High-flying glory days past, Microsoft builds for future

Microsoft's mettle has been tested before, but in the next few years the company will face what are arguably its toughest challenges yet.

Microsoft's mettle has been tested before, but in the next few years the company will face what are arguably its toughest challenges yet.

These include:

  • Finding growth opportunities to offset the maturing of its operating system and Office businesses.

  • Winning back the trust of customers fed up with security shortcomings and what they see as inflexible licensing schemes.

  • Fending off stronger open source competitors as the company creates its next-generation platform, code-named Longhorn.

The world has changed since Microsoft went public in 1986. Gone are the days of 30% to 50% annual growth rates while chewing up competitors. Over the past three years, the company has averaged 11.5% revenue growth, and its stock price has only gone up 1% over the the past 52 weeks.

The company even issued its first-ever dividend to stockholders last year, a sure sign it is transforming from high-flying tech Titan to blue chip.

The transformation was reconfirmed at the company's annual financial analyst confab in July where annual new product demonstrations were replaced by staid assurances of "boosting the business value of software" and talk of revenue dips in fiscal 2004.

"The company is maturing and in general [CEO Steve] Ballmer and [Bill] Gates are a lot more careful," says David Smith, a vice president at Gartner. "They maintain an edge, but they have softened it a bit."

But Microsoft isn't softening as a technology powerhouse. It has $51 billion in cash and a $6.9 billion research-and-development budget focused on everything from servers to the XBox game system. Its client operating system and Office suite each own more than 93% of their markets; both maintained sky-high operating margins in the company's 2003 fiscal year, ended in June; and together they supplied 62% of revenue and 98% of profits.

Such numbers make old habits die hard, so not surprisingly, the company's growth plans are familiar. This was evidenced by a reorganization late last year that created the Windows Core Operating System Division, which will focus on development of the client and server operating system.

Microsoft is looking to capitalize on its desktop dominance and emerging server empire, which are core to a new generation of products under the Longhorn banner. The division will meld the contents of Microsoft's software portfolio, integrate it with other platforms on the back of XML, and, according to a recent report by Goldman Sachs, potentially initiate the largest upgrade cycle in the company's history.

"The simple summary is that we believe that we're just at the beginning of what we can do with software," Chairman and Chief Software Architect Bill Gates said in October.

Feeding the cash cows

Although Longhorn is the future, the technology is not expected to be generally available for at least two more years. In the interim, Microsoft must nurture its client operating system, its server operating system and Office businesses, the only three of Microsoft's seven business units turning a profit.

Revenue growth in its client operating system and Office businesses has been positive but anemic over the past couple of years, but the company projects single-digit declines for both business units in 2004 compared with 2003. Meanwhile, the company's Windows Server business might be hurtling toward the same crossroads.

On the client operating system side, the plan is to move existing users to newer systems and find new markets for its operating system. There are 350 million PCs running Windows NT or 9x that Microsoft wants to convert to Windows XP, a goal laid out by Jim Allchin, group vice president of the platforms group, in July. Many of those converts might be forced because Microsoft has ended or is about to end support for those legacy clients.

The company also hopes to put an operating system in other types of computers, including handhelds, tablet PCs and smart devices, and create multi-PC networked households that use the Media Center operating system as a hub, according to Allchin.

On the server operating system side, Microsoft owns almost 55% of the market, though isn't likely to grab more than another 10% overall, says Al Gillen, an analyst with IDC. He estimates that the overall server operating system market will show a compounded annual growth rate of 9.1% over the next five years, identical to that of 1997-2002.

"That is the sign of a maturing market," Gillen says.

Lately, SQL Server and Exchange have carried the load in Microsoft's Server and Tools business unit with double-digit revenue gains quarter by quarter. Microsoft, which increased head count in its server sales force by 12% last year, is building on that strength with Exchange 2003 and the planned release next year of SQL Server Yukon and Visual Studio. Net Whidbey development tools.

Longing for Longhorn

But the focus for 2004 is further development of Longhorn, Microsoft's "big bet on galvanizing the next big breakthrough - even bigger, perhaps, than the first-generation Windows release," according to a memo Ballmer sent to employees in June. The statement was backed up in October with the release of beta code more than two years before product shipment, the earliest Microsoft has ever let independent developers evaluate new code.

Longhorn's first incarnation is the client operating system, due in 2006, but Longhorn includes servers, development tools, Office and even MSN, the company's online property. Longhorn is designed not only to blur the lines between applications and data on desktops, servers and the Internet but eliminate them and make the systems look like one.

Longhorn has several key elements that support that effort, including Avalon, a presentation system for new applications; Indigo, an XML-based integration bus for clients and servers; WinFS, a platform-wide file system; and WinFX , a new set of APIs.

Those underpinnings grew out of Microsoft Research and were fueled by Microsoft's massive R&D spending, which topped $23 billion over the past five years.

The desire to create the Longhorn "fat client" is a direct attack on rivals such as IBM and Sun that want to break Microsoft's desktop stranglehold using Java Application Servers, portal interfaces and browser-based clients.

Longhorn also is intended to thwart Linux and open source. Microsoft wants to fight the upstarts with a collection of integrated software as opposed to individual features and price on the client or server.

"If Microsoft pulls off Longhorn the rewards are potentially significant, but that's a big 'if,' " says Neil Macehiter, research director with Ovum.

Rivals sense the vulnerability

A recent SG Cowen survey showed that of respondents planning to increase their use of Linux in the next one or two years, more than 70% of current Linux sites planned to increase reliance on it and 29% planned to deploy it for the first time.

IBM has dedicated $1 billion to Linux development, Novell bought SuSe Linux for $210 million, Sun recently released its Java Desktop System built on Linux, and Oracle earmarked $150 million to sway independent software vendors to develop Linux-based Oracle applications.

"If Novell can figure out how to glue its services on to Linux they can compete seriously with Microsoft," says John Enck, an analyst with Gartner. "If you get eDirectory rather than OpenLDAP, that is something real."

But Longhorn's success hinges on Microsoft polishing up its reputation.

"Unless Microsoft solves its image problem, the technology doesn't matter," says Rob Enderle, president of the Enderle Group. "Microsoft is perceived as a company you cannot trust, and once you have that foundation everything flows in that direction."

The European Union's antitrust case against Microsoft is reviving the monopoly tag and fueling open source software in Europe and Asia. That lawsuit could cost Microsoft $3 billion on top of $1 billion it paid in legal settlements in fiscal 2003.

Licensing and security flaps of Microsoft's own creation are fueling customer angst and resentment.

The company's controversial 2-year-old Licensing 6.0 plan and its companion Software Assurance annuity-licensing program has only attracted 30% of the user base, according to The Yankee Group. Designed to eliminate confusing licensing options, the program instead raised fears among customers about steep price increases.

Of the 70% not signed up, 42% have Licensing 5.0 agreements signed two years ago to initially avoid 6.0. Those 5.0 contracts now are coming up for renewal and Microsoft needs converts to new contracts. The company derives nearly a third of its overall revenue, which totaled $32 billion in its 2003 fiscal year, from money paid upfront for licensing and other products and services that are delivered at a later date - so-called unearned revenue.

"If Microsoft can get 20% to 25% [of those whose contracts are up for renewal] to sign up for Software Assurance that would provide a good impact on revenue," says Laura DiDio, an analyst with The Yankee Group.

Trials and tribulations

Microsoft faces a number of challenges with its major revenue-producing products, and with keeping its corporate customers secure, happy and away from Linux. Here is a look at some of the issues going forward.
ChallengesStrategiesThreats
Microsoft must find new ways to generate new customers, upgrades. Longhorn is the bet, but think devices, devices, devices — handhelds, PDAs, tablets, GPS and scanners. Linux/Open source. Microsoft feels heat in Europe and with new businesses. Gartner says Windows could lose 5% to 10% market share to alternative operating systems. The bottom line is David only nibbles on Goliath. here.
Approaching ceiling in server operating system market.Integration of Windows server and server applications. Exchange and SQL Server are leading growth, SharePoint and Jupiter are promising.Linux/Open source again, but a bigger threat
Management of platform.Dynamic Systems Initiative is a long-term, ill-defined bet to manage Windows from the application level on up.IBM, HP, Sun and others are riding on the utility computing bandwagon.
Security bugs gnawing at customer resolve.Improve patching tools and tune system defaults. Security is said to be job No.1, but the results are sketchy.Slow progress means customers continue to beat up Microsoft on this issue, or worse, quit fighting and go somewhere else.
Licensing 6.0 program still in disarray.Convert customers whose old contracts are due to expire. Attraction is additional services and support.Licensing could be final straw for frustrated users.

However, early returns are not promising, as unearned revenue was off $768 million between June 30 and Sept. 30, 2003. Microsoft now is trying to entice holdouts with new support and services added to Software Assurance, since there won't be many upgrades.

Microsoft's effort to win licensing converts has not been helped by security vulnerabilities, including the Blaster worm, whose effect was so bad that CFO John Connors cited it during the October earnings announcement as one reason the company was unable to close some sales.

Over the past few years, the company has trained 11,000 of its developers in writing secure code. Now it is overhauling its patch management tools and resetting defaults in its software to err on the side of security. It has invested $100 million into its Trustworthy Computing initiative in the Windows division to develop its Next Generation Secure Computing Base, a Longhorn technology that combines hardware and software to secure the operating system.

Integrate, interoperate

Addressing such problems is crucial for Microsoft because large customers are tripping on security and licensing issues at a time when they want to better integrate Windows into enterprise infrastructures.

"Microsoft can't take over the world although they wish they could," says Fred Wettling, infrastructure architect for global engineering firm Bechtel. "Microsoft's evolution must help move the industry closer to product interoperability. They need to drive toward more openness."

Microsoft is relying on XML as the answer. Over the past two years, the company has worked with IBM to develop and promote Web services standards. Microsoft has opened more of its source code to partners, governments and universities. The company recently said it would offer royalty-free the XML schemas in Office, which is code that describes how a document is formatted.

"Is what they're doing benevolent?" Wettling asks. "Probably not. But it is part of an evolution that on some level will help end users."

Next week: Microsoft looks for new revenue opportunities.

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