FEBRUARY 22, 2001
SPECIAL REPORT
When Microsoft Gets Past This Rough Patch | Its new businesses could spark a new era of growth. So despite the PC slowdown and a tarnished image, don't count out Gates & Co.
| As the snapshot of a work in progress, Microsoft's Feb. 12 preview of Windows XP offered a richly textured glimpse into the new Colossus of Redmond. Oh, the glitz was showing, all right. Gates & Co. held the event at Seattle's new Jimi Hendrix museum, built by Microsoft co-founder Paul Allen. Company execs declared the new software upgrade the most important to Microsoft's operating system since Windows 95 -- and they may be right.
But the reception was lukewarm at best. Most analysts just yawned. In a way, the event underscored the changes that have occurred in the company in six short years -- and the challenges ahead.
Clearly, Microsoft isn't the same company it was back when the opening bars to the Rolling Stones' Start Me Up heralded the launch of Windows 95. Though the company is still an icon of American entrepreneurial success, Microsoft's public image has been tarnished by the government's antitrust case, persistent allegations by competitors of strong-arm tactics, pesky bugs that still infest many of its wares, and delayed product launches. It was once taken as gospel by many that Microsoft was unstoppable. Today, gleeful critics see it as a defanged pit bull, hopelessly tethered to yesterday's technology -- the personal computer.
STRONG TEETH. The truth is somewhere in between. Yes, Microsoft is going through a rough patch. It's in the midst of a difficult transition as the PC market matures. Its Windows PC software machine may no longer act as its growth engine. But with its lock on the desktop as well as the Internet browser, Microsoft still has plenty of teeth. And Windows sales have become an enviable cash cow for the company, generating funds for substantial investment in faster growing businesses, such as founder Bill Gates's vision for the next-generation Internet.
The goal for Microsoft -- made tougher by the slowing economy -- is to expand its new businesses fast enough to compensate for the slowdown in the 70% of its sales tightly linked to the PC. Michael Davey, technology analyst for Investec Ernst & Co., thinks it may take an additional 18 months for its new businesses to significantly drive revenue. "Then we'll start talking about it in terms of a high-growth software company that is not tied to the PC," he says.
It could be a long wait. For now, growth has all but stalled for the software giant. For the quarter ending in March, 2001, Wall Street expects the company to report earnings of 43 cents a share -- flat with the same quarter a year earlier. The company told analysts its earnings would be around $1.81 for its 2001 fiscal year ending in June, up from $1.71. That amounts to 7% growth -- not bad for a company with more than $25 billion in sales this year -- but anemic for Microsoft, which has averaged 43% earnings growth for the prior 10 years.
Its stock, which once practically stood for growth investing, fell 62% in 2000 as analysts began downgrading it because of worries about slowing PC sales and a shift to handheld and wireless devices. Although the stock bounced in January during a flight to quality, it's trading below $60, far from its high of $115 nearly a year ago. Wall Street's enthusiasm has clearly dampened. In a Feb. 8 report titled, "Wherefore Art Thou, Long-Term Growth," Merrill Lynch analyst Henry Blodget initiated coverage with a tepid "accumulate" rating for Microsoft, predicting long-term growth of about 9%.
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The company is counting on XP to help people get more out of their home computers
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Of course, Microsoft isn't the only victim of a slowing industry. In 2000, retail PC unit sales fell 1% in the U.S. -- in sharp contrast to the 24% growth posted in 1999, according to PC Data. Many analysts now believe the computers already out there in homes and businesses across the country pretty much have all the processing speed and memory users need. Peter Cohan, a consultant who advises companies on Internet strategies, says he hasn't upgraded his system since Windows 95. But that doesn't worry Microsoft. "Most home users do one or two things on their PC," says Shawn Sanford, group product manager at Microsoft for Windows XP. "They've barely scratched the true power of what the PC can do."
That's why Microsoft's new Windows XP is designed to make it easier for users to take advantage of digital video, photography, and music, which could serve as a catalyst for computer upgrades. "It will really unlock the potential of the PC," says Sanford.
"On the consumer side I think Windows XP could be a real winner," says Jeff Van Harte, a portfolio manager with Transamerica Premier Funds. "Maybe not the kind of winner that Windows 95 was, but still a significant step up from where Windows 98 or Windows 2000 is today."
For now, the weaker economic environment will temper the upgrade cycle. The slowdown in IT spending has been particularly hard on Microsoft's high-end sales of server software to the corporate market. Windows 2000 launched last year, but many IT departments haven't upgraded from Windows NT. "Now you would expect the upgrades to begin," says David Brady, a portfolio manager with Stein Roe Funds. "The only problem is the economy."
Microsoft said in its last quarterly report that it remains "guarded" about the economic outlook and its impact on technology spending. "It's a nightmare for Microsoft right now," says James Governor, an analyst with research firm Illuminata. "There's no need for people to upgrade their desktop operating systems and application software. If we were in an economic expansion, they might do the upgrades."
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Its Web sites ranked No. 2 to AOL in traffic rankings
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Truth is, the clouds on the economic horizon have overshadowed a brighter picture: Microsoft is making headway with many of its new businesses after some fits and starts. Windows 2000, at about one-third the price of competitors' offerings and with improved stability, is making inroads with corporate IT buyers. "There is room for them to start moving upstream in the server market," says Van Harte.
Microsoft's consumer divisions are also growing nicely. Its family of Web sites just notched above Yahoo! for the No. 2 spot (behind America Online) in Media Metrix' January traffic rankings. Handheld devices made by Compaq and Hewlett-Packard and based on its Windows CE operating system are finally catching on with consumers after years of badly trailing Palm handhelds. In the rabid gaming community, anticipation is building for the launch of Xbox, Microsoft's new platform.
Granted, Microsoft faces much stiffer competition in all these new businesses than it does in desktop software. In high-end software for computer servers, Microsoft runs up against packages sold by its nemesis Sun Microsystems and Hewlett-Packard, and increasingly the free Linux operating system. America Online dominates the Internet, and Palm and Handspring lead in handheld devices. But Microsoft clearly isn't afraid of bare-knuckled competition and has the financial muscle to keep at it. "People always underestimate Microsoft," says Cohan. "They start off slowly, but eventually they get it."
NOT FAST ENOUGH Maybe so, but with all that competition, these new businesses, while growing fast, aren't growing fast enough to make up for the slowdown in the PC market. Together, they only account for about 30% of Microsoft's revenues, while the remaining 70% is tied to Windows.
"I see this period right now as an adjustment where the 30% of the business that's devoted to new opportunities is just taking off and the 70% that's slowing down is still good," says Investec Ernst's Davey. "But the 30% hasn't come up fast enough to get their growth engine going." Still, he thinks that with nearly $30 billion in cash and equivalents, and operating margins near 50%, it's up to the task. "Any kind of high-growth opportunity they're going to go after," he says. "I think they're going to be the winners by sheer force, sheer scale, and financial muscle."
Longer term, the key to Microsoft's regaining its dominance among technology companies is what it calls the "Next Generation Internet." Announced last June and dubbed ".Net," the strategy is led by founder and Chairman Gates himself, who assumed the title of chief software architect more than a year ago. .Net is a software platform that will enable data to flow seamlessly across the Web to the PC and to all sorts of other devices. One example of how it should eventually work: When you buy an airline ticket on the Web for a business trip, it would simultaneously be paid for out of your travel budget, entered in your calendar, and the details e-mailed to your co-workers.
LEAP OF FAITH Although this kind of service is still years away and will take a leap of faith by consumers -- many of whom aren't willing to give Microsoft much credit anymore -- developers and some industry analysts are intrigued about its prospects. When Keith Teare, CEO of Internet keyword company RealNames, which is 20%-owned by Microsoft, learned about .Net, he set up a page on his corporate intranet and asked every employee to read it. "I was really excited," he says. "It was very advanced thinking, and you could feel the hand of Bill Gates."
Microsoft isn't the only software company thinking along these lines, but its announcement was months ahead of similar visions articulated by Sun and Oracle. "They are definitely going in the right direction, and they were early to the party," says John Robb, president of Gomez Advisers, an Internet quality-measurement service. The importance of the .Net strategy was made clear when Microsoft named Rick Belluzzo, who formerly led Microsoft's consumer and Internet businesses, as the company's president and chief operating officer on Feb. 14.
Another plus for .Net: It makes the desktop central again as the software pulls information from the Web and users become more reliant on having a powerful machine to house the data. Gomez' Robb thinks .Net will lead to what he calls a "desktop renaissance" that would put Microsoft again in the sweet spot of the computing world.
Of course, using its desktop dominance as a way to gain primacy on the Internet has already gotten the company into hot water with the Justice Dept. Prospects looked especially bleak when U.S. District Court Judge Thomas Penfield Jackson last spring ordered the company to be broken in two. But ultimately, few analysts expect that to happen. On Feb. 26, Microsoft will go before the District of Columbia Court of Appeals in hopes of having the decision overturned. Many observers like its chances. "I can't see the government going after Microsoft in a down economy," says Robb. "It was found guilty, and there will be some sort of remedy. But breaking it up seems very unlikely to me at this point."
If Microsoft emerges whole from the bitter court fight, what it may need most is a strong public-relations push. On the defensive so much in the past few years, Microsoft hasn't devoted much marketing to its strong central brand, which has allowed a lot of the criticisms to stick, says Michael Dunn, president and CEO of San Francisco marketing firm Prophet Brand Strategy. "Given their position, they always will have someone screaming at them," says Dunn. "They need to build the brand in a way that allows listeners to be less receptive to all that screaming."
A little polishing could go a long way in repairing Microsoft's battered image -- as long as the company can simultaneously expand its non-PC businesses fast enough to please the Street. Microsoft may never achieve the glory it enjoyed when the PC was central to computing, and it had a lock on the operating system. "It's very difficult for a company that dominated one wave of growth to go and dominate the next wave," says Erick Maronack, research director at investment firm Newbridge Partners. But Microsoft is still a software-building machine with tremendous financial resources. It's far too early to write it off as a victim of a shifting paradigm.
By Amey Stone in New York
Edited by Douglas Harbrecht
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Copyright 2001 , by The McGraw-Hill Companies Inc. All rights reserved.
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