Assessing Microsoft's Windows 10 Revolution, One Year In

Microsoft rewrote its whole playbook for taking a new client OS to market with the Windows 10 release. A year later, the company's financials and analyst reports reveal how well it's working out -- for Microsoft and the ecosystem.

For two decades, the massive Windows desktop OS launch was a rite of passage for the tech industry. Each shipment was the result of years of behind-the-scenes cooperation between Microsoft and its OEM and ISV partners. Release to manufacturing was occasionally marked by dramatic scenes like the liftoff of a helicopter from the Microsoft campus with gold code for OEMs. A few months later came launch day with midnight lines outside retail stores and launch parties with big-name bands in several countries at once. Justifying the spectacle were all the interlocking business dependencies, with OEMs and ISVs frequently enjoying huge sales bumps around a Windows release, first with consumers, later -- after a service pack -- with business buyers.

A convergence of forces has been eroding that model for a while now -- the emergence of cloud, the decline of the PC in favor of smartphones and tablets, faster development cycles, a lessening of mutual interest between OEMs and Microsoft -- to the point that the Windows 8 launch held little resemblance to the heyday launches of Windows 95/98/2000/XP.

Against that backdrop, Microsoft decided a little over a year ago to tear up the Windows client release playbook. The manner in which Microsoft launched Windows 10 in mid-2015 was nothing short of a revolution in Windows affairs. Microsoft's new approach to Windows is a long-view strategy that will take many years to succeed or fail. But after a full year on the market, the numbers are in for how well the revolution is working out with Windows 10 -- both for Microsoft and for its OEM ecosystem.

Pillars of the Revolution
Microsoft has earned a reputation for charging money for everything it can, especially the Windows OS that has been the crown jewel of the organization for decades. Critics even argued that Microsoft hampered its own potential success with Windows Phone by charging handset makers too much for the phone OS rather than trading lower prices to gain a relevant level of market share.

Which is why jaws dropped on Jan. 21, 2015, when Executive Vice President of the Windows and Devices Group Terry Myerson first revealed at a Windows 10 briefing that many Windows 10 upgrades would be free for a year after its release.

"So I'm very excited to announce that for the first year after Windows 10 is available we will be making available a free upgrade to Windows 10," Myerson said. That day he explained that the upgrade would apply to Windows 8.1, Windows 7 and Windows Phone 8.1 users. In the ensuing months Microsoft released more details about limitations, such as that the free upgrade offer didn't apply to Windows Enterprise and Windows RT.

For a company that packaged boxed upgrades for resale for years, it marked a huge shift -- allowing customers to make the move at no cost at the point when interest in the OS is at its highest. It also potentially diminishes the incentive to buy a new PC with beefier specs to take advantage of a new OS. Why not try the OS on the old machine and see if it's good enough?

Myerson revealed another critical element in the same speech -- that Microsoft would essentially be adopting the smartphone model for OS releases. Just as an iPhone user gets the version of iOS that's shipping the day she buys the phone and then can keep updating to the latest version of iOS for free until the software outstrips the hardware's capabilities, a Windows user on Windows 10 could keep on upgrading until their underlying device is out of support.

"Once a device is upgraded to Windows 10 we will be keeping it current for the supported lifetime of the device, keeping it secure, introducing new features and functionality to our customers over time. In fact, with Windows 10 we think of Windows as a service. In the next couple of years one could reasonably think of Windows as one of the largest Internet services on the planet. And just like other Internet services, the question, ‘What version are you running?' will cease to make sense," Myerson said.

By themselves, those two shifts are enough to upend the Microsoft ecosystem. Microsoft wasn't done.

For one thing, Microsoft CEO Satya Nadella has pushed hard across all areas of the company to drive faster release cycles. In some areas, such as cloud, the releases are developed and released constantly. An OS still requires some local control for IT departments, deployment partners and other IT professionals to maintain some sanity. So Microsoft is on a schedule with Windows of major feature upgrade releases a few times a year. In the same vein, Microsoft created different service branches that allow IT professionals to schedule how frequently their users' PCs get the upgrades.

The other shift, which Microsoft communicated well before the pricing changes, was the Unified Windows Platform (UWP) to allow developers to target an OS that spans from a mobile device through a tablet to a PC to a TV to a HoloLens device.

What Microsoft Wants
The goals behind the changes in the Windows licensing model are scale, scale and scale.

Myerson again made headlines in April 2015 at Microsoft's Build conference, saying that Microsoft was gunning to put Windows 10 on 1 billion devices by 2018.

Combining those potential user numbers with the ability to write applications once for all those devices that can all be up-to-date, Myerson said, "Universal Windows apps are going to enable you to do things you never thought were possible. With Windows 10, we are targeting the largest device span ever. We're talking about one platform -- a single binary that can run across all these devices."

Nadella has also talked about how the scale of Windows can drive huge revenues for Microsoft's cloud products -- Office 365 subscriptions, Microsoft Azure usage, Edge browser and Cortana desktop searches creating ad revenue, and so on.

You used to hear about internal grumbling at Microsoft about a Windows-related "strategy tax," where products were killed, changed or de-emphasized because they got in the way of Windows revenues. It seems like Nadella is trading the strategy tax beneficiary from Windows to "cloud-first, mobile-first."

Getting Something for Nothing?
The free upgrade offer for Windows 10 ran from its consumer release date, July 29, 2015, through July 29, 2016. Microsoft's financials, released on July 19, 2016, provide some clues to what Microsoft got for its efforts.

Microsoft's fiscal year doesn't map exactly to the year of free upgrades, but running from July 1, 2015, to June 30, 2016, it's very close.

The financials for Windows were far from great, but they weren't cratering, either, in a 12-month span that was historically terrible for PCs (more later on how much the Windows 10 upgrade offer was to blame for the industry's troubles).

To set the stage, the quarter before Windows made its debut was extremely weak -- which should've given Windows 10 a hot start. In the final quarter (April-June) of Microsoft's Fiscal Year 2015, Windows OEM revenue declined 21 percent. Contributors to those conditions were the comparison to the sales boost Microsoft had gotten the previous year due to the support deadline for Windows XP and the way OEMs were tightly managing PC inventory ahead of the Windows 10 launch.

Over the four quarters of Fiscal Year 2016, here's how Microsoft's Windows OEM revenues compared to the year-earlier quarter:

  • Q1 (July-September, 2015) -- down 6 percent.
  • Q2 (October-December, 2015) -- down 5 percent.
  • Q3 (January-March, 2016) -- down 2 percent.
  • Q4 (April-June, 2016) -- up 11 percent.

In sharing the Windows OEM revenues, Microsoft noted each quarter that the revenues outperformed the PC market overall.

As the end of the free upgrade promotion approached, Microsoft also backed off the 1 billion Windows 10 users goal, largely due to the cratering of its phone business. Microsoft's decision to write off most of the Nokia acquisition and change its mobile strategy, announced a few months after floating the 1 billion-user prediction, affected its projected Windows 10 user numbers dramatically. Windows Phone market share has dropped below 1 percent and phone revenues were down from 46 percent to 71 percent in each quarter during Fiscal Year 2016.

Even with the Windows Phone caveat, the user numbers for Windows 10 are substantial.

"We have increased Windows 10 monthly active devices and are now at more than 350 million. This is the fastest adoption rate of any prior Windows release," Nadella said during an earnings call to discuss Q4 and full year results on July 19.

Effect on the Ecosystem
A Windows release is always judged in the industry by its ability to drag along PC sales on its coattails. That axiom has been less true over the last few releases, and the free offer had industry insiders and observers concerned as the Windows 10 launch approached.

"We're expecting the Windows 10 launch to go relatively well, though many users will opt for a free OS upgrade rather than buying a new PC," IDC analyst Loren Loverde predicted last July.

Windows 10 didn't do much for the market in calendar Q3 of 2015 (Microsoft's Q1 2016) -- Gartner Inc. reported a 7.7 percent decline in units and IDC put the decline at 10.8 percent. Both firms called the Windows 10 impact minimal in the quarter due to the immediate focus on free upgrades with IDC noticing the "immediate suppressive impact" of the OS on PC sales in the United States.

Additionally, IDC's research release pointed out that, "The unusually short time between Windows RTM (release to manufacturing) and the official retail release hampered the ability of OEMs to launch certified new models, resulting in a limited selection of Windows 10 PCs (as well as related advertising) through much of the third quarter."

Things got worse in the holiday quarter from October through December, historically one of the PC market's best periods. PC sales dropped 8.3 percent by Gartner's count and 10.6 percent by IDC's. "The free upgrade path to Windows 10 allowed some consumers who might otherwise have shopped for new PCs during the holiday season to obtain a 'new' PC experience," IDC analyst Lynn Huang said in a statement in the research release.

Total PC shipments for 2015 failed to reach 300 million for the first time since 2008, although Windows 10 was only around for five months of the pain and the first seven months were dismal, too.

Normally, OEM senior management forms a unified front with Microsoft, flare-ups over the Microsoft Surface in the Windows 8 release cycle notwithstanding. But in the tough PC environment this year, a few cracks appeared.

Speaking to analysts during the HP Inc. Q1 2016 earnings call on Feb. 24, HP President and CEO Dion J. Weisler expressed frustration both with the failure of the OS to stimulate demand and, apparently, at being hurt by the free upgrade.

"I would say that Windows 10, whilst I still believe it's a tremendous OS platform and universal apps and continuing computing make devices like the Elite x3 a reality, we have not yet seen the anticipated Windows 10 stimulation of demand that we would have hoped for, and we're carefully monitoring any sort of price developments that could further weaken demand," said Weisler, while explaining drops in revenue for HP's quarter of 11 percent for notebooks, 14 percent for desktops and 16 percent for workstations.

The first full calendar quarter of 2016 continued the weak performance across the industry, with Gartner finding a 9.6 percent sales decline and IDC reporting an 11.5 percent drop. The second quarter from April through June brought some green shoots, especially in the United States. Worldwide sales dropped 4.5 percent, according to IDC, and 5.2 percent, according to Gartner. IDC saw U.S. shipments going up by 4.9 percent in the quarter, Gartner flagged a smaller, but still positive, 1.4 percent increase.

To be clear, not even close to all of the PC market's woes can be laid at the feet of Windows 10. The industry struggled against currency challenges, in which a strong dollar made U.S.-based companies' products much less affordable than they had been. And the apparent longer-term trends that are hurting PC sales are the same ones that spurred Microsoft to shake up its approach in the first place. Those include the longer lifecycles of PCs, the decline of the PC as a holiday must-have and even fundamental questions about the need for a PC in every household, especially in emerging economies.

Short-Term Outlook
A number of structural factors suggest that the PC market could pick up over the next several quarters, both for Microsoft and for the OEMs that remain among its most strategic partners.

One of them suggests an answer to a perennial mystery. How does Microsoft manage to outperform the PC market in its Windows OEM revenues? Part of the answer is by improving its mix of sales of Pro versus non-Pro versions of Windows to the OEMs.

Another answer has to do with whether the OEMs are building up inventory or whittling it down. Right now, OEMs and channel organizations downstream of the OEMs may be building up, suggesting that they're betting on an increase in end-user sales that may or may not materialize.

A comment by IDC's Huang in discussing the stronger quarter that just ended includes insights on what's happening with PCsin the channel.

"A somewhat unexpected boost came from intensified inventory pull-in as cautious channel players, who had been working to pare down inventory over the last several quarters, opened up inventory constraints a bit. This was likely a one-time shipment boost to bring aggregate inventory levels back to market equilibrium. The larger story remains whether an early wave of enterprise transition to Windows 10 could help close out a 2016 that is increasingly looking stronger in the U.S.," Huang said.

Indeed, now that the one-time upgrade offer is over and now that it's clear that there was no consumer PC market bounce from Windows 10, the focus is shifting to the potential for a corporate-buying bounce.

During his latest earnings call, Nadella tried to seed that optimism. "We already have strong traction, with over 96 percent of our enterprise customers piloting Windows 10," he said.

Gartner Analyst Mikako Kitagawa is watching the public sector for now to tell if the channel buildup is a good bet. "The second and third quarter are typically PC buying season for the U.S. public sectors. Positive second-quarter results could suggest healthy PC sales activities among the public sectors. There is an opportunity for a Windows 10 refresh among businesses, which we expect to see more toward the end of 2016 to the beginning of 2017," according to Kitagawa.

Those potential sales bumps for Windows 10 lie in the future. The immediate results of Microsoft's revolutionary Windows release playbook are in. After a year it's been good for Microsoft's market share, neutral for Microsoft's revenues and rough for the PC ecosystem.