Microsoft Software: Rent Me

Since May 2001, Microsoft has methodically reduced customer software purchasing options. Licensing 6 did away with popular off-the-shelf upgrades, replacing them with two- or three-year "Software Assurance" contracts. Rather than upgrade when they want and pay at time of purchase, businesses looking for discounted upgrades must pay 29 percent of the software's cost upfront annually for desktop products and 25 percent annually for server sofware.

Microsoft has continuously reduced licensing options with each product release cycle. For example, with Project 2003, Microsoft changed server licensing so that customers could no longer use the standard version to connect to a Project server. New licensing required the more costly professional version. Similarly, Microsoft made version changes that reduced Office 2003 options, compelling businesses to upgrade to the the pro version to get some features.

Buy Vista Enterprise Microsoft's Way, or No Way
The 2007 release cycle has reduced businesses' licensing options yet again, with Windows Vista as one striking example. To get certain Vista features and extras, businesses must purchase the Enterprise edition through volume licensing. Windows XP Professional makes no such requirement. Office 2007 imposes similar licensing changes, but there is a difference: Many businesses already buy Office through volume licensing. By contrast, most businesses buy Windows on new PCs.

"A lot of organizations are reconsidering SA [Software Assurance] on Windows to get MDOP [Microsoft Desktop Optimization Pack], MUI [Multilingual User Interface Pack] and BitLocker," said Michael Silver, a research vice president with Gartner. "MUI's sort of a big deal for some companies because SA is the only way to get the function. Most got it on XP for way less money and are not too happy they have to buy SA now."

For companies considering Vista deployments, the desktop optimization pack is a must-have tool.

"MDOP has generated some excitement, especially the SoftGrid component," Silver said. "The hidden issue there is that it's a subscription, meaning that if the customer discontinues either SA or MDOP payments, they need to stop using the MDOP function immediately."

Businesses looking for BitLocker won't find it in Vista Business edition. They have to spend more for Enterprise edition, which is only available through volume licensing. The point: Microsoft is changing licensing terms to push, in some cases really obligate, customers to take on two- or three-year licensing contract obligations.

Smoother Revenue at Customers' Expense
The forced path already is making changes. In Microsoft's 2007 fiscal fourth quarter, unearned revenue balance for the Client division, which major product is Windows, grew 25 percent.

During yesterday's earnings conference call, Chris Liddell, Microsoft's chief financial officer, said that unearned revenue contributed "three points" to client revenue growth. If this trend continues, Microsoft may accomplish through licensing what it couldn't organically: A major shift in where and how businesses obtain Windows software. Volume licensing contracts account for more than 40 percent of business division revenue. By contrast, coming into Microsoft's fiscal fourth quarter, OEM sales accounted for about 80 percent of client revenues. Microsoft could see a huge buying swing to volume licensing, if enough businesses choose Vista Enterprise.

Broadly, Microsoft's revenue mix comes from multiple sources, with volume licensing making up the biggest piece:

• Multiyear license contracts: 40 percent
• OEM: 30 percent
• License only: 15 percent
• Rest of business: 15 percent

In its fourth fiscal quarter, which ended June 30, Microsoft recognized $4.9 billion in unearned revenue, essentially cash in the bank from voluming licensing contracts. Microsoft's total revenue for the quarter was $13.37 billion. Unearned revenue works out to about 37 percent of total revenue.

Why Microsoft Benefits More Than Customers
To be clear: Microsoft is not making these changes for customers' benefits. What customer benefit is there to being locked into a contract and paying up front for the promise of an upgrade? Microsoft makes no guarantee that new software versions will be released during the contract period.

Microsoft hugely benefits however, because recurring revenue smoothes out its balance sheet. Software Assurance assures Microsoft it will get regular payments for software, regardless of when new products ship or when customers choose to upgrade. The highs and lows at the beginning and end of product life cycles diminish.

Roger Kay, president of Endpoint Technologies views the Microsoft licensing changes simply: "It reasserts their ownership over the software."

Businesses and consumers pay for Microsoft software, but the company retains ownership. Kay's take: "They're saying, 'We're renting you the software.'" Subscription or subscription-like fees are more in line with renting than owning.

Problematic: There is disconnection, really contradiction, between Microsoft and many customers with respect to software acquisition. In some countries, there are tax advantages to purchasing software through volume licensing contracts, particularly Enterprise Agreement Subscription. However, this customer segment is a minority. Based on analysts surveys, enterprise surveys I conducted when an analyst and IT manager discussions, many businesses would rather pay for software at time of acquisition, particularly discounted upgrades. Smaller businesses are more likely to prefer to pay at time of acquisition, while many very large businesses are more willing to accept blank coverage provided by Enterprise Agreement.

Kay believes there is another catalyst at work. "Microsoft has this huge drive from Wall Street to increase revenue and profit, but they have a monopoly," he said. "So they do things that would be suicidal in a competitive market. There is the missing discipline that comes from competition. They're not getting whacked for doing wrong."

Software Plus Services equals Rent?
Some analysts believe that Microsoft is moving in a direction where more, perhaps most, software sold to busnesses will only be available through volume licensing. Julie Giera, a Forrester Research vice president, is tracking this trend with regards to Microsoft intermediate product release. Microsoft has moved to a schedule of minor, or "R2," releases two years after products like Office 2007 and Windows Vista ship and major releases every four years.

"Will Microsoft only release R2s to Software Assurance customers?" She asked.

Windows Server 2003 R2 was free to Software Assurance and Enterprise Agreement customers. Everybody else paid extra.

The end game may be Microsoft's software plus services strategy. During Microsoft's 2008-2010 product release cycle, desktop software and server-based services will converge. Services customers typically make tidy, recurring payments. How interesting the timing that Microsoft is pushing more of its desktop and server software customers down a path of making recurring payments through volume licensing contracts.

Microsoft has sought the Holy Grail of subscription revenue for more than a decade. The model is getting a refresh in Romania and South Africa, with new pay-as-you-go Office 2007 subscriptions.

Will software plus services equal rent, for all Microsoft customers? Plumbing already is in place for subscriptions, by way of Microsoft's product activation technology and its Volume Activation 2.0 successor used for Windows Vista. The question is no longer if, but when Microsoft will move customers, whether by volume licensing or real subscriptions, to a rental model. Remember, Microsoft only needs to change the software licensing terms.