Why Nadella Could Be Poised for Microsoft Success

on February 5, 2014
Photo of Microsoft management (Microsoft)
From left: Chairman John Thompson, CEO Satya Nadella, Bill Gates, Steve Ballmer

When Richard Nixon was elected president, Herblock, the ascerbic Washington Post cartoonist who loved to draw Nixon with a menacing 5 o’clock shadow, promised the new president a clean shave. I’ve been a bit rough on Microsoft lately, but the appointment of Satya Nadella as chief executive officer merits a fresh look. And while the company faces many challenges, especially in consumer markets, Nadella also takes over a company with tremendous strengths, many of them in the areas for which he has been responsible.

The important thing to note about Microsoft is that while the company faces serious long-term problems resulting from the stagnation (at best) of its traditional PC business and its failure to gain notable traction in the growing mobile market, the company is nowhere close to being in crisis. It is not IBM in 1992 or Apple in 1997 or even Nintendo today.[pullquote]In effect, the choice of Nadella to head the company is a decision by the board to reward strength rather than reinforce failure.[/pullquote]

The money machine. In fact, Microsoft remains a money machine. In the six months ended Dec. 31, Microsoft earned an operating profit of $14.3 billion on revenues of $29.7 billion, a gross operating margin of 48% (the profit would, of course, have been significantly lower if the losses of the Nokia handset operations Microsoft is buying were incorporated on a pro forma basis.) Microsoft’s commercial operations, of which Nadella’s cloud and enterprise group is a large part, account for 55% of the sales and 66% of the profits of the corporation. In effect, the choice of Nadella to head the company is a decision by the board to reward strength rather than reinforce failure.

Technology journalism and analysis is so tightly focussed on consumer and mobile markets that it has largely ignored Microsoft’s remarkable success in business software and services. The enterprise, and to a very significant extent, small and medium business, remain Microsoft territory. Tablets, mostly the iPad, are gaining ground but business is still overwhelmingly PC country, it is likely to remain so, and it runs on Windows and Office. Corporate mail and collaboration is largely Exchange and SharePoint, SQL Server has a big chunk of the mid-range database business and Dynamics has been coming on strong in CRM, ERP, and analytics.

Cloud success. Microsoft has had considerable success converting its software business into a subscription model for both business and consumers. And it has made great strides moving into the cloud, from  its Azure Platform as a Service business to OneDrive (formerly SkyDrive, until it lost a trademark battle with Sky Broadcasting.)

As venture capitalist Brad Silverberg, who headed Microsoft’s Windows 95 development, wrote for Cnet:

Satya has reinvigorated Microsoft’s server and tools business. He’s done a remarkable job getting Microsoft to move fast on the cloud and begin staking out a strong position against difficult competitors, such as Amazon. Most of all, he recognized that the world has changed and that to be relevant and become a leader again, Microsoft needs to embrace those changes and offer solutions for customers that fit in that new world. Whereas once open source was regarded as a cancer at Microsoft, Satya has found a way for Microsoft to add value while supporting new standards, like Linux, Hadoop, Ruby on Rails. It’s exciting to see Microsoft play well in this new world and offer differentiated solutions.

Keeping the parts of the company he knows well on track is the easy part for Nadella. Fortunately, the cash that continues to pour out of the Microsoft enterprise engine buys plenty of time to fix the not so good parts. The first challenge is dealing with Windows. Not being a stupid company, Microsoft realizes that it made a fundamental mistake in the design of Windows 8. The notion that cramming both touch-based and keyboard-and-mouse driven user interfaces into a single package and forcing both table and traditional PC users to deal with both to varying extents was a really awful idea. But Microsoft took a step back with Windows 8.1, is about to take another with Windows 8.1 Update 1 and may go the rest of the way with what may or may not be called Windows 9. due to be previewed at the Build developer conference in April.

Winning the  enterprise. To win enterprise support for Windows 9 and keep Windows 7 from becoming the XP for the next decade, Microsoft needs to give customers the good stuff from Windows 8, such as the cloud integration, while freeing it from a touch-first UI that no one wants on traditional laptops and desktops that are still the backbone of business. At the same time it needs to free tablet users from the legacies of the desktop, which require that the Surface be shackled to a keyboard. The answer may be a rebirth of Windows RT, but this time backed by a rich suite of touch-only apps, including a new version of Office.

Fixing Windows Phone is even more difficult. Many of the same people who hate Windows 8 actually like Windows Phone and also like the new Nokia handsets. But outside of a few markets in Europe and Latin America, it just hasn’t gotten much traction in a field dominated by Apple and Android. Microsoft’s existing hardware business, which consists of both Surface tablets and Xbox consoles, along with a profitable range of accessories, eked out a gross margin of $617 million on sales of $6.1 billion last year–Microsoft did not report the operating margin for hardware, the but the businesses were probably in the red after expenses were fully allocated. Nokia is continuing to lose money by the bucketful.

Struggling phones. There’s no easy way out of this mess. Microsoft has picked up all the business it can from the collapse of BlackBerry, leaving it to fight iPhone and Android. Windows Phone gains have come mainly in the low end of the market, where sales are easier to come by than profits, and it could end up fighting for share with the Nokia Asha feature phones it will still own. Fortunately, the losses from the phone business are modest, even with the Nokia red ink added in, and Microsoft can go on absorbing them for some time while it looks for a solution.

Another interesting dynamic for Nadella will be the role played by Microsoft founder Bill Gates, stepped down as nonexecutive chairman to be succeeded by John Thompson, a former IBM executive and one-time CEO of Symantec who headed the search committee. Gates will become a part-time, but potentially highly influential technology adviser to Nardella. There has been much speculation of where Gates thinks Microsoft should move but he, typically, has kept his own counsel. Ballmer also surprised many observers by keeping his seat on the board, though he will have no management role.