After years of declining PC sales, its failure to make an impact in mobile computing and the increasingly aggressive encroachment onto its turf by arch-rivals Apple and Google, things are finally looking up for Microsoft. New CEO Satya Nadella has just presided over one of the most transformative years in the company’s history in 2014, initiating a new multi-platform, cloud-focused strategy as he bids to keep Microsoft relevant in the enterprise.

Last year’s progress leaves lots of room for optimism, but with numerous challenges looming, analysts warn Nadella will need to stick to his guns if he’s to keep the momentum going, even if it has to come at the sake of revenues and margins.

“Microsoft is recognizing that it’s struggling to maintain its historic dominance,” noted Jan Dawson of Jackdaw Research. “In some cases it’s going to have to sacrifice short-term revenue opportunities to build a long-term base of consumers, enterprises and developers.”

Multiple platforms, numerous opportunities

Former Microsoft CEO Steve Balmer once famously described Linux (and by extension, open-source) as a cancer on the technology industry. Under Nadella, though, Microsoft has done an about-face. Last November, the company revealed plans to open-source most of the full server-side .NET core stack and to broaden .NET to run on both Linux and Mac OS X. Analysts believe Microsoft will push the open source strategy further in 2015.

“The open-sourcing initiatives are clearly an attempt to reinforce its position with developers in particular,” said Dawson. “It’s absolutely necessary for its long-term success, but won’t necessarily please short-term investors.”

Open source software carries lower margins than proprietary software, but sticking with a Windows-centric walled garden strategy was not going to enable Microsoft to grow out of a nearly saturated market.

The new strategy is all about trading margins for revenue, said Rob Helm of Directions on Microsoft, a research and training firm. While products like Windows and Office 365 remain fairly lucrative now, he said the company is looking to expand into larger markets with better customer retention and bring in more income overall, even as the income per dollar of its revenue declines.

“Investors need to adjust their expectations on margins,” said Helm. “In some sense, lower margins means the strategy is working.”

Microsoft must most outside of its comfort zone to realize some significant opportunities, said Nucleus Research analyst Rebecca Wettemann. One those is customer relationship management, where Microsoft Dynamics has seen considerable growth despite having received little attention from either Balmer or Nadella. Another significant opportunity is Big Data and analytics, Wettemann believes. That’s because so much unstructured data already lives in products like Office and SharePoint.

“To truly maximize revenues from these market opportunities, Microsoft will have to make strategic decisions for those areas of the business and shift some focus away from Windows,” Wettemann said.

The last beachhead

While slowly warming to open source in some areas, Microsoft is keenly aware that it remains one of the biggest threats to the company’s strategy where it matters – in the data center. Many enterprises standardized on Windows two decades ago, and while their short-term commitments are unlikely to change, a growing number are casting their eyes on the new generation of cloud and software-led infrastructure, which is overwhelmingly open-source.

Connie Moore at research and events firm Digital Clarity Group believes Microsoft must defend Windows in the data center at all costs. “Microsoft in the data center is the last beachhead to protect,” she said. “If they can’t protect this turf, they not only lose the battle, they lose the war. Cloud is a huge threat because once systems move off-site, the IT organization is more open to switching from the incumbent operating system if it saves them money.”

To shore up Windows in the data center Microsoft may need to further embrace the open-source ethos. To date, most of its open-source moves in the data center have been somewhat half-hearted, and they’re unlikely to sway customers, argued Moore’s colleague Tim Walters of Digital Clarity Group.

“All of the open-sourced elements of Windows are on the server side, meaning that client side tools for building rich applications and user experiences remains unavailable,” said Walters. “That’s like the king announcing that consonants are now openly available but vowels remain a royal prerogative. You can’t make much poetry with that.” 

Container technology, as exemplified by tools like Docker, present both an opportunity and a problem. Containers offer speed and efficiency, but also the need for fewer operating system licenses. Scott Liewehr of Digital Clarity Group believes Microsoft can use the technology to its advantage, however. “More efficiency in the operating system means fewer licenses on one hand, but it also means more innovation and a broader appeal to developers in general, which helps Microsoft to continue its relevancy with developers,” he said.

Microsoft’s cloud services that run on Windows – including Azure and Office 365, “will keep Windows relevant in the data center,” said Helm. “Anything unique that Microsoft builds to run its own data centers will go into Windows to help it compete with open source in other people’s data centers.”

Mobile matters most

While defending its position in the data center, Microsoft is simultaneously going on the offensive in the mobile arena, an area where analysts agree the company must do everything it possibly can to succeed.

“The mobile market *is* the market – it’s where all the growth is, where an increasing proportion of total usage is, and where almost all the innovation is,” said Dawson, noting that its overall device base has shrunk rapidly with the rise of smartphones and tablets. “That doesn’t necessarily mean that Microsoft has to own either the devices or the operating systems, but it does need to be strongly present in mobile through apps, if nothing else.”

At least Nadella seems to recognize this, and it’s one of the areas where his new ‘multi-platform’ approach has been most apparent. “The company is now putting a lot more effort into supplying apps and cloud services for mobile devices on other vendors’ operating systems,” said Helm. “It’s also collecting patent royalties from other operating systems, and these look like more sustainable business.”

Whether these efforts are successful remains to be seen. Wettemann believes Microsoft still has an opportunity in mobile because it possesses the clearest position on both the consumer and business side of the mobile game, though its struggled to articulate the value of what its R&D and developer ecosystem could bring to bear.

“[Success] will require high-level strategic vision and tactical coordination across multiple Microsoft groups,” said Wettemann. “Mobile is important, from the consumer to the individual business users to the broader enterprise and Microsoft has all the technology pieces to tell the story.”

The inventor’s dilemma

Analysts agree that the biggest challenge Microsoft must face is that its expensive products are no longer an automatic first choice for many customers.

“It’s accustomed to being the default option for key categories such as PC operating systems, productivity suites, email servers and clients and so on, but it can no longer take that for granted,” said Dawson. “ It’s going to have to fight harder than ever to keep those customers and win new ones in the face of unprecedented competition.”

Part of the problem is the classic “innovator’s dilemma.” Mature products leave little room for innovation and invite low-cost competition from below, chipping away at market share. Digital Clarity Group’s Walters noted that while Office is still by far and away the most popular office productivity suite, it has changed relatively little in recent years.

“It’s astonishing – or insulting -how little progress has been made with Word and PowerPoint in, well, in my lifetime,” he said, referring to Microsoft’s penchant for making improvements aimed at power users while most people still can’t figure out how to delete an unwanted horizontal line.

Meanwhile, the competition is catching up, with open-source and freemium alternatives challenging Office’s most popular capabilities, said Digital Clarity Group’s Liewehr. “Microsoft, for now, is really lucky that the heel-nipping competitors haven’t yet been able to win over the power users, but licensing models will change over time and Microsoft products could start to be doled out only to power users while others get to choose less sophisticated alternatives,” Liewehr warned.

It’s all about the money

Analysts agree that Microsoft CEO Nadella recognizes where Microsoft’s biggest challenges lie. His biggest challenge will be fend off shareholder demands to maintain the company’s revenues and instead focus on doing whatever it takes to please customers.

In many cases, that means Nadella will have to bite the bullet and forsake some of the company’s revenues, argued Digital Clarity Group’s Moore. “Microsoft’s future rides on how cost-effective it can be to its customer base, which is showing less and less loyalty in light of saving money,” the analyst said. “Stop worrying so much about this or that feature and start talking to your customers about how much money they spend and where they must reduce costs.”

It will also mean taking more risks. Nadella will need to gamble with more experiments like last year’s acquisition of Minecraft and the company’s funding of pure research in technologies like quantum computing, said . “It needs to place several big bets in order to create – or at least find – markets that Microsoft can dominate,” said Walters of Digital Clarity Group. Such gambles are unlikely to please Microsoft’s shareholders, but they’re necessary if Nadella is to take the company forward.

“Satya Nadella should categorically, religiously, fanatically ignore any ‘investor demands,’” Walters said. “If Microsoft’s strategy for the next five to eight years is dictated by shareholder primacy, the company will be largely irrelevant within 10-15 years.”

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