The sound of empire falling, episode 2
<p>From <a href="http://www.nytimes.com/2009/01/26/technology/26spend.html?_r=1&#038;partner=permalink&#038;exprod=permalink$">&#8220;200 Laptops Break a Business Model&#8221;</a> in the pages of the New York Times:</p>
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So whoâ€™s up, whoâ€™s down and whoâ€™s out this time around? Microsoftâ€™s valuable Windows franchise appears vulnerable after two decades of dominance. Revenue for the companyâ€™s Windows operating system fell for the first time in history in the last quarter of 2008. The popularity of Linux, a free operating system installed on many netbooks instead of Windows, forced Microsoft to lower the prices on its operating system to compete.
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<p>Mene, mene, tekel, upharsin!</p>
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<p>Clayton Christensen, author of <cite>The Innovator&#8217;s Dilemma</cite> concluded six years ago that Linux and open source seemed to be executing a classic  <a href="http://en.wikipedia.org/wiki/Disruptive_technology">low-end disruption</a> on Windows and closed-source technology.  But it hardly took the man who formulated the concept of &#8220;disruptive technology&#8221; to notice this; it seemed obvious to me as well on reading his book, and not in the least controversial to the many business audiences I later exposed to the idea.</p>
<p>What Christensen could have added, but didn&#8217;t, is that the crisis moment when an incumbent&#8217;s market collapses is more likely to occur during an economic downturn when all potential buyers are feeling increasing pressure to cut costs.  The NYT article marshals the evidence that, for Microsoft (and possibly for other tech companies like Intel dependent on high-margin flagship products with low-margin competitors), that moment may be arriving now.</p>
<p>In normal or boom conditions, the Vista debacle might have mattered much less to Microsoft.  In the days when the company was sitting on a $60 billion dollar cash reserve Bill Gates used to boast that he could run the company for five years with zero revenue.  That would have been enough coding time to write a new OS core from scratch, if need be. But that hoard is now <a href="http://venturebeat.com/2008/10/23/microsoft-closes-the-quarter-with-less-cash-than-apple/">mostly gone</a>, spent on stock buybacks and acquisitions that have proved uniformly unsuccessful and a net drag on the company&#8217;s core Windows and Office business.  Thus, MSFT is running out of room to maneuver.</p>
<p>If today were still normal or boom conditions, a collapse in Microsoft&#8217;s market share might benefit Apple as much or more than the open-source community.  But downturns hurt high-cost, high-margin products more than commodity equivalents.  Apple is paying the price for its luxury-good positioning now as it reports that revenue from its desktop line fell 31 percent this last year, and its laptop share is being hurt by cheap netbooks.</p>
<p>The one benefit of recessions is that they squeeze inefficiencies out of the market. As cost pressures mount, paying the license fees to shoehorn Vista or XP onto netbooks is going to look less attractive to the vendors and Linux will probably regain much of the the 100% share of that segment it had when this class of machines was first  introduced.  Microsoft will only be able to forestall this the way it pried loose the netbook market a year ago, by subsidizing the netbook vendors to the point where the net cost of an XP or Vista license is effectively zero.   But that tactic can only be sustained for as long as Microsoft can afford to make no actual profit on the only market segment that is actually showing growth.</p>
<p>Extrapolating from Gates&#8217;s implication of about a $12B-per-year burn rate, MSFT&#8217;s cash reserve gives it about 20 months of burn time at this point.  Adding what it can make on per-seat corporate licenses and the Vista-boggle during that time obviously isn&#8217;t coming up with a figure that makes the company&#8217;s financial mandarins happy, or MSFT wouldn&#8217;t have announced its first round of layoffs ever &#8211; and, of course, it missed their earnings-per-share target for the first time, too.  I know how these people are trained to think and what kind of discount on future outcomes they apply, having been a director of a publicly-held company myself, so I&#8217;m pretty certain from their recent behavior that Microsoft&#8217;s own planners aren&#8217;t giving the company more than 30 months to live without one of (a) a major product success, (b) a return to market conditions that make customers much less price sensitive, or (c) a harsh restructuring of MSFT to cut its costs and run rate.</p>
<p>Right now, there is absolutely nobody who thinks the IT or consumer market is going to be back to anything like boom conditions in 30 months &#8211; and even if it did, price ceilings would have been reset by the expectation consumers are re-forming around $200 netbooks.  There&#8217;s simply not enough room in a $200 bill of materials to sustain Microsoft&#8217;s business model. as I&#8217;ve been pointing out for nearly a decade and the NYT has just noticed.</p>
<p>Therefore, the scenario MSFT has to pin their hopes on combines major success for Windows 7 with a drastic downsizing of Microsoft so it can run on the seriously compressed revenue stream that is all netbook-land will afford.  Viewed from this angle, Microsoft&#8217;s recent behavior makes complete sense. But there is no certainty that this strategy will land MSFT with a sustainable business model within its burnout time.  And, even if we assume that it can, there is zero margin for error on the way there.  Even one serious shock, such as a Vista-like failure of Windows 7 to gain traction, will sink them.</p>
<p>It&#8217;s also worth bearing in mind that if my model is wrong it&#8217;s likely to be because MSFT&#8217;s cash reserve and sustaining revenue streams both continued to erode after the most recent date for which I have solid information (November 2008).  Under plausible but less optimistic assumptions (e.g. assuming their cash hoard has continued to decline since November at the same rate it did over the last two years, they keep missing earnings targets, and cutting operating costs proves difficult) they may not have 30 months to recover but as little as 18.</p>
<p>This is how empires fall.  Until the last minute it is difficult to see what&#8217;s coming, because they tend to hollow out from within long before the damage  becomes obvious from outside. Microsoft lost its battle of the Teutoburger Wald when it failed to prevent Linux from going mainstream in enterprise computing around 2003.  Now, with the layoffs and the first-time fall in Windows revenues, we&#8217;re seeing the retreat from the Antonine Wall to Hadrian&#8217;s.</p>
<p>As the final collapse nears, each successive retrenchment will come faster.  If history repeats itself exactly, the splitting of the eagle into a Western (Windows) and an Eastern (Office) empire may be the next major step, with the Western  Empire collapsing shortly afterwards and periodic attempts by Easterners to recapture the OS market coming to nothing.  But here I veer off into fancy&#8230;</p>
