9-218-048 OCTOBER 30, 2017 C. FRITZ FOLEY E. SCOTT MAYFIELD F. KATELYNN BOLAND The Transformation of Microsoft In early 2015, Microsoft’s CFO Amy Hood and the rest of the senior leadership team were preparing for the Financial Analyst Meeting that was set to take place at the end of April. After more than a decade of price stagnation, shares of Microsoft had recently appreciated in value, but analysts remained mixed in their outlook. Hood wanted to use the upcoming event to articulate how and why Microsoft would be relevant in the future. The firm had reached a pivotal point in its evolution. Windows 10, due to be released in a few months, would be the first version to continuously update. Historically, new versions gained adoption when users bought new PCs, but the PC market was declining, and there were concerns about whether users would upgrade. Some advocated for giving Windows 10 away to certain customers. Sales of Office were also shifting away from versions sold under a perpetual license toward Office 365, a subscription service. Microsoft's cloud computing platform Azure had grown to include a broad set of offerings, and many users were adopting it to implement workloads and services that could complement, or perhaps replace, their on-premise investments. Across all these offerings, Microsoft was poised to capture opportunities to serve larger total addressable markets (TAMs). However, adapting business practices gave rise to business model risk, and, furthermore, most adaptions that had been initiated were associated with lower margins than the practices that they replaced. There were reasons to be skeptical about Microsoft’s abilities to prevail as it transformed. Although it had been a leading technology firm for decades, it failed to capitalize on several recent trends. In search, Bing struggled to gain market share against Google; in messaging, Microsoft offerings held only a small share; and in mobile, attempts to enter the phone market had floundered. Several recent shifts in strategic positioning also raised questions about how credible Microsoft was in delineating a vision for the future. Over the last three years, the strategic focus had been described as being “Windows first,” then “devices and services,” and then “mobile-first, cloud-first.” Hood and Chris Suh, who ran investor relations, faced immediate questions about what they should tell investors. How much detail should they give about where the firm was headed and how it would get there? Should Hood state specific financial goals for different parts of the business? These questions related to more fundamental decisions. How aggressively should Microsoft try to transform the ways Professor C. Fritz Foley, Senior Lecturer E. Scott Mayfield, and Research Associate F. Katelynn Boland prepared this case. It was reviewed and approved before publication by a company designate. Funding for the development of this case was provided by Harvard Business School and not by the company. Certain numbers are hypothetical. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Professor C. Fritz Foley is a Microsoft shareholder. Copyright © 2017 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. This document is authorized for use only by Christine Viland ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies. 218-048 The Transformation of Microsoft it made money? Given that many of the changes to the business model were associated with lower margin, did it make sense to sacrifice margin for growth? Company Background History Microsoft was founded in 1975 by Bill Gates and Paul Allen with the intention of developing software for the nascent PC industry.1 Steve Ballmer joined the firm in 1980, becoming Microsoft’s 30th employee.2 In that same year, Microsoft developed the MS-DOS operating system and entered into an agreement to receive a royalty for installing it on all IBM PCs.3 Three years later, Word, the first part of the Office suite of productivity applications to be released, was first sold, and Windows was launched shortly thereafter in 1985.4 Within a few years, Word and Excel displaced numerous competitors, and Windows’ usage share on PCs exceeded 90% beginning in 1993.56 Throughout the 1990s and early 2000s, Microsoft developed other lines of business related to servers, web offerings, business operating systems, multimedia products, and gaming. Exhibits 1, 2, and 3 provide recent income statement, balance sheet, and cash flow data for Microsoft, respectively. Microsoft originally distributed many products to customers through computer and software retailers like Egghead. High levels of demand pushed a variety of enterprises to establish relationships with Microsoft under which Microsoft provided products on a contractual basis. Before the spread of the internet, Microsoft product updates were released every few years. As a consequence, products needed to be highly reliable, and developers focused on building solutions which had a high mean time to failure. Microsoft in 2012 Business Segments By the end of 2012, Microsoft was divided into five distinct segments: the Windows and Windows Live Division, Server and Tools, the Online Services Division, the Microsoft Business Division, and the Entertainment and Devices Division.7 At this time, Microsoft Business Division was the largest division, accounting for roughly a third of revenues, and the Windows and Windows Live Division and Server and tools were each responsible for about a quarter of total revenues. The revenues of the Entertainment and Devices Division were about 13% of the total and the remaining roughly 4% of revenues was generated by the Online Services Division. The Windows and Windows Live Division was responsible for developing the PC operating system, Windows 7 at the time, and any related software and online services or hardware products. This segment played a crucial role in defining Microsoft’s market presence because a software platform was needed on every computer in order for application programs to run properly. Windows performed basic jobs, such as input and output recognition, as well as intricate tasks, such as security and program coordination. Approximately 75% of the revenue from this division came from OEM sales, as many PCs came with Windows pre-installed. Windows Live was a set of software products and web-based services like Windows Live Messenger and Windows Mail. Microsoft had a substantial presence in server and network offerings. Server offerings could be run at a customer's site or in the cloud. The Server and Tools Division developed and marketed server software, such as the database management system Microsoft SQL Server, as well as software developer tools, services, and solutions, including the cloud computing service Windows Azure and the product support and consulting service Enterprise Services. 2 This document is authorized for use only by Christine Viland ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies. The Transformation of Microsoft 218-048 Microsoft developed information and content to simplify online tasks, to facilitate online decision making, and to enhance the effectiveness of advertisers. Tasks related to these activities were performed by the Online Services Division, primarily through the web search engine Bing, news and information service MSN, and search advertising network adCenter. Advertisements accounted for nearly all of the Online Services annual revenue. In December 2009, Microsoft and Yahoo! entered into an agreement under which Microsoft provided the exclusive algorithmic and paid search platform for Yahoo! websites worldwide. The agreement gave Microsoft and Yahoo! a combined market share of about 30% of the US search advertising market.8 The Microsoft Business Division’s primary offerings included the Microsoft Office system and Microsoft Dynamics. The Microsoft Office system, which included Office, SharePoint, Exchange, Lync, and Office 365, generated over 90% of the division’s revenue. Microsoft Dynamics provided solutions to businesses through software applications that enabled resource planning and customer relationship management. Approximately 80% of the Microsoft Business Division revenue was generated from sales to businesses, and the remaining revenue was derived from sales to consumers. The Entertainment and Devices Division had the objective of entertaining and connecting people. Its offerings included Xbox gaming, Windows Phone, and Skype, which was acquired in 2011. This segment was invested in establishing platforms that created connectivity between users. Each segment was structured with its own management team, including its own CFO, controller, and marketing team. Each separately maintained its own profit and loss (P&L) statement and reported to its own division head. Exhibit 4 provides revenue and operating income for each segment from 2010