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Volume 17, Number 20 -- May 19, 2008

Mad Dog 21/21: Saying No No No

Published: May 19, 2008

by Hesh Wiener

Nancy Reagan made quite a point of saying, "Just say no." Amy Winehouse sang that she said, "No, no, no." And "No" is what Microsoft seems to be hearing a lot of lately, too. The software giant has heard it from Yahoo, which it tried to acquire, and it heard it from a lot of prospective PC customers, to whom it wants to sell Vista rather than Windows XP. It's not surprising when Microsoft must fight to reach its goals. But this time its struggle seems a bit different because there's a cultural change underway in the computer industry.

Microsoft's situation was sketched out in its quarterly report for the third fiscal quarter, which, because the company's fiscal year starts on July 1, covered this year's first calendar quarter. Microsoft said it was on track for a year with double-digit growth in revenue and earnings per share. But it also said that the most recent quarter's profits were down. One reason is that the European Commission hit Microsoft with a $1.4 billion fine. Another is that some of the profit the company reported in the same quarter last year was due to delayed recognition of profits from income achieved in prior quarters that distorted last year's results. In other words, Microsoft said it did better than its raw results suggest. So far, then, it's pretty good news.

But that's not the whole story, and the rest of it is the part that has the company and its shareholders thinking hard about what the future might have in store. For instance, even though Web advertising has been rising for many kinds of Web sites, Microsoft managed to lose money in its online services that carry ads, as it has done with grim consistency ever since it got into the segment.

Usually, growth in other segments--PC operating systems, server software, and productivity applications (the operating unit Microsoft calls its Business Division)--is so good nobody cares if Microsoft is putting more money into MSN and Hotmail and other online businesses than it takes out. But this time around, operating system sales in the PC market were off (and Office sales dipped slightly) while growth in server software revenue was not enough to offset the downturn on the client end of the wire.

Nancy Reagan: When a popular and influential First Lady, she told Americans offered drugs to Just Say No.

Operating income from PC operating systems dropped 26 percent from $4.2 billion to $3.1 billion. Operating income from Office slid nearly 10 percent, from $3.4 billion to $3.1 billion. Online services lost $228 million, bringing losses for the year to $745 million, a significantly larger loss than the company reported for this segment last year. Not all the news was bad news. Microsoft said its Xbox360 is in the black and is headed for its first profitable year. And the company's server software group seems to be increasing its already healthy pace of growth.

But the PC side of Microsoft's software business is two and a half times as big as the server side. And the online part of Microsoft, small in comparison to the software product segments, is by its very nature quite visible. Compared to its size compared to other segments, it appears to be disproportionately important to Microsoft's top management.

When the online services group loses a dollar for every two or three it takes in, Microsoft doesn't try to minimize its discontent. The company takes everything it does very seriously. So, while its PR crew puts the best face possible on things, there's no question Microsoft is quite frustrated by its inability to make big money online the way Google, eBay, Amazon, and of course Yahoo do.

What Microsoft decided to do was to buy the expertise it was not able to build: It offered around $50 billion to the shareholders of Yahoo. But to Microsoft's dismay (and probably surprise), Yahoo was taking the kind of advice famously offered by former First Lady Nancy Reagan during the 1980s: It just said, "No." Actually, Yahoo's response was not that impolite; it said it was happy with the idea but wanted a few billion more than Microsoft offered.

Microsoft could have tried for a hostile takeover rather than the friendly one it had sought and it with the right tactics it might succeed. But whether the Yahoo it would end up with at the end of the process is the Yahoo it seemed to want is an open question, and in the end, Microsoft decided not to pursue Yahoo further.

Everyone in the computer industry knows that big mergers are problematic. Hewlett-Packard was able to integrate Compaq, and that makes it one of the few big merger stories in computing with a happy ending. Now, HP is going to absorb services giant Electronic Data Systems, and the odds are it will do this successfully, too. (See HP More Than Doubles Services Biz with EDS Acquisition for more on that deal.)

A more typical outcome, not bad but far from perfect, arose when IBM ate Lotus Software. Lotus is still an important part of IBM's Software Group, but any dreams the company might have had of splitting the desktop software market or the collaboration server market with Microsoft have long since faded away. IBM's Lotus products have done well with what evolved into its Domino server, but got there by a tortuous route. Its Lotus Symphony desktop productivity suite is now part of the open source world, a cousin of OpenOffice, which is controlled by Sun Microsystems. Even though it's free it has not remotely approached its market penetration potential, because IBM never gave it the kind of promotional backing the product requires.

Amy Winehouse: This talented and eccentric singer/songwriter has made a public posture and a hit tune out of her rejection of rehabilitation.

IBM would be wise to get Nancy Reagan to promote Symphony and maybe even a more comprehensive offering that packages a tame desktop Linux distro, a Web browser, and a collection of productivity software with code that makes integration with IBM cloud computing simple and reliable. The slogan voiced by Mrs. Reagan to business and personal computer users on behalf of IBM could be "Just Say They Know."

Observers who think the IBM corporate culture is just too old fashioned to compete with Google and the other firms talking a big Web 2.0 game might want to reflect on the results Microsoft has gotten to date. Microsoft is a lot more youthful than IBM, so maybe the answer isn't youth at all but something else, something Microsoft simply doesn't understand as well as Google does, but which other companies, even IBM, might well figure out that it's youthful and vigorous users, not youthful and vigorous vendors, who constitute the market to be served. All Microsoft and IBM seen to need, in fact, is to find a way to use a little more finesse and a little less brute force.

Nevertheless, as bad and embarrassing as Microsoft's Internet problems may be, they are not as dangerous as the possibility that Microsoft's desktop deficit is not a brief dip but instead showing the first signs that this business is amidst a tectonic movement that will tip its plate downward.

Even a quick look at Microsoft's financial results shows that its gross profit margin on Windows is in the vicinity of 75 percent and that the comparable figure for Office family products is something north of 65 percent. Sure, Microsoft has other costs that burden these segments and bring net profits down from the stratosphere. But basically Microsoft has two segments that churn out stunning profits, money that the company has used to seed its ventures into other product areas.

If the third quarter dip in these segments isn't just a brief fluctuation, if it is the beginning of a new trend in user spending, Microsoft may have to change quite a bit. Consequently, when the numbers were published and some of Microsoft's critics said the dip was in large measure due to poor reception for Vista, Microsoft was probably relieved. Just about every time Microsoft releases a new operating system, it gets some brickbats but after a while (and after a service pack or two), everyone seems to get used to the new software and then quite a few people get to liking it. You know this is the case because when the next Microsoft operating system hits the streets, chances are there will be similar gripes, only this time they will denigrate the newest software and remind everyone how much nicer the old package is.

As it turns out, some of Microsoft's critics made good points. Vista is picky about drivers and does not allow everyone to keep all their old printers, scanners, and other peripherals around. Some software that works well under XP does not work properly with Vista, at least until some patches are released for the ISV package, Vista, or both. Also, there is no question that Vista makes computers work harder, particularly if a user wants the snazziest graphical interface, so users who bought Vista early in the cycle could well have ended up with systems that perform poorly. But now that Vista Service Pack 1 is out, hardware is faster and cheaper, and everyone has had more experience, the old problems ought to fade away, at least as far as consumer and home office buyers are concerned. Things may look different to corporate buyers.

Microsoft keeps extending the life of XP for use on new PCs used in corporate settings. If this continues, it might turn out that corporate customers will be allowed to stick with XP until the successor to Vista, which is likely to be rolled out in 2009 or 2010, becomes available.

The corporate computer support chorus would then have as its theme song a twist on Any Winehouse's hit song Rehab: They tried to make me go to Vista, and I said no, no, no.

The Debut: Microsoft CEO Steve Ballmer (on the right) and a couple other corporate bigwigs helped kick off Vista, which has not yet done well in the hearts and minds department.

The main reason for this may not be any of the gripes that arose in the consumer market. The big corporate customers wanted an answer to very simple question: What is the advantage of Vista over XP for corporate users? Microsoft might not have had a very good answer, except for users whose work involves the use of videos and other multimedia content. And those users sometimes prefer Macs to Windows machines anyway. It more polite to put this another way, which is to say that the computers on corporate desktops running XP are working very well and, with business conditions a bit shaky, corporate IT personnel are not too keen on pushing for a hardware and software upgrade that has as its main benefit a clock reset on PC warranties.

In better times, these same enterprise computer buyers might well have gone with the Microsoft flow. But the jump from XP to Vista is a big one and in general will mean not only replacing PCs with more muscular models but also upgrading many displays. Moreover, because Vista is so different from XP, migration will be more difficult than the jump from Windows 2000 to XP, which in many ways was more like a installing a Service Pack than moving to a whole new environment.

In mid-May, users were reminded that operating system upgrades sometimes go awry. Microsoft released Service Pack 3 for Windows XP and the initial distributions were blemished. While there is no doubt Microsoft will fix any bugs in SP3, shops with a lot of XP machines and particularly those where the PC configurations differ don't have an easy time addressing problems that are brand new. They have enough trouble coping with old, often familiar software flaws and quirks. So some corporate computing departments will defer (or avoid) installing the patch, at least until it seems pretty clear that it is available in a bug-free version. Another factor that could slow the adoption of SP3 is the fact that many corporate users are happy with XP just the way it is right now. Conditions could change if some code only available in SP3 became very desirable, but at the moment that does not appear to be the case.

In a climate where Service Packs make corporate IT groups edgy, operating system migrations have to pack a lot of rewards and a relatively modest heap of risks to be attractive. So far, Vista just doesn't look that good to enough corporate customers, but XP was a slow starter in the same market segment, too, and only took off after its first Service Pack cured the most prominent problems that were caused by the initial release.

Nonetheless, there is one really big difference between the good old days when XP came out and today's Vista era: cloud computing. Productivity applications, which are so important to Microsoft that it puts them in their own corporate group (and their own financial reporting segment) are not only available as free downloads, but are also available on the Internet to use for free or, under schemes that are more private, for a modest fee. Google Apps, one of the top offerings, costs $50 per year per user for a collection of applications that might include all the software a business user needs.

Cloud applications are features of online services that can also include extensive collaboration features. In effect, Web-based word processors, spreadsheets, presentation writers and the other applications that are part of what is called cloud computing come with a free ersatz Exchange Domino server. All Web-based applications require in the way of a client is a machine with a more-or-less current Web browser. The computer doesn't even have to be a Windows machine; it can be a Linux box or a Mac. But the user absolutely needs connectivity, and the higher the bandwidth the better. Google Apps and competing cloud systems offer fee-paying users of their services a growing number of offline options but the offline functionality is a secondary aspect of the Google Apps concept as it is currently presented.

If Microsoft wants to compete with Office or IBM with Symphony, making the online technology an extension of local functionality, more or less the way the two companies now offer their client and server technologies to individual companies, is an alternative that might have more appeal in some circles. But as it stands, neither the Google-style approach nor the Microsoft-style approach have been a killer product. So maybe Microsoft doesn't have to worry too much about Google Apps yet, but that doesn't let it off the hook.

Microsoft may be having a recurring nightmare that centers on a mix of local and cloud applications from a company that has in the past demonstrated superior insight into what the public wants. That company might be Apple. It hasn't always succeeded but its winners--the Mac, the iPod, and the iPhone--have influenced the information culture out of all proportion to the revenue they have produced. IBM, in its heyday, did the ideas stuff and the money stuff better than anyone, and as things stand, it might have as good a chance of coming up with the next big thing as Microsoft, although it would be stunning if it tuned out to match Apple's creativity.

And then there's the final possibility, one that has cropped up time and again when computing seemed to be at a crossroads or, worse, pretty much lost. Some new idea has arrived seemingly out of nowhere and captures everyone's imagination. That's how we got the World Wide Web and companies like Netscape. It's how we got open and free software through groups like the gang behind Linux. And it might be how we get a family of technologies that create a new fusion of local and cloud computing.

And in America, the companies at the top of the information technology business are hoping that the next big thing is local and particularly that it doesn't have as its motto, "Just Say Ni Hao, Ni Hao, Ni Hao."




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