Business as Usual for Microsoft? Hardly

By Alex Salkever The sound of champagne corks popping in Redmond, Wash., is turning out to be the shot heard across the continent. Since a federal court judge signed off on the Microsoft (MSFT) antitrust settlement on Nov. 1, its shares have surged some 7%, closing at $56.68 on Nov. 5. And the party has spread to the rest of the Street, prompting a high-tech mini-rally. Now comes the hard part. With the sword of Damocles no longer hanging over its head, the Colossus of Redmond faces a host of demanding challenges.

The ruling from U.S. District Court Judge Colleen Kollar-Kotelly was, by almost any measure, a near-total victory for Bill Gates's gang. Not only did Kollar-Kotelly uphold Microsoft's earlier settlement of a massive antitrust case with the U.S. Justice Dept. but her ruling also ordered nine states to stand down on requests for further punishments against the software giant.

In her 500-page decision, the judge said she would personally supervise Microsoft's compliance with the earlier agreement stipulating that it shall not threaten PC makers that want to put Redmond alternatives on their desktops and hard drives. Under that agreement, Microsoft also would license key parts of its technology to other software companies, ostensibly to allow everyone to develop programs on a more even footing.

STRESSED CASH COWS. The states and Justice are unlikely to appeal Kollar-Kotelly's ruling, according to many experts. And her decision could adversely affect the legal chances of Sun Microsystems (SUNW) and America Online (AOL) in their respective antitrust suits against Microsoft. In all likelihood, that means if Microsoft behaves, it's free to pursue business as usual.

Still, business as usual is anything but these days for Microsoft. Going forward, it'll face intense pressure to maintain revenue growth. It relies on its traditional business of selling desktop software and operating systems for fat profits. But those cash cows are looking more stressed as the PC slump heads into its third year.

And that's a problem, since Microsoft's other lines, such as business software and its MSN Internet service, have yet to generate big profits. Sony (SNE) has thus far trounced Microsoft in video-game consoles. At the same time, Linux, while a tiny bump on the desktop computing landscape, is finally approaching a level of usability that big corporations might find appealing.

STRICTLY SINGLE DIGITS. Gates & Co. "has spent most of the last decade trying to extend its monopoly from the desktop to other devices. That failed completely," says Clay Shirky, a professor in New York University's Internactive Telecommnucations Program. "They don't have a monopoly or even a majority market share in game machines, PDAs, or servers."

For starters, the twin pillars of Microsoft's profitability, Windows and Office, face slowing growth. Sales of the operating system and office software logged $5.1 billion in the first fiscal quarter of 2003 -- a staggering 66% of total revenues. Companies replacing older PCs and consumers buying machines for their homes will likely continue to drive growth, but it will be in the single digits, nothing remotely resembling the double-digit growth expectations of the 1990s.

True, Microsoft posted a hefty 26% increase in sales in the most recent quarter, thanks largely to movement of its desktop software and Windows operating systems. But that quarter may be the last hurrah. Microsoft forced many companies to sign multiyear deals for upgrades and support or face stiff a la carte price increases.

BUTTERFLIES EVERYWHERE. Now, who is left to sell? "Corporations aren't seeing compelling reasons to upgrade to the latest version of Windows or Office. It's biggest competitor is itself," says Matt Rosoff, an analyst with consultancy Directions on Microsoft.

With big marketing and software development budgets, Microsoft is pushing hard to grab ISP market share from leader America Online. Witness the huge push behind MSN 8, its latest online software package, complete with a seemingly ubquitious advertising campaign featuring a butterfly motif. But MSN has yet to turn a profit. And in the latest fiscal quarter ending Sept. 30, gross revenues stagnated at $427 million, down 1% from a $430 million take in the same period during 2001.

Since Microsoft only recently began breaking out MSN numbers, the Street will be watching closely. Already, Redmond is negotiating placment and merchandising deals with companies such as electronics mega-retailer Best Buy (BBY). "In 2000, eyeballs were all that mattered. Now they're making the moves to turn what has been a cash drain into a profitable line of business," says Charles DiBona, senior software analyst at investment research house Bernstein.

CAN XBOX SCORE? A similar scenario is shaping up in video-game consoles. Microsoft remains far from profitable with its bold Xbox venture. This market brought in $7.1 billion in 2001, according to Instat/MDR, and should grow quickly as all three console makers add multiplayer gaming over the Internet to their repetoire. But despite hundreds of millions spent on advertising, Xbox remains a distant second or third, tied with the Nintendo's (NTDOY) Game Cube but far behind Sony's Playstation 2. Sony (SNE) expects to have a user base of 40 million consoles by the end of 2002. Microsoft may hit 4 million by that point.

Most analysts have put Xbox' breakeven point somewhere in 2004. But it could cost Microsoft billions in below-cost console sales to get to that point -- if it ever gets there. Capturing the "cool" factor in game consoles is tricky. And unless Microsoft can start catching up to Sony fast, it may have trouble attracting independent game designers to make games exclusively for a far less popular console such as Xbox.

That may be why Redmond, which has remained tight-lipped about its gaming finances, is also paying premium prices for titles. In late September, 2002, Microsoft bought 49% of British software maker Rare from Nintendo, adding the popular "Donkey Kong" line to the Xbox stable.

VIABLE ALTERNATIVES. Finally, there's the specter of open-source software. Until now, Linux servers have taken away market share mainly from Unix machines, while Microsoft has been sopping up share in the server market's lower end. Now, for the first time, desktop machines running Linux office applications are starting to pop up as viable business alternatives to pricey Windows boxes. "I think low-cost, bare-bones, productivity software could really cut into [Microsoft's] business," says analyst Rosoff.

None of this is to say that Microsoft has gone from champ to chump. With cash reserves of more than $40 billion and net cash from operations clocking in at $6 billion per quarter, Redmond can afford to dabble in these businesses for many years. In databases and other enterprise software, Microsoft has made notable inroads in the small and midsize business markets.

And its .Net server effort, which gives some businesses better interactivity and synchronization of online tasks, seems to be catching on. Bernstein's DiBona feels that .Net could turbocharge sales of Office and new operating systems -- if Microsoft can create ways of using .Net Web services that would allow tech-support staffs to more easily deploy and troubleshoot machines.

"RISKIER BUSINESSES." DiBona figures that .Net could one day create a user network that would be tremendously valuable. "Growth for this company is going to come from more immature, riskier businesses. I personally feel they have a good strategy for getting that growth," says DiBona.

Microsoft will surely grow, but doing so will take more flapping from the MSN butterfly's wings than Gates & Co. has grown accustomed to. Salkever is technology editor for BusinessWeek Online

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