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Can Microsoft pull a rabbit out of its hat?

The software giant will need more than luck to overcome what promises to be its toughest transition in years. Chris Le Tocq steps you through the challenge facing Bill Gates' minions.

Microsoft's Office business model is aging, customers have been slow to upgrade their applications and the company faces a difficult transition to .NET. In this new reality, the obvious conclusion that Microsoft faces keen challenges becomes more than mild understatement.

To be sure, Microsoft does have a plan.

With upgrade cycles for its desktop applications business slowing down, Microsoft wants to move all its customers to subscription services over the next four years. If successful, the company would be able to force an effective two-year renewal, topped off by additional subscription services delivered via the company's new .NET architecture.

Here's why this is so important. Office and other desktop applications represented 46 percent of the company's gross revenue and the majority of its earnings for its last fiscal year. But when Microsoft recently announced its December quarter, it reported that Office grew at just 2 percent year over year--and this in a PC market that grew at 14 percent worldwide.

In the corporate market Microsoft has used various changes in licensing methods to increase Office per-user revenue and cajole customers into moving away from the efficient minimalism of Office Standard. But for most organizations, Gartner recommends that Office need only be replaced every three or four years--if not longer.

That means it's more cost-effective for a company to upgrade Office at the same time that it installs a new operating system or hardware upgrade, rather than install new versions on existing hardware. But Microsoft has been slow to respond to the trend; in fact, current Office features and messages actually encourage organizations to do wholesale, costly, over-the-network migrations.

The upshot: Instead of increasing per-user revenue, Microsoft's approach has paradoxically contributed to the deferment of upgrades.

Microsoft's stick and carrot
On the one hand, Microsoft's plan focuses on taking advantage of its control of the applications desktop by transitioning customers from the current perpetual license to a non-perpetual, yearly renewal model. The second facet of the strategy involves persuading customers that there is real value in a subscription by including Web-based productivity application services over time.

This stick-and-carrot approach is not subtle and certainly carries risk.

Microsoft is taking a substantial risk on lower initial revenues against the opportunity to increase revenue over time with annual subscriptions. The price points for Office Standard at $480 for the full product and $180 for the upgrade perpetual license already make Office far more expensive than most software. Businesses buying new $800 PCs are finding it quite easy to defer making $180 upgrades.

Making the transition to subscriptions
The only way a subscription service--or indeed any successive upgrade offering--can represent a cost-effective choice for a customer is if the service level increases substantially in the new version. Significant enhancements to the base Office PC product appear unlikely given its maturity. Users could be persuaded to renew their subscription if Microsoft includes services based around .NET as part of the upgrade.

These types of services might include synchronization to Web storage for users, or access to a SharePoint collaborative site for businesses, along with other services likely packaged as a combined user experience under the MSN or bCentral brands. The point at which the user first has to make a decision on another subscription fee will be the point at which Microsoft will succeed or fail.

With the advent of the Office.NET services not anticipated to be launched on a broad scale until mid-2002, the timing is right for these services to coincide with the first yearly upgrade requests. For its subscription service to work, however, the price is going to have to be right.

With most users upgrading Office every three to four years, users and organizations should pay no more than 25 to 30 percent of current upgrade prices. And that means Microsoft is going to have to sell a lot of subscriptions at this price to match current revenue.

A transition to a new business model is never easy, and for Microsoft there is always the temptation to take advantage of their control of existing markets. That would be a mistake.

If Microsoft prices to the 25 percent level, it has an opportunity for rapid acceptance of the subscription buying process and .NET. But if it chooses 50 percent, customers will complain about being gouged. What's more, the subscription transition will be deferred for years, substantially impacting .NET's chances for success.