In late April, two weeks before Microsoft announced the biggest batch of layoffs in its history, the company experienced a lesser-noticed milestone that may have signaled even more about the state of its business.
For the first time in Microsoft’s history, revenue in its Server & Tools division — which makes behind-the-scenes corporate systems and programming software — surpassed revenue in its Windows Client division, which makes the PC operating system responsible for much of the company’s past success.
To be sure, Windows remains hugely profitable, bringing in more than half of Microsoft’s $4.4 billion in quarterly operating income. And the situation was caused in part by the economy’s impact on PC sales. The server division benefits from long-term licensing deals with corporations, a more reliable revenue stream.
But the simple fact was that the company’s flagship division suddenly found itself in third place in revenue — behind not only the server group but also the No. 1 revenue generator for the quarter, the Microsoft Business Division, which makes Office and related products.
The situation demonstrates the changes being forced upon Microsoft’s business, and helps explain Wall Street’s skepticism about the company’s ability to keep up. The company’s share price has been stuck below $30 for much of the past decade, most recently hovering around $20 a share.
Beyond the current economic turmoil, Microsoft’s biggest products face long-term threats from the software industry’s shift toward internet services and online advertising. At the same time, rivals are giving Microsoft’s core Windows business new competition.
“If you were to sum (the threat) up in one word, it’s basically Google,” said Sid Parakh, an analyst who covers Microsoft for the McAdams Wright Ragen brokerage firm in Seattle.
Of course, it’s not Google alone, Parakh pointed out. However, the Mountain View, Calif., search giant happens to be the most prominent and representative example of the competition nibbling at Microsoft’s business.
In the area of online advertising, for example, Google posted more than $5.3 billion in revenue last quarter, thanks to the strength and widespread usage of its internet search engine. Microsoft’s overall advertising revenue was about 10 percent of that, $521 million.
In assessing Microsoft’s business in the short run, analysts will be watching closely to see if large companies renew the long-term licensing deals that fuel sales of Microsoft’s traditional software. Many of those enterprise agreements are coming up for renewal now, and the stakes are high because of the way the deals are structured.
“That doesn’t just affect the current quarter, that affects the next two or three years,” said Matt Rosoff, an analyst at Kirkland-based research firm Directions on Microsoft.
Another big question is cloud computing, the industry’s phrase for programs and storage delivered over the internet from remote data centers to computers and devices.
Microsoft is developing its own cloud computing system, Windows Azure, to compete with Google, Amazon.com and others. Microsoft has been stressing the benefits of software plus services — a mix of online and desktop computing. But over time, a shift toward “the cloud” could diminish the importance of the highly profitable Windows franchise.
“If the computing factor does move into the cloud, then do you really need a very powerful OS on the desktop? Probably not,” Parakh said. “If that is a trend that catches on, then clearly the operating system business is under threat.”
For now, Microsoft’s strong revenue from software licensing more than makes up for its competitive weakness online. It also insulates the company from the current turmoil in online advertising. However, unless it can improve its position, the company could find itself in a tough spot if the industry continues to shift toward advertising as a way of funding software.
And there’s no assurance that the Windows business will always be so strong.
“Windows has clearly become the corporate desktop standard, but at the same point, we’ve seen so few businesses adopt Vista,” said industry analyst Michael Gartenberg, vice president of strategy and analysis at Interpret LLC in New York, referring to the version of the operating system finished in late 2006. “Microsoft can’t afford another upgrade cycle like that.”
That’s why the company is looking to the upcoming release of Vista’s successor, Windows 7, to put the business back on course. The new Windows leadership team has taken steps to avoid the software and device compatibility problems that plagued Vista’s release, and many in the industry are expecting a much smoother launch, targeted for the Christmas holiday season this year.
Google and others are a threat there, too.
The search company’s Linux-based Android operating system for mobile phones is being positioned for possible use on “netbooks” — small, web-oriented notebook computers. Microsoft has tuned Windows 7 for netbooks, as well, but their rising popularity could hurt the company’s bottom line, because Microsoft doesn’t make as much on copies of Windows sold for them as on those sold for traditional computers.
Microsoft has historically done well selling in bulk to businesses, but consumers have increasingly become the bellwethers of technological trends. The company’s Windows advertisements over the past year have recognized that fact, trying to strengthen Windows PCs in the minds of consumers, seeking to counteract competition from Apple.
The Redmond company’s challenge in the consumer market is exemplified by the way Apple’s iPhone has been able to generate more consumer excitement than phones powered by Microsoft’s Windows Mobile operating system.
At the same time, Microsoft did sell nearly 20 million Windows Mobile licenses last year.
“You can’t ignore those kinds of numbers. They’re huge,” Gartenberg said. “On the other hand, if you are Microsoft, you have to be able to generate buzz, generate excitement, and recognize that these are not just business devices anymore, that these are devices that are bought by people, that are bought by consumers, and Microsoft had ignored that trend for some time.”
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