop a device that
would be based on the next iteration of the Windows Mobile operating system.

This project, which ultimately became Kin, started in 2008 with the goal of creating “a platform
agnostic, cloud-centric feature phone” (Topolsky 2010), and along with Kin came a suite of
services primarily targeted at social networking scenarios. This vision sounds surprisingly similar
to Microsoft’s “mobile-first, cloud-first” mantra of 2014. But after an internal battle between
Microsoft executives, Kin was pulled into the Windows division and suffered massive delays as
the platform was rewritten (Ziegler 2010). In addition, once the phone was finally released,
Verizon priced the phone and its required data plan much higher than Microsoft had anticipated.
A phone that was essentially two years late and overpriced had no chance to succeed in the market,
and Microsoft discontinued the phone in June 2010, less than two months after it had launched.

Kin can be viewed as a failed attempt at a “Service Funnels” model. In addition to the more obvious
reasons for its failure described above, it lacked the key elements that allow such a model to

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succeed: namely, low device price, competitive functionality in hardware and software, and
services that are desired by the user and that can be offered in a better or more convenient way
than in existing commodity devices. Certainly, had the phone been released on schedule and with
a more aggressive pricing scheme, it would have been much more competitive with other offerings
on the market at the time and been more successful in driving users to the Kin cloud services.

6.5 Surface

The Surface line of tablets was launched in 2012 as a direct response to the overwhelming success
of Apple’s iPad. Unquestionably, this was an example of the “Hardware First” strategy –
Microsoft, like Apple, was attempting to build a general-purpose computing device where it
controlled the entire hardware and software experience.

In statements from its Form 10-Q in January 2014, Microsoft describes its own motivation for
creating the Surface line of tablets:

A competing vertically-integrated model, in which a single firm controls the
software and hardware elements of a product and related services, has been
successful with some consumer products such as personal computers, tablets,

mobile phones, gaming consoles, and digital music players. Competitors
pursuing this model also earn revenue from services that are integrated with

the hardware and software platform.

In the same Form 10-Q, Microsoft also points out the obvious downsides to building its own
hardware devices: “Efforts to compete with the vertically integrated model will increase our cost
of revenue and reduce our operating margins. … In addition, Surface competes with products made
by our OEM partners, which may affect their commitment to our platform.”

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Despite a massive marketing campaign, the Surface was met with tepid reaction by consumers.
Microsoft took a $900 million charge to write down the value of unsold Surface inventory in July
2013. This caused many observers, including some Microsoft board members, to question whether
it was wise for Microsoft to expand into hardware even more aggressively with its purchase of
Nokia’s handset business (Cave 2014). If nothing else, it was quite apparent that Microsoft had
not yet developed the core capabilities of a hardware company like Apple.

6.6 Nokia

After several years of close partnership, Microsoft completed its acquisition of Nokia’s devices
business in early 2014, as discussed in more detail in Section 2.3. Unlike the arm’s-length strategy
Google used with its Motorola acquisition and later divestiture, Microsoft has shown that it intends
to fully integrate Nokia into its corporation in order to take full advantage of its position to gain
efficiencies and synergies that were not possible while the two companies were separate. In doing
so, Microsoft has again shown a desire to imitate Apple’s model of owning the end-to-end
hardware and software experience of its devices – perhaps an example of the “Hardware First”
approach, at least within the confines of the Microsoft Devices division.

At the time of this writing, not enough data exists to make a judgment call on the success or failure
of the Nokia acquisition. Based on past precedent, we can expect the Nokia strategy to mostly
align with the Surface strategy, and likely with similar results – especially since Microsoft has
decided to tie the fortunes of its device families together by unifying its operating system and
developer ecosystems with its Windows 10 release due in late 2015.

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6.7 Summary

Microsoft has a long history of building hardware devices with decidedly mixed results. Indeed,
this section has only covered Microsoft’s more well-known hardware ventures, not even touching
on less-publicized projects like the acquisition of Perceptive Pixel as an entry into the niche market
of extremely large-screen touch-enabled displays. The one clear success story is Xbox, a case
where Microsoft has used the “Service Funnels” strategy to drive significant revenue through sales
of games and subscriptions. But in nearly every other case, Microsoft has been late to market and
has followed a combination of the “Hardware First” and “Proprietary Devices” strategies where
they have not proven themselves particularly adept. Indeed, our set of examples throughout this
paper have shown that software companies tend to be more successful when their devices promote
their own software and services, rather than trying to be an end in themselves.

Microsoft may certainly be successful with its current hardware device lineup, but as a software
company at the core, it must carefully consider how to use its devices to promote its ecosystem of
software and services in a way that is not achievable on its competitors’ devices. The spectacular
failures of devices like Zune and the first-generation Surface are examples that warn against a
software company like Microsoft building devices for their own sake out of perceived competitive
pressure, rather than crafting a device that is advantageous to the company’s core business.

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Chapter 7: Conclusions

We have seen that the trend toward smaller, more highly-integrated devices, along with the fast
pace of innovation in the technology industry, has caused software companies to build hardware
products to showcase their own software. We have also seen that building hardware products does
not always lead to success, and in fact this strategy creates a financial risk for the company by
significantly reducing profit margins as compared to the traditional profit margins to which large
software companies are accustomed.

Because of these risks, a firm must carefully consider whether building hardware will be
advantageous to its business objectives and ultimate financial success. We have observed three
specific strategies that firms have used successfully in this area. We initially looked at the
“Hardware First” strategy, wherein a company builds devices with the primary goal of selling
those devices – bundled, of course, with the company’s software. Apple is the classic example of
this strategy, and firms that have attempted to copy their model, such as Google with its Motorola
acquisition or Microsoft with its Nokia acquisition, have not yet been met with great success.
Second, we considered the “Proprietary Devices” strategy, in which a company builds a device
that is targeted at a particular market or function and locks in the customer to the firm’s ecosystem.
This strategy has been observed to succeed in markets where the technology is not yet mature,
such as with Apple’s iPod or iPhone, as well as in cases where the device has a very particular
purpose that cannot be achieved as effectively with a general-purpose device, such as with IBM’s
mainframe computers or Amazon’s Kindle series of devices. Third, we considered the “Service
Funnels” strategy, wherein a firm builds hardware devices that are primarily intended to drive
usage and revenue of its core software and services products. Successful examples of this strategy
include the Kindle, as well as gaming consoles like Microsoft’s Xbox or Sony’s PlayStation.

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Finally, we summarized the various hardware strategies that have been used by Microsoft over the
years, including products such as Xbox, Zune, Kin, and Surface. We have shown that each of the
preceding three strategies have been used by Microsoft at various points in its history, and we have
used the analysis of these strategies to help explain why some products have succeeded and why
other products have failed dramatically in the marketplace.

In 2015 and beyond, the biggest unanswered question for Microsoft’s hardware strategy is what it
will do with the recently-acquired Nokia devices business. Microsoft has already begun the process
of fully integrating Nokia and bring it under its corporate umbrella, including combining it with
its existing hardware division and eliminating the associated redundancies by laying off nearly half
of the acquired workforce. Smartphones and tablets will be branded with Microsoft’s name, not
Nokia’s, which further indicates the extent to which Microsoft aspires to fully integrate Nokia’s
hardware business into its own. But as Google did with Motorola, there remains a high likelihood
that Microsoft will integrate the most desirable pieces of Nokia’s business – namely, the Windows
Phone ecosystem that it has produced – and simply sell off or even abandon the rest.

For Microsoft, the key takeaway is that it must continue to build only those devices that are
advantageous to the core revenue creators of the company – namely, its software and services
products such as Windows and Office. Microsoft’s core capability is in software, and it must learn
from both its own history and the history of other companies in the industry when making decisions
about how to market its hardware products. Developing a mutually-beneficial relationship between
its hardware and software products will be key to the long-term success of Microsoft in today’s
technology landscape.

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