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Interesting news: the share of computers with Microsoft Windows OS surfing the web dropped below 90% (article here).

Of course, Microsoft (NASDAQ:MSFT) is still an enormous cash machine. It still has a near monopoly on the corporate desktop and laptop market. Many investors might assume that the company can still produce great returns. But I think the Empire is cracking.

Let's take a look at the last quarterly report (quarter ended September 30), available here.

Operating Income by Divisions
Client division, i.e. Windows for desktop/laptop: $3.2 billion, slightly less than a year ago.
Server and Tools division, i.e. Windows Server, SQL Server, Exchange and other things: $1.15 billion, or 20% more than a year ago.
Business division (Office): $3.311 billion, 20% increase.
Entertainment and devices (Xbox and Windows Mobile): $178 million, slight increase.
Online services: loss of $480 million, compared to $267 million a year ago.

This is operating income. If you look at it from the corporate point of view, entertainment and devices is in red, and online division is a huge sinkhole.

Balance sheet looks healthy. Lots of cash. One small problem is that all that cash and then some is already allocated for a huge buyback. Microsoft, for the first time in its corporate life, is issuing debt. It has enough free cash flow to service it, so debt shouldn't be a problem.

It looks like a picture of a very healthy company, maybe with some small problems. What can possibly go wrong? The answer is simple: real competition. Let's see by divisions.

Client division:
Strong competition from Apple (NASDAQ:AAPL) on the upper end. And competition from Linux in subnotebooks (AKA netbooks) segment. The last one is so bad for Microsoft, that it had to do the unthinkable: issue licenses for a product it wanted to retire, Windows XP, specifically for subnotebooks. Competition is mostly localized to the home computer segment so far. Microsoft still dominates the client OS market for businesses for now. There are a couple of small problems here though: businesses mostly refuse to upgrade to Vista (no additional revenue), and Apple has started penetrating into enterprise.

Server

Windows Server: Strong competition from Linux. UNIX is still in business too.
SQL Server: Very strong competition from all sides: Oracle (NYSE:ORCL), IBM (NYSE:IBM) DB2, open source (MySQL, PostgreSQL, Ingress).
Exchange: No serious competition so far.

Business division: No serious competition to Office. Companies have an option of switching to open source (Openoffice), but reluctant to do so.

Entertainment and devices: Very stiff competition. For Xbox it's Sony (NYSE:SNE) PlayStation and Nintendo (OTCPK:NTDOY) Wii, for Windows Mobile it's Apple iPhone, running OS X, Google Android and Linux.

Last but not least: Web services. It's not that Microsoft has competition here. It's that Microsoft is not a competition for others. Companies with which MSFT wants to compete are profitable: Yahoo! (NASDAQ:YHOO) and Google (NASDAQ:GOOG). Attempts to throw huge money on this problem doesn't help.

How fast can Microsoft fall? That's a big, $180 billion question. Thing is, tech companies sometimes can die fast, like CDC or Wang Computers. They can linger for many years (as Jim Cramer says, dead companies walking), like Unisys (NYSE:UIS). Or they can reinvent themselves, like IBM, which is more like an integrator than a tech company.

I don't think Microsoft can reinvent itself. It never could compete on an even field. All its victories in competition were achieved by "leveraging" its OS monopoly. Now, when this monopoly itself is under question, what can Microsoft do? It's still possible that the company can survive for many more years, just on the sheer inertia of a huge installed base. The best decision would be to split into two or three companies. Just close the Web shop (no one in his sound mind would ever buy it), sell entertainment and mobile, if there is a buyer. Core businesses need to be changed too. OS development has to be completely changed. Every successful OS right now is UNIX or Linux based. The only way to make a good OS is to take BSD UNIX and add some proprietary GUI, like Apple did. You can even call it Windows Berkeley. Office can do just fine. Mobile shop has to be closed too, it can't compete on its own with Apple and Google. I see a separate OS company, Office company and Enterprise Server company (Exchange and SQL Server). Resulting companies can be much smaller, drastically cutting costs.

Can the company do that? I don't think so. But I'm watching Microsoft now. If there is any hint of a split, I am a buyer.

Full disclosure: At the time of publication author had long positions in AAPL and GOOG and no positions in other companies mentioned. Positions can change any time.

Source: Is the Microsoft Empire Cracking?