Microsoft's Remembrance of Returns Past


Throughout the 1990s, few tech companies could match the sustained growth and regular stock gains that Microsoft delivered: As the software king rode the explosion in demand for PCs, its revenues rose an average 36% a year for the decade -- and its stock climbed from a split-adjusted 60 cents to $59.19. The New Millennium has offered a startling contrast. Microsoft's annual revenue increases have yet to top 16%. And since January 1, 2000, its stock has fallen by more than half, to around $26, as of June 23.

It's true that Microsoft (MSFT) remains a safe harbor in an ocean of tech companies whose performance is uncertain: Its Windows and Office products add $1 billion a month to its cash horde, which now stands at $46 billion. Yet it also seems obvious that jump-starting growth is no longer as easy for Microsoft as introducing a product, spending a fortune on marketing -- and watching sales take off. With its sales approaching $32 billion a year, it'll be hard to regain that magic. As a maturing company in a suddenly slow-growth industry, Microsoft will have to work harder than ever to rescue its stock from lackluster performance.

One indication of the less-friendly world in which Microsoft finds itself is the cool reception so far for Web-services initiatives, including .Net (pronounced dot-Net). Microsoft's idea was to get a leg up on rivals for corporate business. And sure enough, it ran to an early lead three years ago, when it was the first major player to lay out a vision for automating mundane tasks by letting disparate and aging computer systems share data via the Web. But .Net, like every other company's Web-services initiative, has taken hold slowly -- and the delayed surge in demand has let competitors such as IBM (IBM) catch up.

BEYOND THE CORE. Some potential .Net customers have worried about the security of key data transmitted over the Web. Yet that fear may be secondary to the slow economy, which has been particularly deadly for tech companies. According to market-research firm IDC, worldwide tech spending will climb an anemic 2.3% this year -- and that will be the first gain since 2000.

IDC expects PC unit sales to climb 6.3% this year after inching up only 1.5% in 2002 -- vs. a 24% increase as recently as 1999. "There has been [corporate] resistance to spending money on anything because of [economic] uncertainty," says Microsoft CFO John Connors, though he adds: "The mood is improving."

The sluggish economy has forced Microsoft to expand beyond its core markets in search of areas that don't depend on the maturing PC business. Fortunately for the software giant, it has the money to help force the issue by finding new niches for its twin monopolies -- its Windows operating system and its Office suite of word-processing and spreadsheet software -- and thus try to rocket into new markets while its cash-strapped competitors hang back.

THINKING SMALL. Take Office. Many corporate customers feel they can make do with aging versions that Microsoft launched in 2000, or even 1997, since those old editions still do everything lots of companies need. So Microsoft's strategy is to segment Office to create additional niches for it. When the newest upgrades hit stores this fall, a specialized version for small business will be available. And Microsoft is ginning up new products under the Office brand in such areas as "business intelligence" -- software that extracts data from various computer systems in a company, then analyzes it and helps execs produce reports to guide their decisions.

Microsoft is looking for growth in new markets, too, such as run-the-business applications for small and midsize businesses. This has been a fragmented area, with scads of companies offering software to handle everything from customer-relationship management to human resources to accounting. But because it has been so hard to achieve economies of scale, the software companies that cater to big business, such as SAP (SAP) and Siebel Systems (SEBL), have largely stayed away.

Microsoft has taken the plunge, investing $2.5 billion over the past two years to acquire two of the biggest players in the market, Great Plains and Navision. Sales from the new Microsoft Business Solutions division are expected to top $500 million in the fiscal year that ends June 30. And Redmond is betting that the business will add $10 billion a year to its top line by the end of the decade.

BATTLE FOR THE HOME. Microsoft is taking the same sort of big-bet approach to video gaming. It has sold nearly 9 million of its Xbox consoles since it launched in November, 2001. That puts it slightly ahead of Nintendo's GameCube in worldwide sales, making it No. 2 behind Sony's PlayStation 2. How did Microsoft pass Nintendo (NTDOY)? It lavished $2 billion on Xbox marketing, money that most tech and consumer electronics companies couldn't match.

Microsoft lost nearly $715 million on Xbox in the first nine months of its current fiscal year. But its cash cushion has allowed the Colossus of Redmond to absorb that pain as it gambles on its long-term strategy of competing with Sony (SNE) to dominate the digital home.

Microsoft's cash horde has allowed it to do one other thing -- erase questions raised by ongoing litigation. The company has settled its long-running antitrust case with the federal government and all but one state, Massachusetts. It has also settled class actions filed in various states across the country.

OPEN THREAT. And it recently resolved a dispute with AOL Time Warner (AOL), which claimed that Microsoft had illegally leveraged its Windows operating-system monopoly to crush Netscape Communications, which AOL bought in 1999. Microsoft has paid more than $2 billion to put those disputes behind it. And while it still faces a handful of other cases, only two pose significant financial and operational threats: The antitrust probe by the European Union and a private antitrust case brought by Sun Microsystems (SUNW).

In fact, the biggest threat Microsoft now faces is in the marketplace. The open-source Linux operating system is seeping into corporate computing, and Microsoft has been unable to slow its spread. According to IDC, Linux now has a 13.7% share of the $50.9 billion market for servers, vs. Microsoft's 59.9% -- and the Linux chunk should climb to 25.2% by 2006.

So far, Linux' gains have largely come from users of the Unix operating system, who are opting for the cheaper hardware that Linux runs on but don't want to switch to Windows. That's an opportunity lost for Microsoft. Its latest tack is to pitch the rich Windows ecosystem, for which developers have created thousands of applications, as superior to Linux, for which far fewer applications have been written. "We have to do a great job describing why our development platform is better," Connors says.

GOOD OLD DAYS. Microsoft almost certainly will continue to outrun its software peers -- no surprise for a company that so dominates its business. Yet for now, the red-hot growth of the 1990s is only a memory. Analysts expect earnings in the fiscal year that ends June 30 to climb 12%, to $11.3 billion, on sales of $32 billion, also a 12% increase. During its last conference call with analysts, in April, Microsoft was cautious about its projections for fiscal 2004. Indeed, analysts expect only 6% sales growth for that year -- and 3% earning growth.

That could be enough to spark a 20% increase in its stock price over the next year, according to consensus analyst projections. But Microsoft's bets on Xbox, small-business software, and even .Net need to prove their value before the stock can regain its old exuberance. By Jay Greene in Seattle, with Steve Hamm in New York


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