AFTER years at the cutting edge of technology, Microsoft seems in danger of falling off the pace.
According to Nomura analyst Richard Windsor, in the short-term Microsoft is going to have difficulty sustaining its current share price.
"Microsoft needs to find revenue growth in order to justify its current share price, which represents a price-to-earnings ratio of 25 times," he says. "Growth in the personal computer market is last decade’s story, and market penetration has slowed."
The relentless attack on Microsoft’s flagship software products by lower cost rivals is the most worrying factor. The company’s software is increasingly seen as expensive in the PC market, where hardware and software prices are falling.
Open-source software using non-proprietary operating systems, such as Linux, is also cutting into Microsoft’s virtual monopoly of desktop software as governments and corporations become attracted to the cost-savings they offer.
Governments, including Germany and China, have already begun a move towards open source, with Sweden, Denmark, France and the UK also testing the water. Sweden has recently identified savings of more than $1bn a year, while Denmark has identified cost reductions of between $480m and $730m a year.
According to calculations made by Sun Microsystems, the UK’s government services could save roughly 3bn a year by following the same path.
Competition rulings would also prevent aggressive discounting of Microsoft products to key clients.
But cost-savings are not the only reason governments are switching to Linux-based software. Germany has quoted security as a major consideration and others are now following suit and beginning to question the security of Microsoft’s Windows.
Like all operating systems, Microsoft is built on a foundation of computer programming, referred to as the source code. Since its launch in 1975, Microsoft has kept the source code to its operating system a closely-guarded secret.
The disadvantage to a customer such as the German government is that it cannot fine-tune the underlying code to make it comply with its own security standards.
Reluctantly, Microsoft recently agreed to allow governments access to the code. But it is now under pressure to extend the same right to a growing number of its corporate customers.
Rivals such as IBM are now preaching the open-source message to their business clients. Organisations currently implementing such software with IBM’s assistance include Banco de Brasil, Mercury Insurance, VeriSign and the Genome Sequencing Centre at Washington University.
Manufacturers are also starting to ship laptops and desktop PCs porting Sun Microsystems’ open-source alternative to Microsoft Office - StarOffice - which sells for a tenth of the price. Microsoft Office retails at around $500 in the high street in contrast to StarOffice’s $50. The prices charged to computer manufacturers such as Sony are estimated to be about $50 and $5 respectively.
Microsoft Word documents and Excel spreadsheets can be freely exchanged between the two operating systems, which have a similar look and feel.
The main reason Microsoft has been able to maintain its prices throughout every new version of Office is that it has enjoyed a virtual monopoly of desktop software products.
As long as this pertained, corporate IT buyers were secure in the knowledge that they were buying software that would be compatible not only with their own organisation’s IT but also with that of their customers and partners.
Now that organisations are beginning to examine the cost-savings to be made with open-source software, Microsoft is in danger of losing its market grip. This is potentially disastrous news for Office is the company’s cash cow.
Although the company does not reveal which of its products produces the highest revenues, Office is estimated to account for about 30% of Microsoft’s $28bn revenues with additional desktop software products plus Office totalling half the income.
If StarOffice looks cheap at $50 beside Microsoft Office, pirated copies of Office available on the street in China, where more than 90% of software is pirated, cost as little as $3. The relatively high prices charged by Microsoft has made its desktop products a target for illegal copying.
A more serious problem is a growing body of evidence that organised crime and international terrorism are being drawn to software counterfeiting as a way of laundering cash. Illegal copying costs Microsoft around $10bn a year in lost revenues.
Counterfeiting software in this way is reasonably straightforward. Despite the relatively high price charged for Microsoft Office in well-regulated markets such as the US, all the customers actually get for their cash is a legal licence to use some of the company’s intellectual property, a few cents worth of packaging and a silver CD disc.
Microsoft is determined to clamp down on what it regards as infringement of its copyright. But the experience of the music industry, which is losing billions from internet copying, has shown that clamping down on non-profit making internet peer-to-peer sites is a little like trying to put the genie back in the bottle.
With customer resistance to its pricing policy, a growing counterfeiting problem and the PC market reaching saturation, Microsoft is pinning its hopes on two new products: its Xbox games console and its Smartphone mobile phone software.
The company is betting that these new products will enable it to establish a bridgehead in fresh markets, but so far the plan has met with stiff resistance from the industries concerned.
Microsoft’s Xbox strategy is essentially flawed, since it brings the software manufacturer into direct competition with Sony, which has a stronger brand in the consumer electronics market.
What of mobile phone software? Windsor added that if Microsoft could manage to use Smartphone to eradicate rival mobile operating system Symbian, it could extend its dominance from the desktop to mobile phones. But the mobile industry is wary of inviting Microsoft to its party.
Microsoft may find it has to fight hard to maintain even a niche market in mobile phones.
Smartphone has a cousin in Microsoft’s Pocket PC operating system which has captured a significant share of the handheld computer market through the popularity of devices such as Compaq’s iPAQ, a personal digital assistant (PDA) that does almost everything a desktop computer can.
Microsoft’s problem is that the PDA, where it must compete with well-established rivals such as Palm, is essentially limited and is now being regarded as something of a dead-end by many in the industry.
The reason is that mobile phones running either Symbian or Smartphone can perform all the applications of a PDA and offer online communications and voice calls as well.
Unless Microsoft can start to develop some major new revenue streams, its recently issued first dividend to shareholders may turn out to be a consolation prize.