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In a previous article, I predicted that Microsoft (NASDAQ:MSFT) will eventually follow software dinosaur Ashton-Tate into extinction. According to IDG, many IT professionals had "completely replaced" their laptops with IPads as early as January 2012 (16% in the U.S., 23% in Europe, and 27% in Latin America). That's a lot of foregone Windows sales. And it clearly marks the trend. The outlook is even more dire on the server side.

When it comes to paradigms, shifts happen

The underlying thesis is that both consumer and business computing are shifting to a paradigm that favors less local processing. Users increasingly rely on web browsers or lightweight clients for many tasks, while all the heavy-lifting, - both storage and processing, occurs in the "cloud." As a consequence, business users and consumers can do just about everything they need to with a "slim" device like a Chromebook, tablet, or even a smartphone. This new paradigm leaves no room for Microsoft. Microsoft doesn't even have a toehold in the slim device market, which is completely dominated by Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL). And it is barely an upstart in Software as a Service (SaaS) and Cloud Computing, which are dominated by companies like Salesforce.com (NYSE:CRM), SAP, Amazon (NASDAQ:AMZN), and Rackspace (NYSE:RAX). To make things worse, many top SaaS and cloud companies host their services in Microsoft-free server farms.

Incredulous (and vituperative) readers wanted to see how this actually applies to Microsoft's income. So we'll do that in this article.

How Microsoft Makes Its Money

Unfortunately, Microsoft only reports income in the divisions listed below. While the 10-Qs don't specify income for individual products, we can glean it from company statements and conference calls. For example, we know that Windows and MS Office account for over half the company's income. We also know that the fastest growing components - Lync and Dynamics (with 30%+ growth rates) - are generally the least consequential.

Division2012 Income (Loss)2011 Income (Loss)Comment

Windows & Windows Live

11,460

12,211

About 2/3 Windows

Server and Tools

7,431

6,290

Mostly SQL Server, Exchange, and MS Server; also Azure

Online Services Division

(8,121)

(2,657)

Primarily MSN & Bing

Has lost money every single year it has existed under this name.

Microsoft Business Division

15,719

14,657

About 2/3 MS Office, but also MS Dynamics, Lync and others

Entertainment and
Devices Division

364

1,257

Primarily Xbox, but also Zune (Skype is trivial)

The most striking thing in this table is the spectacular loss from Online Services. Microsoft has provided online services for over a decade and all they have to show for it is a cumulative loss of $16 billion. Luckily I have a recovery plan for them: if both Nicaragua and Armenia fork over their entire GDPs to Microsoft, they could make the company whole in about a year. In return, maybe Microsoft can give them a $15 discount on Windows 8. That being solved, let's look at the other divisions.

The Windows Division: Broken

Windows and Windows Live account for about a third of Microsoft's income. The big driver for Windows is of course PC sales. Unfortunately for Microsoft, PC sales have flat lined, according to the Gartner Group. Last quarter, Apple sold more Ipads than HP or Dell sold PCs. That probably has a lot to do with it.

The table above shows that Windows income declined year over year. But the quarterly numbers are even more interesting: Windows sales are declining even faster than PC sales (which have been flat or down slightly). How can that be? The answer is that a lot of those PCs aren't going to consumers, they're ending up at big server farms (remember the new paradigm). As we'll discuss below, there's no Windows "down on the farm."

The bottom line on the Windows division is that flat PC sales, along with Intel's lowered guidance suggest a third of Microsoft's income is at risk. The risk is magnified as the PCs are increasingly going to server farms rather than consumers.

Server and Tools Division: Shutting Down with "Nowait"

In the old days, a company with 50-5000 employees would have a network of Windows PCs. The IT staff would maintain the PCs and a bunch for Windows servers for MIS and database functions. The database choice was really a toss-up between Oracle and SQL Server.

Under the new paradigm, companies are doing away with much of that; they're meeting their computing needs with SaaS or cloud services. If they can, they're replacing laptops and even desktops with tablets. And the in-house servers are going away entirely. This makes it cheap and easy to "rightsize" their computing resources. The problem for Microsoft is that all the big cloud providers, (e.g. Amazon and Rackspace) run their big server farms on Linux, not Windows. The same of course goes for the big SaaS providers, (e.g. Salesforce.com and Taleo). No Windows means no Microsoft Server and Tool products.

So why don't the SaaS and cloud providers use Windows and SQL server? I've looked at a lot of benchmarks, and I have to admit that SQL Server beats DB2 and nearly matches Oracle. . .on Windows. Therein lies the problem. Windows is bloated, slow, and riddled with security holes, so it's a big handicap for anything that runs on it. SQL Server does indeed match Oracle performance on Windows, but an independent study showed that Oracle runs 38% faster on a Linux system with the same hardware.

Then there's the security problem. Just yesterday, the German government advised all users to stop using Microsoft Internet Explorer because of extreme security risks. This reflects the risk in the Windows OS itself. If you manage a server farm with 5,000 servers, how would you like to install a hotfix from Microsoft every "patch Tuesday" to fix the latest threats? Especially when you know that a poorly tested update from Microsoft killed half a million Sony Vaios.

I concede if you're only managing a few dozen PCs, it doesn't make sense to install Linux and hire a Unix sysadmin. But if you're running a server farm with thousands of PCs, you'd be crazy to do anything else. If any company is at the forefront of highly-available, performance computing, it's Google. Does Google use Windows or SQL server on their ~2 millions servers? Of course not. They run a custom version of Linux. They use mySQL for some smaller applications and a special hash table (called "BigTable") for big applications. Google has blazed the path that others are now following. That path leaves Microsoft in the wilderness.

The bottom line is that as more and more data and processing moves from smaller local office sites to big server farms, there will be less and less of a market for Microsoft Server products. This transition has only just begun and will manifest itself increasingly in future quarters.

The "Risky Business" Division

The one bright spot in Microsoft's recent earnings is the Business Division. Whatever Microsoft fans might say, this division is driven by MS Office sales, which account for 2/3 of the profit. So let's examine those sales. The MS Office sales cycle generally lags the Windows cycle. This is probably because Windows ships with "Office Starter" or an Office trial version. After users get tired of the Starter version or the trial runs out, some eventually pay up. So the 2012 figure in the table above is at least partially reflective of Windows sales from last year. We can expect it to fall to match declining Windows sales this year.

Although we don't think the average small business is going to install Linux, we know that more and more are trying MS Office substitutes that are available for free or low cost. Google claims that 5 million businesses now use their Apps. LibreOffice has around 25 million users and is growing fast. OpenOffice has had 100s of millions of downloads and is doing extremely well in the fast-growing developing markets. For example, OpenOffice has garnered a 25% market share in Eastern Europe. In the best case scenario, MS Office sales will follow Windows sales downhill. The more likely scenario is that Office sales will decline even faster than Windows sales as more users switch to free software. That means $10 billion, or about 1/3 of Microsoft's profit is at risk.

Entertainment and Devices

When it comes to slim devices, Microsoft isn't even an "also-ran" According to IDC, the Windows phone isn't second or even third place in global market share. It's fifth. That explains the E&D division's tiny profits.

I actually thought the IPhone 5 launch was a big disappointment. For all the hype, it was little more than catch-up and incremental improvement. But it doesn't matter. All the IPhone 5 pre-orders sold out in less than an hour. In the meantime, Android devices dominate the low-price end of the market, with a whopping 100 million phones shipped just last quarter (more than 20 times what Microsoft sold).

The new Nokia Lumia is expected to ship in November. But I'm skeptical. One thing I remember well from working for a phone software company, is that a last-minute change that delays a software release for a week, can delay a phone for months. Even if the Lumia does make it in November, it will face a well saturated market, where brand loyalty is already well established.

As for the Microsoft Surface tablet, we got some clarity from Steve Ballmer this week about the pricing: "$300 to $700 or $800." That "clarity" makes me wonder how close it actually is to release. In the meantime, Apple shipped 17 million Ipads just last quarter and is rumored to announce the "Ipad mini" in October. Again, Microsoft will be arriving very late to a saturated market.

Maybe the Lumia and the Surface will turn out to be great devices (that's a huge "maybe" based on Microsoft's numerous UI flops). But it won't matter anyway. Microsoft and Nokia are on the wrong side of market momentum -- just as Apple was with the Mac for so many years. Developers won't bother with their devices, because there's no user-base and nobody will use them because all the good apps are on iOS or Android.

What About Microsoft's Cash Stash?

Doesn't Microsoft's $60 billion of cash support its value? Unfortunately, this cash is like opium in the hands of a junkie. It has tremendous value, but only if you can take it away before he does something really stupid with it. The recent AQuantive writedown should give you a sense of the possibilities. Microsoft paid $6.3 billion for AQuantive in 2007 and just wrote it down by $6.2 billion. The good news: maybe it's still worth $100 million. The bad news: if Microsoft had bought 30-year T-notes instead, it would have $10 billion instead of $100 million to show for it. Now those poor folks in Nicaragua and Armenia are going to have work for free for a year.

Recall also that Microsoft was ready to buy Yahoo (NASDAQ:YHOO) for $44.6 billion -- roughly three times the current enterprise value. The only thing that saved Microsoft from a $30 billion writedown was a "greater fool" at Yahoo who thought it was worth more. The people of Nicaragua and Armenia are thanking that guy for sparing them from lifetime servitude. And then there's the $8.5 billion Skype purchase. For all the hype about the number of Skype calls made, the reality is that the entire division only generated $364 million net for fiscal 2012. And most of that's from Xbox, anyway.

How to Profit

The coming Microsoft decline may constitute the greatest evaporation of value in our lifetime. But it will take a while to play out. For that reason, I'm now favoring Single Stock Futures (SSFs) over options as a way to trade it. Right now SSFs are available for October, December and March. Unlike options, they expose you to the full price fluctuation of the underlying stock. However, they don't have any theta or time decay. My strategy is to sell the SSFs and roll over the position each month. I'll do this until they hit 0.

Disclosure: I own puts on MSFT and am short MSFT single stock futures I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Microsoft: Defenestrated By A New Paradigm