The end of the Microsoft Empire?

The abysmal quarter reported last week by Microsoft was hardly a one-time occurrence. While Redmond may bounce back somewhat in the future, a host of headwinds makes a return to dominance highly unlikely for the software giant.

The numbers were breathtakingly bad. Sales revenues of $13.10 billion for the fourth quarter ending June 30, 2009, represented a stunning 17 percent decline as compared to the same period last year. Operating income, net income and diluted earnings per share looked even worse, logging year-over-year declines of 30 percent, 29 percent and 26 percent, respectively, for the quarter. Worst of all, Microsoft (MSFT) reported a 3 percent year-over-year decline in revenues for fiscal 2009, the first such decline since 1986.

A look through Microsoft's numbers show that every single business unit showed reduced revenue for the quarter. This is unusual for Microsoft, which has almost always managed to show decent growth in at least one of its business units. In particular, the server and tools portion of the company (consisting primarily of its well-regarded Windows server products) has generally shown strong growth. But not a single part of the company avoided a decline. Microsoft CFO Chris Liddell claims he is seeing signs of a bottom. That may be but, regardless, a bounce for Microsoft will be much more muted than in the past for a number or key reasons:

  • Microsoft blamed sluggish PC sales for decline in its client software division. Clearly, PC sales have cratered. But Microsoft will likely enter a new era of extreme downward pricing pressure on Windows OS licenses for the consumer market due to the rising popularity of netbooks. The margins on these dirt-cheap, stripped down laptops are already very small, due to the low, low price tag of $400 or less. Lower margins mean less pricing power for Redmond which, in turn, means lower profit margins.
  • The "Server and Tools" division has been a huge growth driver but it faces related threats -- virtualization and cloud computing. Virtualization allows companies to slice up a single server to behave like multiple virtual servers, each running a different operating system. Microsoft does sell a virtualization product but virtualization also reduces the need to purchase more computers and does apply some downward pressure on Microsoft's margins for enterprise software. Cloud computing makes it easier for companies to rent pieces of servers -- rather than buy single servers -- for a variety of uses. The net effect is fewer server license purchases by end users and more server license purchases by big cloud computing operators, who have far greater bargaining power.
  • Microsoft Office will face excruciating pressure on margins for its upcoming release of the extremely lucrative Office software package. Why? First, Microsoft has finally gone to a freemium model by putting up a lightweight version of Office online. That will carve off one tier of people who might have paid in a pinch. Second, Microsoft has already lost a real portion of the small business market. Most of the startups I speak to in Silicon Valley are using Google Apps or another free or cheap online office suite. Google's own spreadsheet product is greatly improved over past versions and is quite adequate for basic spreadsheet tasks. Microsoft sure realizes this but is unlikely to drop prices to woo small biz as that would hammer margins of sales of Office to larger companies, the true cash cows of this segment for Mister Softee.
  • As we've said before in DailyFinance, the vaunted arrival of Windows 7 is greatly overdone. In fact, Redmond will not see much of a bump from Windows 7 until 2011, after the first two service packs are released. You see, Microsoft has a bad habit of releasing Windows upgrades with great fanfare then, with far less fanfare, releasing massive software patches several months or a year later. Naturally, this has made corporate IT departments extremely wary of buying any new Windows releases in any quantity until at least two major code fixes have come out and roughly 18 months have passed. This means shareholders are in for a long wait.

None of this is to say that Microsoft is going to blow away and die. To the contrary, Redmond will remain a potent force in software for some time. But the sun is clearly setting on the Age of Microsoft as the pre-eminent software company in the world. Shareholders have known this for a while. Microsoft shares trade nearly 19 percent below five-year highs, unlike many of its tech brethren such as arch-rival Apple. The market is clearly telling us something about the future of Microsoft. The numbers from this quarter put some real meat behind the long held pessimistic sentiment and are the strongest sign yet of Redmond's growing weakness.

Alex Salkever is a senior writer for Daily Finance, covering technology, green tech and clean tech issues.
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