W. H. Lo prepared this case under the supervision of Professor Ali Farhoomand for class discussion. This case is not intended to show effective or ineffective handling of decision or business processes. © 2014 by The Asia Case Research Centre, The University of Hong Kong. No part of this publication may be reproduced or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise (including the internet)—without the permission of The University of Hong Kong. Ref. 14/541C

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ALI FARHOOMAND

MICROSOFT: NEW WINE IN AN OLD BOTTLE?

Within four weeks of becoming the new CEO of Microsoft, Satya Nadella laid out the major challenges that awaited him in the two letters he sent to everyone at Microsoft.1 He defined Microsoft’s battlefield as the “mobile-first and cloud-first world.” 2 That was where Microsoft needed to get its products and technology right, to build platforms and ecosystems and to integrate Nokia devices, services and the new mobile capabilities. In order to do so, Microsoft needed to zero in on a mobile and cloud-first world and do new things. In his view, “industry does not respect tradition – it only respects innovation.” And in order to innovate, he needed his 130,000-strong staff around the world to lead and help drive cultural change, to find Microsoft’s swing so that the team was “in such perfect unison that no single action by any one is out of synch with those of all the others.”3 Many challenges awaited Microsoft in its transformative journey. On platforms, the future of Windows was not clear. On devices, Microsoft needed to find ways to woo application developers to build its mobile ecosystem. On integration, the company had to find ways to transfer and to grow the mobile capability acquired from Nokia. And most importantly, Nadella had to figure out how he could achieve cultural changes to focus everyone on innovation via collaboration.

The Business Legacy

Business Performance When Steve Ballmer retired, he left behind a record high revenue year in 2013 but a trail of sluggish stock performance [see Exhibit 1 for the company’s revenue and net income figures

1 Nadella, S. (3 March 2014) “Satya Nadella Announces Changes to Senior Leadership Team,” Microsoft press release,

http://www.microsoft.com/en-us/news/press/2014/mar14/03-03email.aspx (accessed 30 March 2014); Nadella, S. (4 February 2014) “Satya Nadella Email to Employees on First Day as CEO”, Microsoft press release, http://www.microsoft.com/en- us/news/press/2014/feb14/02-04mail2.aspx (accessed 30 March 2014).

2 Satya used the phrase “mobile and cloud-first world” in his letters to the Microsoft staff to stand for “mobile-first, cloud-first world,” which he reiterated many times during public and press meetings and events.

3 All quotes were from Nadella’s memo mentioned in footnote 1.

HK1039

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2000-2013; Exhibit 2 for a chart showing the stock price of Microsoft 1986-2013]. The company had also generated ample cash and had handsomely sent its shareholders consistent returns of dividends over the years [for a history of Microsoft, see Exhibit 3A and Exhibit 3B]. Its financial metrics of profits, dividends, and cash returns of the last decade had beaten those of Amazon, Google, IBM, Oracle, and Salesforce. Apple was its only competitor that produced better financials [see Exhibit 4 for the comparison presented by Ballmer during the company’s latest financial analyst meeting]. The company’s flagship products were the Windows operating systems and the Office applications for personal computers and servers. Microsoft also had two profit-making lines of businesses: the growing servers and enterprise cloud business and the Entertainment and Device Division that housed the well-known Xbox. The company’s only losing product group was its online service division, which included Bing and its online advertising service [see Exhibit 5 for a breakdown of Microsoft’s product divisions’ income 2005-2013]. Until the end of the last decade, Microsoft had never departed from its tradition of relentlessly protecting its dominance in personal computer operating systems and software licensing. The shift of technology to smartphones and tablets gradually meant personal computers were displaced, and at the turn of the decade, Microsoft came to terms with the end of the dominance of its flagship operating system. In 2011, it released the Office applications for Mac. In 2012, its Azure cloud enterprise offerings began to support Linux, which competed head-to-head with Windows for server dominance. These were followed by Office for iPhone and Android in mid-2013.

Limited Success beyond the Comfort Zone of Windows and Office Beyond the comfort zone of Windows and the Office applications, Microsoft achieved traction in the consumer market with its Xbox and in the enterprise segment with its cloud service offerings.

Xbox The first-generation Xbox was released in 2001. It immediately allowed Microsoft to take the second place in the market, albeit a distant second, behind Sony’s PlayStation 2 and slightly ahead of Nintendo’s GameCube. With the rolling out of Xbox One in October 2013 with Skype pre-installed, the company ambitiously positioned the device to be the single interface for all living room experiences, from entertainment to communication and networking. Despite its success, the Entertainment and Devices Division, where the Xbox was housed, had cumulative losses of over US$3.5 billion as of 2013, though it started to make a positive contribution to the company’s bottom line in 2008.4

Azure and the Cloud Microsoft’s cloud activities started in its heyday in 1997 after its acquisition of Hotmail. For over a decade, its cloud offerings took the form of “Software as a Service” applications; revenues were mainly generated from consumer offerings, such as Bing and Hotmail. The company deliberately focused on these cloud offerings only so that the cloud-based applications would not be in the way of its traditional products of Windows, Office, and Windows Server. 5 The decade-long delay of Microsoft to properly address the market potential of cloud computing caused the company to trail behind Amazon’s 71% market share. A major change occurred in the company’s cloud strategy in 2010. The company rolled out 4 Microsoft (2002–2013) “Annual Reports,” http://www.microsoft.com/investor/AnnualReports/default.aspx (accessed 30 March

2014); the contributions and losses of the Entertainment and Devices Division were calculated from information available from Microsoft’s annual reports from 2002 to 2013.

5 Iansiti, M. and Serels, A. (4 April 2013) “Microsoft Server and Tools,” Harvard Business School Business Case No. 9-613-031.

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Windows Azure and SQL Azure, the company’s “Platform as a Service” cloud offerings that were positioned to compete with traditional server businesses, including Windows Server. By April 2013, the company’s enterprise cloud platform offerings claimed a distant second market position with its US$1 billion billings. It was expected to grow stronger, challenging Amazon’s huge lead of an over 70% market share; an analyst at Forrester Research Inc. anticipated that Microsoft could narrow the gap substantially by commanding as much as a 35% market share in a year’s time. 6

Failures to Catch the Shift to Mobile Devices

Tablets Despite the fact that Bill Gates predicted tablets’ cannibalization of desktop computers and notebooks, Microsoft consciously chose to give up the strategic development of tablets and touch-screen smartphones. 7 It viewed the tablet as a complement to Windows, instead of seeing the potential of tablets to revamp consumers’ digital and technological lives. It therefore put the development and marketing of the tablet PC under its Windows division, which meant the company’s attention was not on getting the tablet experience right. Rumor had it that Microsoft’s Pioneer Lab had a similar concept with a Courier tablet around the time when Apple was developing the iPad. But Microsoft’s Windows-powered tablet would not arrive until two and a half years after the iPad. However, the device and the operating system did not live up to market expectations, and the company had to include a US$900 million inventory write-off of the device in its 2013 books.8 The company had three different Windows operating systems that ran on different platforms: Windows RT ran Surface RT, Surface Windows 8 / 8.1 powered Surface Pro and PCs, and there was Windows Phone OS powered smartphones. In an in-house interview with Gates, he described the direction as a plan to “merge all of the operating systems, which work well with the company’s long-term endeavors in both cloud storage and cloud-based personalization across multiple devices.”9

Mobile Operating Systems and Devices When Microsoft launched Windows Mobile in 2003, all major mobile vendors were reluctant to adopt the platform lest it would claim dominance in the mobile operating system domain, like what Windows had achieved in the PC market. But Microsoft never managed to achieve the critical mass required for a dominant position. It failed to develop an operating system that would offer the right smartphone experience, which was not the usual Windows experience crammed in a cell phone. The smartphone market would have to wait until Apple’s iOS and iPhone arrived in 2007 to take off. It took Microsoft five years after the iOS launch to release a smartphone operating system that seemed to be on the right track, especially with its Windows Phone 8 touch- and tile-based Metro user interface, and the shared kernel between Windows 8, Windows RT, and Windows Phone 8 that allowed developers to create applications that could run on all three platforms of PCs, tablets, and smartphones. The software company was flexing its muscle made up of a huge Windows user base to try to catch up with building an ecosystem of application 6 Bass, D. (30 March 2014) “Microsoft Azure Sales Top $1 Billion Challenging Amazon,” Bloomberg,

http://www.bloomberg.com/news/2013-04-29/microsoft-azure-sales-top-1-billion-challenging-amazon.html (accessed 30 March 2014).

7 In his keynote speech during the fall 2001 Comdex, Bill Gates said, “[A tablet] is a PC that is virtually without limits – and I predict that within five years it will be the most popular form of PC sold in America.” Raju, H. (11 December 2001) “Tablet PC, An Overview,” SLCentral, http://www.slcentral.com/articles/01/12/tabletpc/ (accessed 30 March 2014).

8 Sams, B. (26 August 2013) “After a 900 Million Write Down, Microsoft is Building a Surface RT 2,” Neowin, http://www.neowin.net/news/after-a-900-million-write-down-microsoft-is-building-a-surface-rt-2 (accessed 30 March 2014).

9 Hatchimonji, G. (26 October 2012) “Gates: Microsoft Intends to Merge Windows and Windows Phone,” TabletPCReview, http://www.tabletpcreview.com/default.asp?newsID=3597&news=microsoft+windows+8+phone+rt+surface+merging+single+ OS (30 March 2014).

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14/541C Microsoft: New Wine in an Old Bottle?

 

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developers that the competing iOS and Android had already achieved. Its acquisition of Nokia provided another missing piece of the ecosystem—much-needed mobile devices that would run the Windows Phone platform.

Missing the Market Opportunities of Search and Online Advertising Seven years after Google was incorporated, Microsoft finally had its own search engine to switch over from Inktomi, which had powered its MSN portal’s search engine till then. 10 Microsoft’s Online Services division, which housed Bing, the company’s search brand, was dwarfed by Google in many ways. The division’s search service and online advertising revenue was a mere US$3.2 billion for its financial year 2013, while Google pocketed US$50.5 billion revenue for the same period (excluding Motorola’s billing). The software company had a cumulative US$17 billion loss on its Online Services division since its inception in 2005. Bing’s market share was 18% in October 2013, trailing far behind Google’s 67%.11

The Organizational Legacy

Mixed Success with Inorganic Growth When Ballmer retired, he left Microsoft with the acquired mobile capability of Nokia. The company had a doubtful record of integrating non-software-related acquisitions despite its repeated successes in absorbing software-related acquisitions into its business. Its US$8.5 billion acquisition of Skype in 2011 not only allowed Microsoft to have a strong and popular real-time communications offering with revenue opportunities, but also provided a much- needed way for Microsoft to claim a place amid the trend of social and professional communication and networking integration. Microsoft realized the strategic potential of Skype by pre-installing Skype in Xbox One and by merging Skype and Lync, which was the company’s Office 365 communication application positioned for professionals. In 2008, Microsoft acquired the much-needed search technology behind Fast Search, enabling Bing, Microsoft’s Live Search (renamed in 2009), to become the distant number-two search engine behind Google. And almost immediately after the acquisition of Yammer in 2012, the company deployed it as its preferred enterprise social networking technology. However, when treading beyond software and applications, Microsoft’s acquisitions did not work out. A glaring example was its acquisition of aQuantive in 2007, then one of the world’s largest advertising agencies. The company paid US$6.3 billion for the agency, and wrote down its value by US$6.2 billion for fiscal year 2012. So when Ballmer announced the Nokia acquisition in September 2013, the world started speculating whether Microsoft would be able to make sense of this deal. The pressing need to regain the market’s faith in Microsoft’s mobile ability meant that the company needed to quickly decide how to match Nokia with the rest of the Microsoft family.

The Silos and the Politics Analysts and journalists following Microsoft did not hesitate to agree that the company had a lot of politics going on and a great many silos existed that hindered performance and killed creativity. After interviewing existing and ex-Microsoft employees, observers concluded that

10 Google (n.d.) “Financial Information,” http://investor.google.com/earnings.html (accessed 30 March 2014); Richardson, C. (1

July 2004) “Microsoft Gives Facelift to MSN Search,” Web Pro News, http://www.webpronews.com/microsoft-gives-facelift- to-msn-search-2004-07 (accessed 30 March 2014).

11 Goodwin, D. (14 November 2013) “Google Fails to Gain Search Market Share, Bing Steals from Yahoo,” Search Engine Watch, http://searchenginewatch.com/article/2307115/Google-Fails-to-Gain-Search-Market-Share-Bing-Steals-From-Yahoo (accessed 30 March 2014).

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14/541C Microsoft: New Wine in an Old Bottle?

 

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corporate success within the software company depended not on work excellence or creativity but on a mastery of office politics.12 One reason for the proliferation of office politics could be traced to the huge wealth disparity between the “old folks” and the newcomers. The “old folks” were those who had joined the company before the internet bubble burst. During those days, Microsoft’s always rising stock price and stock options meant that these people could count on their creative works and quality output to become millionaires. The newcomers, those who joined Microsoft after the bubble burst, found that they were better off moving up the corporate ladder rather than counting on the rewards the company offered for their innovative excellence. The stack-ranking approach provided a breeding ground for office politics.13 The original objective of the stack-ranking approach was to “balance creativity and discipline.” 14 As time went by, the company deployed systems and procedures to help manage almost every facet of the corporation, including recruitment progress, employee appraisals, procurement, production, sales management, finance, product development, and innovation.15 With operations in over 100 countries, and human resources of around 100,000 people [see Exhibit 6 for head count information for Microsoft 2004-2013], institutionalization was necessary for the company. However, for a company like Microsoft, whose excellence depended highly on the quality and brainpower of individuals and teams, much was at stake if the balance of creativity and discipline was upset and the former became gradually traded for the latter. An example would be the employee performance management system and stack- ranking employee review approach that was adamantly criticized by both Microsoft employees and the press. The stack-ranking system was first introduced by Gates back in the early days when he was still the CEO. Supervisors and managers force-ranked their staff by numeric values that closely resembled a bell shape, and Microsoft rewarded the high performers disproportionately while the low performers ran the risk of being invited to leave; in essence this system meant that each team had a predetermined target of achievers versus underperformers and of reward distribution. Over time, the approach was institutionalized with the support of a performance management system; managers were encouraged to execute “stack-ranking” religiously.16 Gradually, it became a sort of central focus of everyone; some even described this reward system as an integral part of the company’s culture.17 The immediate downside of this approach was that even a team of the brightest would have some of its team members ranked low despite them being among the brightest at Microsoft; therefore most Microsofters, even achievers, were reluctant to work with other smart Microsofters. What was even worse was that in order to move things ahead and to obtain support within the organization, one had to make sure that the job or work was tied to others’ “stack-ranking” in some way; this was the beginning of bureaucracy. Such bureaucracy repeatedly hurt Microsoft by slowing it down, as shown in its slower than a snail’s pace response to the smartphone market and the developments in internet search. The stack- ranking system not only hurt morale and hindered collaboration but most importantly deterred innovation.

12 Eichenwald, K. (August 2013) “Microsoft’s Lost Decade,” Vanity Fair,

http://www.vanityfair.com/business/2012/08/microsoft-lost-mojo-steve-ballmer (accessed 30 March 2014). 13 Ibid. 14 Herbold, R. J. (January 2002) “Inside Microsoft: Balancing Creativity with Discipline,” Harvard Business Review, 80 (1), pp.

72–79. Robert J. Herbold was Microsoft’s ex-chief operations officer, and the phrase was borrowed from the article written by him.

15 Ibid. 16 Ibid. 17 Budd, C. (13 November 2013) “Farewell, Stack Rank: Why This Change Was So Big for Microsoft,” Geekwire,

http://www.geekwire.com/2013/farewell-stack-rankings-billg/ (accessed 30 March 2014).

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14/541C Microsoft: New Wine in an Old Bottle?