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posted: 2/8/2014 7:39 AM

Nadella faces pressure to gut Microsoft's flagging consumer divisions

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  • A Windows operating system logo sits on display inside Microsoft Corp.'s new store in Berlin, Germany.

    A Windows operating system logo sits on display inside Microsoft Corp.'s new store in Berlin, Germany.
    Associated Press/November 2013

The Washington Post

Now that the confetti has cleared, Microsoft's new CEO Satya Nadella faces tough choices about the path forward for the company.

Two influential Microsoft shareholders have been pushing the Redmond, Wash., software giant to abandon what they view as nonessential product lines so that it can focus on a core strength: selling enterprise software to businesses. Nadella, who spent the past seven months running Microsoft's $20 billion server and tools division, could be ideally suited to manage that transition.

In a companywide email sent Tuesday, Nadella hinted he'll be taking Microsoft into a "software-powered world" that evolves alongside new hardware.

"I believe over the next decade computing will become even more ubiquitous and intelligence will become ambient," Nadella wrote. "This will be made possible by an ever-growing network of connected devices, incredible computing capacity from the cloud, insights from big data, and intelligence from machine learning."

Analysts say that Nadella's background in computer science -- he holds a master's in the subject from the University of Wisconsin, as well as an MBA from Chicago -- will engender respect among Microsoft's competitive, engineer-heavy employee base.

Nadella's familiarity with Microsoft's culture and his perspective near the top of the firm also positions him well to guide the company's future, said Norman Young, an analyst at Morningstar.

"If you're installing someone with a lot of enterprise experience and has a lot of success driving enterprise success, that's pretty good," Young said. "Because the future of Microsoft is almost certainly going to be in the cloud."

But making that transition would mean repudiating much of the legacy of his predecessors, Bill Gates and Steve Ballmer, who have long believed that Microsoft needs to win over consumers, not just corporate IT managers. As a 22-year Microsoft insider, Nadella owes much of his career to Gates and Ballmer. They both remain on the board. Ballmer reorganized the company last year to emphasize "devices and services."

Nadella's tenure at Microsoft's helm will be largely defined by how he balances competing visions of Microsoft's future and the strong personalities in the boardroom. Having activist shareholders urging Microsoft to rethink its vision could give Nadella an opening to face down his predecessors. But it wouldn't be easy.

The fate of consumer tech at Microsoft is unclear. Microsoft's Windows division has faced shrinking profits; last year, the unit pulled in a net $9.5 billion, down from $11.6 billion in 2012 and $12.3 billion in 2011. Company filings suggest that the drop is largely attributable to declining demand for Windows among consumers, even as sales of Windows to businesses remain strong. The same division also reported a $900 million loss on unsold Surface tablets. The online services division, which oversees search engine Bing, reported a loss of $1.3 billion in 2013 -- less than the previous year but still in the red.

Some investors have suggested that Microsoft spin off its money-losing consumer products. Even the Xbox deserves to go, Paul Ghaffari, the wealth manager for Microsoft co-founder Paul Allen, said last year.

Robert Bontempo, a management professor at Columbia Business School, is skeptical that Nadella will be able to chart his own course. "You're asking for Nadella to walk into a board meeting and look Ballmer and Gates in the eye and say, 'The decisions you've made over the past two decades are a mistake,'" Bontempo said. "That's going to take some serious strength of character."

On top of naming Nadella as its CEO, Microsoft confirmed another circulating rumor: Gates is coming back. The Microsoft co-founder is set to step down as chairman and intends to take a more active role "shaping technology and product direction."

This may bolster confidence in investors who believe Nadella lacks the experience to oversee the company's work on consumer devices. Critics say Nadella doesn't know enough about retail.

If Nadella does turn more decisively toward business customers, he may find a useful ally in Mason Morfit. Morfit is a 37-year-old activist investor whose employer, the private hedge fund ValueAct, acquired a 0.8 percent stake in Microsoft in August. That was enough to put Morfit on the board.

Morfit was reportedly among those who urged Ballmer to step down. Microsoft denied that ValueAct played any role in the decision. More important, ValueAct has been a critic of Microsoft's strategy and -- like Ghaffari -- wants the company to consider shedding some of its investments in consumer technology.

With the addition of Morfit, Bontempo said, "this is going to be an extremely toxic environment ... There's going to be a lot of tension."

But there are early signs that Nadella is interested in continuity with his predecessors rather than a radical new strategy. The Indian-born engineer asked for Gates to step away as chairman of the board so Gates could advise him. It's clear Nadella recognizes his own weaknesses when it comes to consumers. It suggests Nadella's faith in the "device" part of Microsoft's "device and services" mantra.

Gates' close association with the personal computer is, in some ways, the opposite of what Microsoft needs, which is to shift away from that slumping market. Analysts say the programmer-turned-philanthropist has exerted a strong influence at Microsoft behind the scenes, even as he's kept a low public profile at the company.

"The problem with Gates taking on that role," said Michael Silver, a Gartner analyst, "is suspicions that he's played a larger role in the company over the last few years than people think, and that he bears a lot of responsibility for the trouble Microsoft is in today."

Nadella hinted at wider changes in the company email. "Our industry does not respect tradition," he wrote. "It only respects innovation."

With its $10.4 billion research division, Microsoft could have a prime opportunity to do what others in this space have done: Build a consumer-facing brand that highlights Microsoft's technologies in everything from ATMs to gas station terminals or that shows how Microsoft services are behind the next wave of other people's technological innovation. IBM's Smarter Cities Challenge is one example of a services company that stays in the public eye this way. So is General Electric's Ecoimagination project.

If they can do it, why not Microsoft?

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