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By Carl Howe

A flurry of stories about Microsoft (MSFT) recently got me thinking today about computer history. First was the story yesterday in the Wall Street Journal about whether it's Time to Dump Your Desktop? Another was the recent revelation that Microsoft is developing its own Zune music player and is creating yet another music store to compete with iTunes. Another was about how Google's new spreadsheet service could ultimately dent Microsoft's Office business. And then there was this compendium of articles about Bill Gates stepping down and another marketing executive leaving. These stories seemed to be saying something, but no one told the whole story. And then it hit me.

Microsoft is about to lose the software business the same way that IBM lost the PC business in the 1980s.

Now, for those of you who didn't live through it, a quick refresher: In the 1980s, it wasn't Microsoft who dominated PCs, it was IBM. The IBM PC was the fastest-selling product IBM ever had, and it was the gold standard for desktop machines. But even so, MIS departments (Management Information Systems organizations, what IT was called in those days) still called PCs "toys" and snidely thought that they would never be able to handle "real" work like their IBM mainframes and minicomputers.

IBM planned to change all that with OS/2, which would be its best and most compatible system. And best of all, it would work seamlessly with the rest of IBM's systems and be supported by the IT department. It was complex and needed the latest and greatest hardware (the IBM PS/2) to run, but it worked.

Trouble was, OS/2 was too late. The PC "toys" powered by Microsoft software took over -- they could be bought off the shelf and snuck into the business without the approval of MIS. And despite the fact they were less capable, no one except MIS cared; they did the job for people who wanted to do a few simple things and who couldn't wait for MIS. And the PCs got better and better until MIS had to embrace them or become irrelevant.

That same process is happening right now, except this time, it's Microsoft and Microsoft-centric IT departments calling Internet services and non-Windows PCs "toys". They call Google's spreadsheet a toy that is nowhere as powerful as Microsoft Excel. They insist Apple's (AAPL) Macs will never be accepted in corporations. And they insist Linux is just too difficult to work for real business. And besides, Windows Vista and the new Microsoft Office -- complete with a completely new interface designed to befuddle users used to the old one -- will work so much better and more seamlessly with all other things Redmond. Everyone just has to upgrade, and life will be grand.

The only problem with Microsoft's story is that just as with IBM's story in the 1980s, there's now competition from "toys". The "toys" made by competitors just do stuff that users want. And they do it fast. And the users vote with their dollars.

Look at Apple. In the time since Windows XP was released, Apple has released five versions of its Mac OS X operating system, which, of course, run on Macintoshes, computers IT considers toys. Each one has gotten better than the last. Today, if you go to a developer's conference, the cool kids have Mac OS X laptops. Why? They evolved faster than Microsoft-powered laptops, to the point where both the laptops and the OS are fashion statements.

Or look at Google (GOOG). Last week, it reported that it doubled profits to more than $700 million for the quarter, most of it from advertising on search results and its ad network. Microsoft keeps saying, "we'll be there with a better search and ad network soon", despite the fact that it is more than five years behind Google with customer experience. How many iterations has Google's Adsense been through in the meantime? A lot. How many people are waiting for Microsoft and expecting it will hit it out of the park with its first try? Not a lot.

The reality of Microsoft is that only two products, Office and Windows, bring in 90% of its revenue and all of its profits. And the toys are slowly destroying the monopolies and value of both those franchises. You don't need Windows or Office to build a spreadsheet with Google Spreadsheets, edit a document with Writely, build a Web page with Google Pages, or collaborate online with Skype or Gizmo. Nor do you have to pay for any of them. Which means that Microsoft's revenue is under attack.

With toys attacking its cash cows of Windows and Office, what is Microsoft doing? It me-tooing the toy companies. The XBox 360 is attempting to catch up to Sony (SNE), the company that launched 100 million Playstation 2 consoles; XBox 360 has shipped five million in eight months. Today, Microsoft confirmed that it will build it's own Zune music player, in an attempt to catch up with Apple's nearly 60 million iPods. And both businesses will lose money for years, depending on the Windows and Office cash cows -- yes the same cash cows being attacked by the toys -- to support them. Just this quarter alone, the home entertainment business unit at Microsoft -- home of both XBox 1 and Xbox 360 -- lost nearly half a billion dollars. On a yearly basis, that division has never made money.

Think Microsoft has something in the labs that will pull it through? Here's a test: name three technologies that Microsoft has deployed and profited from in the last five years, when it has invested more than $20 billion in research and development. For $20 billion, you'd think at least one of those toys would have made it to market.

Now some have said that Microsoft can always buy its way into a market with its billions of dollars in cash. That sounds possible, but history doesn't support that theory. IBM wasn't able to buy its way to being competitive in minicomputers. Microsoft hasn't been shy about throwing money at AOL-killers (MSN), iTunes-killers (URGE, MSN Music, and countless others), and Yahoo (YHOO) Mail-killers (Hotmail). None of the Microsoft efforts have yielded profitable businesses, despite multi-billion dollars investments over time. In fact, it's hard to find any example of buying into a market yielding a profitable long-term business. Subsidies kill innovation.

Microsoft suffers from a classic case of American obesity. It is too rich and comfortable to move quickly and win in new markets without its monopoly to prop it up. The two monopoly products that fund Microsoft's are falling subject to David Pogue's software paradox: "if you upgrade software enough times, you eventually ruin it." Meanwhile, the hungry toy makers are running fast to deliver new solutions, make profits, and steal Microsoft's customers.

Microsoft is not alone in seeing its business hurt by more nimble competitors. Just last week, the stock market bruised Intel, Dell, and Yahoo for similar reasons. But Microsoft is alone in not employing the billions of dollars in its cash horde to create new profitable business value. It even admitted as much by announcing a stock buy-back program. You only buy back stock when you can't earn more using that money in the business. And with 10 billion shares outstanding -- one and a half or every man, woman, and child on earth -- even the $20 billion allocated to the stock buyback will only delay an inevitable decline.

The Bill and Melinda Gates Foundation will spend billions this year to cure disease throughout the world. It's a tragedy that the company that created those billions can't cure the disease within itself.

MSFT 10-yr chart:

MSFT 10-yr chart

Disclosure: The author is long shares of Apple, and has no holdings in other stocks mentioned.

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Source: Microsoft's Current Situation: Like IBM in the '80s