Microsoft's Dilemma

[BRIEFING.COM - Robert V. Green] With the collapse of the Yahoo acquisition, Microsoft now faces the hardest question for growth companies that have matured: what now? It is a hard question to answer.

The Environment For Microsoft

Microsoft is still the largest software company with a virtual monopoly on operating system software for desktops, laptops, and medium-sized servers.

However, the desktop market has matured. While the upgrade cycle used to be the driver for Microsoft's growth, it is no longer the growth engine it used to be. Vista is proving to be a slow sell to the marketplace, particularly at the enterprise application level. Most IT systems at large corporations are simply "good enough" at this point.

This maturation of the core market that built Microsoft has been an issue for the company for more than six years. (See the Ahead of the Curve column of "18-Mar-02 The End of WinTel As Investments " for how we viewed this as a problem for Microsoft at the time.)

For the most part, Microsoft has not effectively addressed the maturation of the operating system and tools marketplace.

We feel this is the primary reason why the stock has gone nowhere over the past six years. MSFT was $31.14 on a split-adjusted basis on March 18, 2002. Today, the company is trading around $29.35.

While the company has increased EPS over this time, the market has continually reduced the premium it is willing to pay for future MSFT earnings, as growth expectations have been continually lowered.

So what should Microsoft do now?

The Internet Advertising Market

The future of Internet advertising is behavior-tracking. (For more on this idea, see the Ahead of the Curve column of "08-Jun-07 Owning the Internet - A Brief History (Part IV)", along with part 1, part 2, part 3, and part 5. )

However, Microsoft is far behind Google is the race to build this next attempt to "own the Internet."

Google's Lead In Behavior Tracking Ad Networks

Google's acquisition of DoubleClick a year ago heralded the future of Internet advertising. By combining the behavior tracking features of the DoubleClick network with the widespread presence of the Google Ad Network, Google threatens to be able to "target" advertising more effectively.

Advertisers have always been willing to pay a premium if they know that their message is directed to a known audience segment. This basic principle is well established in magazine and television advertising.

If Google ever demonstrates that behavior tracking on the Internet actually does allow the Internet audience to be finely targeted, it would revolutionize the advertising world. Instead of "broadcasting" the same message on a television show to a large, but defined audience segment, Internet targeting could be specific to a single individual.

That is the promise, as yet unproven, of the Google-DoubleClick combination. However, to successfully draw advertising dollars to the Google network, this promise only needs to show partial and incremental improvement over existing Internet advertising budgets.

Microsoft Lacks An Advertising Network

Microsoft, despite dominating the browser market, has not been able to establish a significant presence in the advertising network market. (See the June 8, 2007 AOC column for data showing Google's dominance of this market.)

Microsoft's acquisition of aQuantive a year ago seemed to indicate Microsoft's willingness to fight for a strong presence in the Internet advertising world. The aQuantive technology provides similar behavior tracking functionality as DoubleClick.

However, in order to track millions of users, the aQuantive network needs to be combined with an established advertising network. Microsoft has no such network, although their MSN branded site presence is significant.

Acquiring Yahoo would have given Microsoft a toe-hold in the advertising network world, even though Yahoo is still a minor player as well.

The Enterprise Application Market

Microsoft has virtually no presence at this level of the software market, despite having a near monopoly at the operating system level. Their dominance of the productivity application market (Word, Excel, Powerpoint) is significant, but that market has matured as well.

However, the future of software at the enterprise level is enterprise-wide applications. SAP is the dominant provider of this software, with Oracle a serious challenger. Oracle has built its presence at this level through acquisitions, having acquired the most significant application vendors over the past four years.

We documented the evolution of the enterprise application market starting in July of 2004. (See the Ahead of the Curve column of "09-Jul-04 The Software Industry Matures: Part 4 - Conclusion" for more; click here for part 3, part 2, and part 1.)

We also picked acquisition targets for the consolidation of this marketplace in January of 2005. These predictions eventually came to pass, as both Hyperion Solutions and Business Objects were acquired.  (See "07-Mar-07 Hyperion Solutions - An Acquisition Premise Fulfilled" and "09-Oct-07 Business Objects Acquired as Predicted" for more.)

We still believe that software vendors will continue to lose pricing power at the enterprise level, unless they have presence at the application level. After all, the application level is the only reason that IT systems were built in the first place.

Microsoft continues to ignore the fundamental shift that has occurred in the enterprise level.

What Should Microsoft Do?

We think Microsoft should address the Internet advertising market in the following way:

• Acquire Yahoo - it was a good idea
• Acquire ValueClick - the only existing large-scale advertising network

Combining the Yahoo and MSN search engines and combining the behavior tracking functionality of aQuantive  with the ad network of ValueClick (VCLK) would still put Microsoft behind Google in the race to build a true, highly targeted advertising network on the Internet.

We think Microsoft should address the enterprise application market in the following way:

• Acquire SAP (SAP)
• Acquire NetSuite (N)
• Acquire RightNow Technologies (RNOW)

We have argued that Microsoft should buy SAP for a long time. (See the Ahead of the Column of "24-Jan-05 Microsoft Should Buy SAP " for more.) This is the only way for Microsoft to achieve meaningful presence at the enterprise application level.

Acquiring other functionality, such as NetSuite and RightNow, does not make sense unless Microsoft first acquires SAP. These niche firms are simply too small.

Conclusion

Will Microsoft make any of these "catch-up" acquisitions that are so badly needed in the most important segments of the software market?

The collapse of the Yahoo deal seems to indicate that Microsoft is abandoning any effort to build a competitive advertising network to counter Google's strategy. Whether the collapse was actually a short-turn tactic on Microsoft's part is unclear, but seems unlikely. To achieve a strategic objective, Microsoft simply could have begun a hostile proxy vote to acquire Yahoo, as Oracle has done in the past.

Microsoft's continued neglect of attempting any type of presence at the enterprise application level is likely to continue. If presence there was strategically important to Microsoft, they would have acted by now. The customer bases of the best independent enterprise applications are now gone (acquired by Oracle).

Working harder to make "the next version of Vista" even better would be very myopic. And counting on X-box and other consumer sales to be a strong growth engine would border on foolish.

So what should Microsoft do to revive their ability to grow in such a way that MSFT stock can become a good investment?

That should be the question Microsoft management asks itself every day.

With such an impressive past and still extremely profitable position, they probably don't think they are even facing a major strategic dilemma. The collapse of the Yahoo deal and the continued neglect of the enterprise market seem to imply that.

With the core markets of operating systems and tools become mature, however, Microsoft needs to develop a long-range strategic vision. Otherwise, they are likely to see their core revenue streams slowly erode over time, making a major strategic shift harder and harder the longer they wait. If they wait too long, it becomes impossible.

After all, that's what happens to the dominant vendors in the computer industry. Just look at IBM and Digital Equipment, each of whom once enjoyed dominance in the IT world, as Microsoft does now.

Comments may be e-mailed to the author, Robert V. Green, at rvgreen@briefing.com

Microsoft (MSFT): May 9, 2008, midday: $ 29.36 +0.09 (+0.31%)

Yahoo (YHOO): May 9, 2008, midday: $ 25.86 -0.36 (-1.37%)

Google (GOOG): May 9, 2008, midday: $ 572.70 -10.31 (-1.77%)