The announcement by Microsoft that it planned to build its own tablet to compete with the iPad reflects a major breach between the company and its historic partners, like HP and Dell.  Microsoft clearly understands the threat of tablets, particularly Apple’s iPad, to its traditional business of selling software at relatively high prices to PC manufacturers who sell hardware at razor thin margins. This economics of this approach severely limits the funds available to the manufacturers for hardware design and purchasing high quality components. Essentially there has a been a race to the bottom in the PC market.

As Apple continues to grow, Microsoft faced a potential nightmare.  If PC manufacturers could not design and build attractive touch-based computers, Microsoft’s software sales, both for its Windows operating system and its Office suite, would decline, perhaps precipitously. So Microsoft may have felt painted into a corner, and it announced its Surface tablet with little or no notice to its “partners.”

This breach was covered today by Nick Wingfield in the New York Times:

For hardware makers, the PC market has long been a struggle because Microsoft and Intel, maker of the microprocessors that power most computers, have long extracted most of the spoils from the industry, leaving slim profits for the companies that make them. Manufacturers pay hefty fees to license Windows from Microsoft, putting pressure on them to make computers as cheaply as possible using commodity parts.

That, in turn, has limited their ability to take the kinds of risks on hardware innovation that have helped define the iPad. Furthermore, with the iPad, Apple has proved that there are significant advantages to designing hardware and software together. When separate companies, each with its own priorities, handle those chores, integrating hardware and software can be more challenging.

An even better summary of the breach was provided by Horace Deidu in his Critical Path podcast last week. It is well worth a careful listen if you are interested in the future direction of the industry. Here is a sample of what Deidu has to say:

If we simply divide [Microsoft software] revenues by PCs sold we get about $55 Windows revenues per PC and $68 of Office revenues per PC sold. The total income for Microsoft per PC sold is therefore about $123. If we divide operating income by PCs as well we get $35 per Windows license and $43 per Office license. That’s a total of $78 of operating profit per PC.

Now let’s think about a post-PC future exemplified by the iPad. Apple sells the iPad with a nearly 33% margin but at a higher average price than Microsoft’s software bundle. Apple gives away the software (and apps are very cheap) but it still gains $195 in operating profit per iPad sold.

Fine, you say, but Microsoft make up for it in volume. Well, that’s a problem. The tablet volumes are expanding very quickly and are on track to overtake traditional PCs while traditional PCs are likely to be disrupted and decline.

So Microsoft faces a dilemma. Their business model of expensive software on cheap hardware is not sustainable. The future is nearly free software integrated into moderately priced hardware.

 Disclosure: I am long AAPL.

Related articles

• Microsoft Taking Direct Aim at The iPad, But Questions Loom Large (allthingsd.com)
• Acer: Microsoft will fail if it copies Apple’s hardware strategy (venturebeat.com)
• MICROSOFT: Okay, Fine, We Admit It–Apple Was Right (businessinsider.com)
• Microsoft’s Dilemma (ritholtz.com)