Microsoft's Trojan Horse

 

Intel's bad news last Friday helped pull down the entire NASDAQ.  After rallying since we last posted in mid-August, tech stocks have further bad news to contend with. This raises the question: Has Wintel, the dominant technology of Microsoft(MSFT) and Intel(INTC) reached a permanent zenith or are there even more worries to come?

We have some thoughts on MSFT --particularly how it might be able to escape the trap of its own making-- and are seeking further input.  Here are some of the pluses and minuses for MS as we see them:

Microsoft's ascendancy as a supercompany has been unprecedented.  Its dominance over the industry is greater by magnitudes than its predecessor, IBM, in a number of important ways. Because its sits on nearly every computerized desktop in the world and provides a window to the internet through its browser, MS Explorer and an entertainment channel through its Media Player, MS's importance cannot be underestimated.

  Where Intel, the dominant chipmaker for PC's, has had to deal with a pesky AMD forever on its heels, there is no equivalent counterweight in desktop operating systems and application software. Consequently investors have given MS a P/E valuation  nearly double that of INTC.

Aware of their own recent past, when against all odds they toppled the single industry giant, IBM, founder Bill Gates and college buddy Steve Ballmer set out as early as 2000 to conquer new space even as market and government forces gathered around them.  What they had to grapple with for the first time was the power of Washington DC and the FTC but even more insidiously was the reputation they had brought to a high polish as being lethal business partners.

In the heady growth years MS had always prevailed but often by eating its own siblings and young.  Where Apple and Digital had remained closed systems, the PC world flourished because of open standards that allowed the influx of creative energies.  By the turn of the millennium, MS had hobbled or destroyed most of those forces that had helped the PC revolution become the most important techno-industrial movement of our time.
But even Tyronasaurus Rex MS found it had limits.  Should MS have now made a direct move into the hardware business; i.e., building and marketing the PC platform, its closest allies, the Compaqs, Dells, HPs, IBMs of the world would have closed ranks against it. After all, a weakened but still viable Apple had always maintained a lead in building operating systems so an alternative OS might have been possibly available for enough cash.  The stakes were clearly that high.

Further the new climate in the regulatory agencies would have made a move by MS to further dominate both hardware and software nearly impossible. The opposition knew and respected the great beast and was also legally savvy and well funded; in the background, once technically unsavvy judges were more likely to at least know qwerty, and even a US district court judge might be expected to have experienced a browser named Netscape that disappeared as a new installation of Windows did its slight of hand, suddenly making Explorer the default.

Gates and Ballmer et al. started looking around.  The Internet was surely the new battleground; it was the phenomenon that was propelling PC sales into the mainstream at an ever faster pace but it also provided dangers both predictable and unforeseen. MS's dominance on the desktop did not stretch to the larger servers it had relegated to the sidelines that now powered  the Internet. And so, at least on the server side, as Digital began to fade from the picture, and the IBM mainframe faded into history, Unix was still king.

With Windows NT, MS would go after that marketplace as well.  But further down the road there were even greater perils: the desktop computer had after all snuck into the backdoor of the global corporate world by replacing terminals which connected to a central server.  Users liked the variety of software they could get on their local PC's and hated the dependence and domination of their corporate Data Processing centers that controlled software, access and policies with the deftness of the Politburo.

But the model of central server, or servers in the case of a Web architecture, was well understood and, in light of the speed in which the Internet was taking hold, there could be a time when it might re-emerge and overtake the desktop as a practical model.  And that scenario just might put MS out of business!

So along with its new line of server software launched with NT and Windows 2000, MS needed a way to not only exploit the Internet but to dominate it as well.  In order to insert itself into the very DNA of electronic commerce, MS began to feverishly design what came to be called .NET (Dot net).

There were, however, also several fast growing and potentially competitive markets where MS controlled neither the software nor hardware: PDA's, Cell Phones and Games.  MS would go after all three but it may have been the game market that they understood to hold the most potential. As it was to turn out, Nokia, Motorola and the Koreans were far too advanced in phones and well too aware of MS's past business practices to even open a crack in the market.  Meanwhile, even as MS became competitive with the dominant Palm OS on the handhelds, the PDA market began to inexorably merge with that of the cell phone and wireless email market.  Never an innovator, always a follower, MS was in the undesirable position of trying to play catch up in an area where its industry desktop domination afforded it hardly a hint of leverage.

And so it was in games that MS would put their greatest effort.  They introduced the first Xbox in 1991 in an attempt to catch the industry leaders: Sony and Nintendo.  From a technical perspective, an Xbox is a computer whose functionality is optimized for speedy reads and advanced display capabilities.  In this market, MS would be going up against two strong Japanese companies (Sony and Nintendo) and would thus not have the same level of worries about US regulators and Japanese lobbyists.

The going in games has been rough and costly but MS has thrown enormous resources in a market where from zero four years ago it now holds roughly 33% market share.  In the meantime, Nintendo has fallen somewhat by the wayside and Sony's PlayStation has emerged as the major player.

<h4>Developments have made the Xbox strategically important for Microsoft</h4>

First, we are talking about nothing less than a user base of the next generation of computer users, kids who have grown up with electronic games, telephones, instant messaging and mobile phones with cameras. Further, the kids who gamed would respond to the best software and hardware. Game platforms like the Xbox and PlayStation have about a 4 year lifecycle and a new round is about to begin in 2005 when, if things go as expected, first Nintendo, then Sony and finally MS will come out with their next versions.

  What's more, in their always-on lives, the idea of sitting at a console and not connecting with others would seem downright counterintuitive to these kids. As a result, the door is being left wide open for a generation of computers that, first off, purchases nearly $18B annually (a sum that rivals Hollywood) in software alone. But, more importantly, this is a generation that will demand be wired (connected to a highspeed Internet) for games and messaging.  Could Internet telephony on the game box (VOIP) be far behind?
 
  Our point is that in the Xbox Microsoft may have found its Trojan horse.  In one swift coup, a way to get into the hardware business, Internet commerce and the telephone industry, all areas that have hitherto been blocked to it by the deep pocketed incumbents?  The results would be numbing!
     
<h4>Immediate Questions on Investors' Minds</h4>
 
Meanwhile investors in Microsoft have been taking a beating and have begun to rebel against the world's most cash rich company.

Dude, where's my cash?" That's the question punters have been asking Microsoft (MSFT )for months as the company's green stuff piled up in the coffers to a total of more than $60 billion. On July 21, they got their answer. Microsoft announced the largest one-time corporate dividend in history. On Dec. 2, MSFT will pay back an eye-popping $32 billion to shareholders. It will also double its annual dividend to 32 cents a share, or $3.5 billion, and buy back $30 billion worth of its own stock over the next four years.

<h4>Sleeping with a Dinosaur</h4>

Microsoft (MSFT) has offered --upon shareholder approval-- investors what looks like a bulletproof offer: Buy our stock by November 17th and receive a special dividend of $3 a share on December 2nd.  At last look, MSFT was selling for somewhere close to $27 a share.

Since July 16th when Microsoft made the offer the stock, it temporarily bounced to $29.  But since then it has actually lost some ground. So what's up with Microsoft, investors are asking. Aren't they the world's greatest monopoly guaranteed to sell their software every time someone around the world buys a PC? Don't they own the desktop application world with their professional and home-office application suites?  Aren't they the guys who even got the government to back down on their monopolistic practices?  So why do they have to urrh... bribe me to buy their stock?

Here are some of MSFT's woes:

Foremost is the continued postponement of the shipping date of their next OS, Longhorn (now,2006), which, importantly from a technology perspective, they now say will not have the innovative file system they have been promising.   Development problems are enormous:  First there's QUALITY: a bug-riddled legacy of code that somehow has to remain backward compatible to not offend their entire user base. Next comes SECURITY.  Security never was an important factor in the closed world of LAN's and has thus continually plagued their software going forward. Security is now a major issue with most attacks aimed squarely at the leading provider of software, Microswoft. Then there's a nearly complete lack of  USER LOYALTY :  many customers may be neutral at best despite MS's relentless feel-good advertising.  But there are also millions of haters of the BORG, as they like to call it, who, in some cases, will go to great lengths to sabotage the behemoth's progress. Finally there'sBROADBAND and the NET:  As MS struggles to build a massive new operating system that somehow can support legacy code it must guess forward years in advance as to how the world will look when it finally reaches release date.  Unlike its predecessor and former Goliath, IBM, which could call all the shots in its closed domain, MS can be practically sure its weight will not be enough to subdue the unleashed forces of a fast growing world wide web it can't control.

Some readers might remember Oracle's CEO Larry Ellison's proposal several years ago of an Internet appliance that would interact with server-based applications through a browser. This idea was motivated by his desire to bypass MS.  To many folks at the time, it sounded a lot like back to the future and the bad old days of timesharing on the mainframe.  At 56Kb connect rate there wasn't much that could make this feasible.  But the march to broadband via cable, satellite, WIFI and DSL, however plodding at first, has now reached the point where more than half of those connected to the web in the US are linked via a broadband ISP.

Suddenly, the idea of a web-based world, with the Internet itself acting as the operating system, does not seem so outlandish.  Couple that with the rise of Open Source software, particularly Linux and its support by millions of volunteer programmers and companies like IBM and what have you got?  Well, in our eyes you have a viable alternative that for the moment is partially stymied by some patent claims coming from a company called SCO, which bought the UNIX operating system and now claims that Linux, a collaboratively programmed Unix system that works on machines powered by Intel chips and licensed for free, is in violation.  Deep pocketed IBM, which also holds a number of Unix patents is leading the legal battle against SCO and has offered to donate any patents it holds to the Open Source community.  Although a bump in the road, it's hard to believe that SCO will prevail in this fight in any significant way.

As we have been reblogging in our Cherry Picks column, IBM has recently scored some courtroom victories over SCO and Linux, which is in wide distribution already, is likely to prevail.  For its part, MS, as we said, has tried to build its own server software but has been stymied in gaining the kind of market share it would have liked. Linux, and the open source free software community that has grown up around it, thus, becomes one potentially lethal dagger pointed at MS's heart. 

But the problems don't stop there. MS was able to force the original browser heavyweight, Netscape out of the market by bundling its own browser, Internet Explorer, into every version of Windows it shipped. This kind of tactic was vintage MS behavior.  For years, the brute force strategy has held up as a way for MS to crush any possible competition. For those who on the outside, it's important to note that despite the advertisements, innovation and passion have never been part of MS's DNA.  In fact, founders Gates and Allen did not even develop the original DOS operating system that got them started but managed to talk another Seattle company into a licensing deal just as giant IBM --the big iron guys-- went in search of a new operating system for its first PC. What became MS-DOS, itself, was modeled on another shipping OS called CP/M, a company IBM decided to bypass in favor of a couple of kids in Seattle.

Neither was there even a trace of innovation in Windows an operating system "shell" that was first developed by Xerox, improved upon by Apple and finally adapted by MS as a way to juke IBM and the entire PC application world into going in the wrong direction.  IBM, had decided to build its own OS, OS2, and gave MS the job of building the graphic user interface. Bill Gates thus had pulled a classic business coup by managing to roll out of bed without being crushed by IBM and landing on his feet with Windows applications products to sell.  IBM probably suffered the greatest business embarrassment in history and Gates was crowned a "genius".  In the same stroke, MS crushed WordPerfect and Lotus, hitherto the dominant players in emerging PC office applications. These companies had developed their next versions for the promised new OS/2 and suddenly all that was left standing were a new stable of Windows applications, bundled in MS Office.  Lotus and WordPerfect never recovered!

The same fate would occur to the tool making companies like Borland and finally to Netscape along with a slew of lesser companies. Meanwhile more innovative companies like Apple, first, then Sun, were pushed to the extreme edge of the market as scale and the IBM legacy of business acceptance propelled the tandem (Wintel) fortunes of Intel and Microsoft to near total dominance.    

But even here something had happened along the way.  Companies no longer invested effort, time and money into the development of innovative new applications for Windows since potential investors had the sure knowledge that sooner or later MS would catch on and pounce.  It now became left to MS themselves to innovate where they might.

By the year of millennium it was becoming clear to everyone that the distribution model for entertainment products --music and movies-- was going to be forever changed by the Internet and digital technologies.  For the music industry the problem surfaced immediately.  After all, they had already gone to the CD and digital for all their products and not understanding the danger of leaving bits and bytes nakedly out in the open, they woke up to find "their" music being freely distributed across the Internet at the speed of light.

And so it seemed that a perfect opportunity was opening up for Microsoft, king of the desktop.  After all, they could see that it was only a matter of time before bandwidth increased and the days of music stores and the Blockbusters of the world went into the same dustbin that already contained the Rust Belt manufacturers, the typewriter and the horse and buggy.  MS reasoned that they could position themselves as the gatekeeper of the new distribution system, extracting a toll from each transaction. 

But even in self possessed Hollywood the moguls had heard, no doubt with more than a bit of envy,  about Gate's insatiable appetite.  There was no way these tooth and nail guys in the "business" would contemplate sharing even a tiny piece of their game. Confronted with the possibility that somebody from Seattle might have their eyes on the entire biz, the industry circled its tents.

What's more, as Linux grew from being an interesting experiment to a solid operating system, at least on the server side, Windows' desktop future for the first, at least in the Third World, was being newly challenged. For another thing, foreign governments could fear that they were building mission critical military scientific communication applications on a proprietary American owned software base.  They all knew what happened to Saddam Hussein in the first Gulf War when his entire command and control operation was brought down at the flick of a switch.

Further, there were enormous savings to be had in foreign currency if Windows licensing fees could be reduced or eliminated altogether by a feasible alternative.  Growing anti-American sentiment was another factor.

And so, for the first time since PC's emerged as the dominant platform, it has become possible to envision a world in which MS will face competition on its own turf. One thing that has been made eminently clear; Microsoft is a tough competitor.  Perhaps, like the ancient Greeks, future victory will rely on something as simple as the Trojan horse we mentioned above.

In the meantime, we can promise lots more on the digital music and film wars in coming weeks.

Let us know what you think. 

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