Consider the latest news from Microsoft: The company is busy creating a music player and service, dubbed “Zune,” to compete with Apple Computer’s iPod, and on August 17 signed up EMI Group as a music video partner. The company’s Xbox is a money-losing venture, but remains a hit with gamers. Meanwhile, Microsoft is offering PC makers design kits so they can dress up their computers to match the company’s new Vista operating system due in early 2007.

The common thread: Microsoft, well known as a software giant, is increasingly dabbling in hardware and playing a bigger role in product design. The big question is: Why? While some analysts dismiss Microsoft’s efforts as Apple envy, experts at Wharton say there is a bigger picture. Microsoft wants more control over integrating its software with the gadgets that could open new markets. Its real mission: Find new vertical markets to dominate so it can continue to grow even if its Windows monopoly erodes.

“Microsoft understands that software, its core business, is becoming increasingly commoditized. It needs to find new revenue streams if it wants to keep growing,” says Wharton legal studies and business ethics professor Kevin Werbach. “Across the computer industry, value is moving from the desktop to network-connected services. Integrating software, hardware, content and services, as Apple has done so effectively with the iPod, can be a wonderful business model if you can do it right.”

If the vertical market playbook sounds familiar, it is: Microsoft has $34 billion in cash and short-term investments as of June 30, largely because it profits by controlling a PC ecosystem that revolves around Windows. In other words, Microsoft’s Windows has become a de facto standard. Apple is also using the same approach in music by pairing the iPod with the iTunes music portal along with its digital rights management software which controls how content is used. All three pieces of the iPod ecosystem have become dominant standards.

To Wharton operations and information management professor Eric Clemons, Microsoft’s forays into new markets tell a larger tale of the software giant’s insecurity. “The bigger story here is twofold: Microsoft’s continued fear that it may lose its power and pricing in operating systems, and Microsoft’s continued need to show rapid growth in a world in which it already owns nearly the entire market in its core product areas,” says Clemons.

What remains to be seen is whether Microsoft can make the right moves in its products and strategy to own a new market. In many respects, market domination is the equivalent of a lightning strike. Other companies, such as Google with its search engine and Apple with the iPod, have also developed hits due to fortuitous timing and well-designed products. “There’s this notion that Microsoft lies in wait and then dominates a new market,” says Wharton marketing professor Peter Fader. “But it’s not true. Microsoft fails as much as it succeeds.”

Werbach notes that what Microsoft is attempting — integrating everything from software to hardware to services in a particular market — has been tried repeatedly in the technology industry, with mixed results. “The history of the computer industry is littered with the remains of companies that tried to integrate hardware, software and services, but lost out to more focused competitors,” says Werbach. “But with newer, specialized platforms like mobile devices and home media centers, there may be more benefits to integration.”

Kendall Whitehouse, senior director of information technology at Wharton, argues that Microsoft’s persistence often pays off. For instance, a decade ago few would have predicted that devices from Palm would run Microsoft’s Windows mobile operating system. Today they do largely because the original Palm operating system failed to evolve quickly enough while Microsoft steadily improved its mobile software. “If it tries long enough, eventually Microsoft will succeed. With enough money and enough time, anything is possible,” says Whitehouse.

What could emerge is a new Microsoft geared more toward services and integrating various devices littering the digital living room, including PCs, game machines, digital set-top boxes, digital cameras and music players. In this vision, Microsoft’s software and Internet services become the glue connecting a host of devices. “Everything today directly or indirectly now also connects to Internet-based services,” said Ray Ozzie, Microsoft’s chief software architect, at the company’s July 27 financial analyst meeting. 

Perhaps one of the larger questions revolving around Microsoft is whether it can succeed at everything. “Can a tech company really have multiple core competencies, as Microsoft says it can?” asked Merrill Lynch analyst Kash Rangan in an August 2 research note. “Microsoft has a breadth of products and markets. Competing and winning in all of them seems to be a dizzying proposition that could tax even the most competent of management teams.”

The Importance of Zune

One way to answer Rangan’s question will be to look at Microsoft’s Zune music player. Little is known about Zune, beyond a few pictures leaked on the web and hints that Zune will include built-in Wi-Fi network access. But Microsoft will have to line up music partners, create an online service to sell songs and design a portable music player in order to launch the product by its planned fall release.

Robbie Bach, president of Microsoft’s entertainment and services division, said at the company’s analyst meeting that it will be involved in all aspects of building services and hardware for Zune. “We have to tie those things together … like we have in the Xbox world,” said Bach, who added that Zune will be a three-to-five year investment. As for dollars invested, Bach said Microsoft will spend hundreds of millions on Zune, less than the billions spent on Xbox.

“Why is Microsoft doing this? Perhaps to make money selling portable music players as Apple has done, but I suspect it’s really more about controlling the distribution chain for digital music,” says Whitehouse. “With the success of its iPod and digital rights management that only works with the iPod, Apple has control of the entire channel. Microsoft’s move is an acknowledgement of Apple’s leverage.”

And with a new project like Zune, it’s unclear whether the goal is to sell the player, distribute songs, give Microsoft’s software (such as its Windows Media Player) and digital rights management tools better footing, or just keep Apple in check, say Wharton experts.

To analysts like Piper Jaffray’s Gene Munster, Microsoft’s Zune is a critical part of the effort to thwart Apple’s dominance and prevent it from usurping Windows as consumers buy iPods and Macintosh computers. “We believe Microsoft needs to start chipping away at Apple in the near term or risk losing more ground as Apple expands its massive footprint,” says Munster. According to Fader, however, it will be difficult for Microsoft to curtail Apple’s momentum in digital music. “The idea behind Zune is to give the consumer a better experience, but it’s not clear it will do that well. The Apple iPod is a rock-solid reference and anything Zune does will be compared to the iPod. The iPod is the standard.”

Nevertheless, he argues that there is an opening for Microsoft. Apple’s DRM provisions, he notes, can be restrictive and its player doesn’t contain features other music players have — such as a built-in FM radio receiver or voice recorder, or the ability to use some of the major subscription music services.

Part of the reason Apple has been so successful is that CEO Steve Jobs successfully lined up all the major record labels behind the iPod and iTunes. In addition, Apple is viewed as more hip, and any product it develops comes with that aura. “Apple has a glow and Microsoft has a burden that it’s not friendly to customers,” says Fader. “I think Microsoft’s reputation is unwarranted. In the end, Apple and Microsoft are just tech companies trying to make a buck.”

End of Desktop?

Given Microsoft’s recent activities, it seems clear that the company is anticipating a time when Windows yields to something Whitehouse calls the “webtop.” “Microsoft is preparing for the day when it doesn’t have control of the dominant software platform,” says Whitehouse, who argues that many software applications will one day become subscriber-based services delivered over the web.

Rangan noted a host of new markets for Microsoft, including enterprise servers, databases, games, online advertising and television. “Microsoft is attacking vastly different markets, seeding a variety of potentially large opportunities,” he suggests. In these new markets, integration becomes more important since software that can’t connect with other devices can become irrelevant. That means that Microsoft has to become more of a “glue” company focusing on middleware, or software that is used to connect disparate applications. 

Indeed, at the analyst meeting, Ozzie emphasized Microsoft’s role in connecting and integrating multiple devices. And as Knowledge at Wharton previously reported, at the recent Supernova conference in San Francisco, Lili Cheng, head of Microsoft’s Windows user experience group, pointed out, “Today, we may think of Microsoft when we think of [personal computer] operating systems, but there are many kinds of operating systems — on your cell phone, on an Xbox. The question for the future is how we merge these … to support a user experience that includes sharing, synchronizing information, making the experience expand and come alive.”

According to Whitehouse, this is a new focus for Microsoft. “Instead of trying to put the PC operating system everywhere, the new challenge becomes synchronizing everything.” The problem, says Fader, is that “it’s hard to be seen as a glue company when you’re seen as a Windows company. Microsoft can’t just jam Windows into everything as the glue. It has to be nimble and have a different approach.”

Werbach, however, adds that the ability to connect various platforms may be within Microsoft’s reach. “Microsoft knows a thing or two about integrating platforms. Even though it only controlled the operating system, it was able to dictate the structure of the PC ecosystem for years. Making devices and services work together is an immense challenge, which no one, even Apple, has fully solved. Microsoft at least has the benefit of many years of working to make an astounding array of hardware and software co-exist with Windows.”

In general, Microsoft’s focus on connecting various devices makes sense, Werbach argues. After all, it can’t compete with the likes of Apple on product design. “What Microsoft hopes to do is make software ‘middleware’ the differentiator in an integrated environment, because that plays to its strengths.”

Clemons, however, is wary of Microsoft’s integration pitch and suggests that there is a big difference between integrating only Windows-based software and combining a whole universe of other applications. “My sense is that Microsoft would love to see Windows extended as a platform for anything and everything,” he says. “But their strategy will not be based on ease of commingling but rather on their ability to integrate and sell a single system, albeit a single system for each vertical market or each application.”

A Device-Driven Market

For Whitehouse, Microsoft’s biggest challenge is changing the company’s culture away from extending Windows into every market to thinking more in terms of providing a compelling consumer experience that can make it successful in new markets. Whitehouse says Ozzie is changing how Microsoft thinks about developing products and markets.

Among the signs Microsoft is changing:

  • It’s increasingly focused on hardware and software integration with efforts like Zune;

  • It doesn’t try to fit full-blown Windows into every device. For instance, the Xbox doesn’t use Windows software;

  • It’s increasingly focused on web services through initiatives like Windows Live.

While that’s progress, Microsoft faces substantial challenges. For instance, “hardware is a different business, economically and culturally, than software,” says Werbach. “Apple has thrived because it’s a very design-oriented company, and good design is one way to succeed in hardware. Microsoft isn’t a design-oriented company.”

Indeed, Munster notes that Microsoft first has to create a Zune device that consumers covet or the rest of its music strategy will be moot. While music services and online communities are nice add-ons, “we believe that this is a device-driven market. For Zune to be successful, Microsoft must develop a device that captures customers from Apple.”

What remains to be seen is whether Microsoft’s new efforts can get enough momentum ahead of any potential decline in the Windows franchise. “The mighty can fall quickly in the computer industry. Microsoft understands this, which is why it has made such an aggressive push to realign itself,” says Werbach. “How do you keep growing when you’re as big and successful as Microsoft has become?”

According to Rangan, it will be unprecedented if Microsoft can win in multiple markets. “Success in multiple ‘core’ businesses would be significant — something never really seen before from a technology company,” he wrote in his research note.

It’s hard to count Microsoft out, Clemons says. “The right question is whether or not Microsoft’s current dominance of the operating system market can be preserved over time and extended into different areas. So far the answer has been yes — and for a decade longer than my students expected.”