Easy Windows 7 upgrades could earn Microsoft billions a year extra

Most analysts who looked at Microsoft’s announcement earlier today of its new lineup of Windows 7 editions have focused on the number of SKUs and are busily debating whether the new selection will make choices more or less confusing for Windows customers. But there’s a more important story buried in the details. By making upgrades easy and cheap, Microsoft could finally convince its enormous user base to start paying extra to unlock features in higher-priced editions and pull in billions of dollars in additional revenue.

Most analysts who looked at Microsoft's announcement earlier today of its new lineup of Windows 7 editions have focused on the number of SKUs and are busily debating whether the new selection will make choices more or less confusing for Windows customers. But there's a more important story buried in the details, one that will only become apparent when Microsoft fills in the rest of the picture by attaching price tags to the members of the Windows 7 family.

Two weeks ago, Microsoft delivered the shocking news that its Windows Client division reported declining revenue on a year-over-year basis, despite selling approximately as many licenses as it did in the previous year. It's easy to blame the shortfall primarily on netbooks, as Microsoft did. Indeed, those small, cheap PCs are part of the problem. The market figured out that the least expensive Home edition of Windows (XP or Vista) is an ideal choice for netbooks and in fact is perfectly adequate for many tasks on mainstream PCs. That's why Vista Home Basic is so popular on entry-level business PCs.

The big challenge for Microsoft in the Vista-to-7 transition is how to increase the average price of a Windows license without making users scream or quit in protest. By changing the upgrade game in Windows 7, they've created the conditions for a whole new revenue stream - and, paradoxically, have the chance to offer Windows customers an upgrade deal they'll actually want.

I've crunched the numbers, and my rough calculations suggest that this realignment could be worth hundreds of millions, and perhaps billions of dollars in new revenue for Microsoft, even if PC sales remain flat. Here's how I came to that conclusion.

On new PCs, which make up the overwhelming majority of the PC market, Microsoft's partners choose which Windows editions will be installed on a given PC at the time of purchase. Their goal is to keep costs as low as possible, which is terrible news for Microsoft's bottom line. In essence, OEMs make their OS choice based on the total price they want to sell a system for. If you buy a system sold at a retail outlet like Best Buy, customization is impossible: You get what's preinstalled. Companies that offer build-to-order PCs sometimes give the buyer a choice, but most customers accept the default configuration, which usually includes Vista Home Premium for a consumer PC, Vista Business for models designed for the corporate market, and Home Basic for entry-level systems for home and small business buyers.

OK, so you buy a new PC with Vista Home Premium and take it home, and then you discover that you can't use Remote Desktop to manage that system remotely, and it doesn't allow you to recover files saved by the Previous Versions feature, and you can't do image backups. If you want those features, you have to buy an upgrade copy of Ultimate edition at a typical cost of $150 or more. And if you decide to upgrade after the fact, you not only pay through the nose, you also sign up for several hours of downtime as the upgrade completely replaces your existing installation and then migrates your programs and data files.

Long story short, the current Windows upgrade model is completely irrational. As a result, almost nobody upgrades their copy of Windows Vista. You use what came with your PC and Microsoft sees almost nothing in upgrade dollars.

That means, in practical terms, that Microsoft's revenue from Windows client licenses is set by the mix of PCs in the marketplace and effectively determined by OEMs. To get a handle on how the mix works, I did some very rough back-of-the-envelope calculations. The following table assumes that Microsoft sells 200 million Windows licenses per year. I consulted with a few industry analysts to guess at approximate market shares and OEM costs for those licenses, and came up with the following total.

Vista SKU Share* OEM cost* Total**
Home Basic 12% $30 720
Home Premium 65% $60 7,800
Business 20% $90 3,600
Ultimate 3% $120 720
- Total - Avg: $64.20 $12.84B
* Estimate, for illustrative purposes only

** Based on 200 million licenses sold

The only way for Microsoft to adjust that number is to convince OEMS to build new PCs with higher-priced editions (and thus higher price tags) than they previously used. Good luck with that strategy.

So what's Plan B?

Crunching the Windows 7 numbers -->

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With Microsoft's latest product mix in mind, let's look at the numbers for new PCs purchased with Windows 7 in the first full year after Windows 7 ships. All of those buyers in the U.S., Western Europe, and the rest of the developed world who would have purchased a PC with Vista Home Basic will have to choose the higher-price Home Premium edition when purchasing a Windows 7 PC. The only buyers left for Home Basic are in emerging markets, which cuts the percentage of Home Basic buyers down (but not to zero, because emerging markets are booming). At the high end, some buyers who previously would have chosen Ultimate (because they wanted Media Center and Remote Desktop capabilities, for instance) can now choose the less expensive Professional and still have the features they need. Figure that knocks a point off Ultimate's already low market share.

Here's what the Windows 7 numbers look like in that case:

Win7 SKU Share* OEM cost* Total**
Home Basic 7% $30 420
Home Premium 70% $60 8,400
Professional 21% $90 3,780
Ultimate 2% $120 480
- Total - Avg: $65.40 $13.08B
* Estimate, for illustrative purposes only

** Based on 200 million licenses sold

Assuming the number of license remains constant, the change in SKUs alone means a bump in the average selling price (and thus the total revenue, assuming flat growth in PC shipments) of 1.87%. Since this is back-of-the-envelope stuff , let's round it up to an even 2%.

But here's where it starts to get interesting. With Windows 7, Microsoft has made it technically easy to upgrade, and for the first time they also have the opportunity to price those upgrades reasonably. Imagine that an aggressively priced upgrade program is able to convince a mere 4% of the total Windows customer base to upgrade after the initial PC purchase, with the overwhelming majority going from the dominant Home Premium edition to Professional. Assuming 200 million new Windows-based PCs, that's 8 million buyers with cash in hand. If they can be convinced to pay an average of $50 each to unlock those Windows 7 Professional features, Microsoft pockets $400 million in extra revenue. No sales get cannibalized; these are buyers who would have never upgraded in the Vista world, because the cost and hassle factors were way too high.

Those assumptions might be too optimistic, but even a 1% upgrade rate translates into $100 million dollars in new revenue over the course of a year, something that Microsoft can't afford to sneeze at in these tough times. And if they can boost the upgrade rate into double-digit percentages at a higher price, the result could add up to billions in new revenue.

So who loses in this revised model? Entry-level buyers in the U.S. are the most obvious victims in this scenario. With no Home Basic edition, the price of a $400 budget Windows PC is going to rise by about $30, or 7.5%. Ouch.

Anyone trying to squeak by on a netbook with older, slower hardware is going to be stuck between a rock and a hard place, too. The low-priced XP Home is still available for those systems until June 30, 2010, but after that it's Windows 7 Home Premium (too expensive), or Windows 7 Starter Edition (too limited) or Linux (too not-Windows).

And that model doesn't factor in the bump in revenue coming from Windows Vista users who are enticed by Microsoft's "aggressive pricing" and special offers when Windows 7 launches.

All in all, it adds up to a potentially enormous bump in revenue for Microsoft from a seemingly small change.


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