Help! Between Microsoft and a Hard Place

When computer maker Acer looked at its future, it didn't like what it saw. Now that Microsoft (NAS: MSFT) is rolling out its own Surface tablet, Acer fears that that Microsoft's move into hardware will "create a huge negative impact for the ecosystem, and other brands may take a negative reaction." As the Financial Times reports, Acer goes on to say, "it is not something you are good at, so please think twice."

Microsoft should see this criticism as a sign that its hardware push was the right one, whereas hardware makers should prepare for a rougher future where they'll need to dramatically change tactics to survive.

Vertical integration, or, not depending on anyone
A business can place itself anywhere along the product-creation line, from mining the minerals required to make a product to selling the product to the customer. Typically, certain businesses develop competitive advantages by operating in one specialty. For example, while an agriculture company will be the best at producing cotton, a designer will be the best at marketing that cotton, while a manufacturer will be the best at turning that cotton into clothing, and a retailer the best at selling that clothing to the customer.

If a company believes it can do better if it owns more than one of the steps that a product takes, it can "vertically integrate," and move up the supply chain to become its own supplier, or down to become its own vendor. This move can help it cut costs, control quality, and decrease reliance on other companies.

Take Apple (NAS: AAPL) , which designs its processors, writes its software, and markets and sells its products to the consumer. Apple has found a way to be extremely successful in each step of the process and now relies on others only to construct and assemble its devices. Its retail stores dominate any other company in sales per square foot, and its product design and operating system have helped it take a vast slice of market share and earn the company a 25% net profit margin.

A company like Dell (NAS: DELL) or Hewlett-Packard (NYS: HPQ) , however, buys components that a chipmaker like Intel designs, assembles them, installs Microsoft's operating system, and hands off a portion of retailing to stores like Best Buy. This earns Dell and HP around a 5% net profit margin. It also forces a reliance on Intel and Microsoft to provide quality products at fair prices. And Intel and Microsoft have to depend on Dell and HP to produce products that consumers will want to buy.

Unfortunately for Dell and HP, consumers aren't buying their products. In second-quarter estimates according to Gartner, U.S. PC shipments for HP fell almost 13% while Dell's fell 9.5%. Apple's, on the other hand, gained 4.3% versus an overall 5.7% decline in shipments for the industry.

Vertically challenged
Microsoft, recognizing this sales slump, now wants to try its own hand at producing a product along with its software. And Acer recognizes that Microsoft is encroaching on its territory. Microsoft, to have a chance, realizes that it must have more control over the hardware. And despite what Acer says, Microsoft has arguably proved itself in hardware with its Xbox game consoles that brought in more than $1.2 billion in operating profit in 2011 (unfortunately, the division the Xbox falls under is lumped together with payments to Nokia in 2012). And even if Microsoft fails at a tablet, it has enough cash to fail for a while, so hardware makers should be ready for a significant change in its relationship with Microsoft. Like Netflix is squeezed between content providers for supply and Internet providers for distribution, hardware companies could be squeezed by less power over suppliers and less demand from customers.

Plenty of operating systems in the sea?
What can hardware makers do? HP made a feeble attempt at launching its own mobile operating system on its TouchPad tablet, but that experience has probably discouraged others from doing the same on either mobile or desktop systems. That's OK, though, as Google (NAS: GOOG) can be the savior for these companies that are OS-less. Besides the Android mobile OS that Google helped cultivate, Google's Chrome OS might become a much more popular desktop operating system. This cloud-based laptop and desktop OS currently has models built by Samsung and Acer, but Google could seize the opportunity to extend its market share through other aggravated hardware companies.

Otherwise, Microsoft will build hardware that better integrates with the operating software, and companies like Dell will suffer. Less desirable products will lead to lower prices, and that would cut into already small profit margins.

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Fool contributorDan Newmanholds no position in any of the above companies. Follow him on Twitter,@TMFHelloNewman. The Motley Fool owns shares of Best Buy, Apple, Intel, Microsoft, and Google.Motley Fool newsletter serviceshave recommended buying shares of Microsoft, Apple, Intel, and Google and creating bull call spread positions in Microsoft and Apple. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days. The Motley Fool has adisclosure policy.

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