Microsoft's Midlife Crisis

Threats abound: Linux. European trustbusters. Key product delays. Can Gates & Co. restore growth?

Would you invest your hard-earned dollars in a company like this? Its revenues soared an average of 36% through the 1990s, but now it's heading into miserly single-digit growth. It has long been a powerful engine fueled by major updates of its products, yet the next major one, an unprecedented five years in the making, isn't expected until 2006. The company hasn't made much headway in newer, promising markets. And its share price is stuck exactly where it was in mid-1998. Not buying, huh? Well, tough luck: You probably already own a piece of this rock.

The company is Microsoft Corp. (MSFT ), one of the most widely held stocks on the planet. And sure, for all its challenges, this icon of American capitalism still has a lot going for it. With a market cap of $279 billion, its valuation is the second highest in the world after General Electric Co. (GE ). And it remains the most profitable company in the $1 trillion tech industry, pumping out $1 billion a month in cash.

But Microsoft just isn't the phenom it used to be. After 29 years, the software giant is starting to look like a star athlete who's past his prime. Growth is tepid. Expansion is stymied. Bureaucracy is a concern. And a company that used to be so intimidating it attracted antitrust suits on two continents seems, well, vulnerable.

The threats it faces are among the most serious in Microsoft's history. For starters, there's Linux, the software dubbed "open source" because the code is shared freely by developers around the world. With grass-roots and government support from Finland to China, Linux has become so popular that it's challenging Microsoft's core business as no rival ever has. Europe's trustbusters are coming down hard, too. On Mar. 24, they smacked the company with a ruling aimed at preventing Microsoft from leveraging Windows to gain ground in new markets, which could keep the giant tied up in court for years.


But most worrisome are delays of the new operating system, the very heart of Microsoft's business empire. Code-named Longhorn, the next version of Windows is an ambitious attempt to fundamentally change how people use computers. But critics have taken to calling it Long Wait. Already, execs concede that it won't debut until 2006, three years after researcher Gartner Inc. (IT ) originally expected it to ship. That means Longhorn will come out five years after the last operating system, the longest gap ever between major Windows updates. And BusinessWeek has learned that to hit even that target, Microsoft is lowering its sights for the product, cutting back on key features such as an innovative way to store and search information on PCs. "Schedule is a priority for the release," wrote Microsoft Vice-President Joe Peterson in a Mar. 19 e-mail to employees on the project. "[We] expect teams to scale back features to meet target dates."

All this has Wall Street's best and brightest penciling in estimates for Microsoft that would have been an insult a few years back. Never mind 30%, or even 20% revenue growth. The optimistic forecast is for 11% growth over the next few years, shown here as the best-case scenario (charts). The Wall Street consensus is that the company will boost revenues 8% a year through 2006, according to Thomson First Call. That's right in line with the rate Gartner expects for the overall software industry. In other words, after nearly three decades of outracing the market, Microsoft is expected to be a middle-of-the-pack performer. "Microsoft is doing what large companies do -- invest in new segments while maintaining the core," says David B. Yoffie, a professor at Harvard Business School. "So far, though, they're not doing it successfully."

The significance of this goes way beyond Microsoft's growth rate. For almost two decades, Gates & Co. have set the agenda for the tech industry, the most dynamic slice of the U. S. economy. Where Microsoft led, everyone from partners and rivals to Corporate America followed. The question now is whether Microsoft is losing the dynamism it needs to retain that leadership. Is mighty Microsoft becoming IBM in the 1980s -- profitable but lumbering? Big but irrelevant? A giant but toothless? "They are already less relevant now than they were 10 years ago," says Michael A. Cusamano, professor at Massachusetts Institute of Technology's Sloan School of Management and co-author of Microsoft's Secrets, a book on the company's success.

But ask CEO Steven A. Ballmer if Microsoft is past its prime, and he bristles. "No -- in no sense do I feel like we're past our prime," he says during an interview in his windowless conference room. "The thing that I think is fair to say is we are past adolescence. Isn't adolescence when you grow really fast and you can sometimes be a little raucous? And then when you get into your prime, you're just hitting on every cylinder, you're having a great life, you're creating a family, you're rising to new responsibilities. We're in our prime, baby. We're post-adolescent. We are in our prime." He pulls out color-coded charts that show Microsoft outpacing a host of well-respected companies: Intel (INTC ), GE, SAP (SAP ). "Here's Dell, the great growth story of our industry," he says, pointing. "Growing more slowly than Microsoft."

Ballmer's right. Microsoft has boosted revenues 13% over the past three years, a stellar performance during tech's darkest days. But analysts are predicting a slow-mo future, and Ballmer declines to say whether they're wrong. "I'm not going to make some bold prediction of what a good growth rate is or a bad growth rate. I want to make sure that we're doing well relative to our industry."

Ballmer's boss of more than two decades, Chairman William H. Gates III, takes issue with the entire measurement of growth. He says it's naive to compare the $32 billion Microsoft with smaller players. "If growth is your metric, we're not your guy," Gates says, jumping out of his seat. Instead, the company's focus is on innovation, says Gates, who gave up the CEO title four years ago to become chief software architect. "We're doing more new things than any other company."


While Ballmer drives day-to-day OPerations, the 48-year-old founder is taking personal control of the technology charge. He has put together what is now called "The List" around Microsoft's Redmond (Wash.) campus. It's a priority ranking of 50 or so initiatives that cut across product lines and are critical to making the next generation of products successful -- everything from security software and the user interface to Web search and telephony. The List is so important that each item has been assigned to one top executive, who is responsible for driving it throughout the company. "We're using a lot of IQ to go after these things," says Gates.

A look down The List provides intriguing insight into Microsoft's concept of innovation. The company pours about $6 billion a year into research and development, and the vast majority of that goes to improve its monopoly businesses, Windows and Office. In the past, it developed ClearType technology for high-resolution text displays and grammar checking that identifies errors as people write with its word-processing software. Gates's work now on security and search also will be baked into Microsoft's most popular software. This approach, which he calls "integrated innovation," is the reason people continue to buy new versions of Windows.

"I don't know if people really get what I'm saying or if they just think I'm being cute when I say our biggest competitor is our installed base," he says. "You can sit on the existing [products] -- that's a perfectly legitimate choice. This is not a soft drink where you get thirsty and say, 'I drank my word processor. Let's have another."'

Microsoft's success in making people thirsty has been critical in the development of the entire personal-computer industry. From the biggest PC makers to the smallest software-application developers, almost all built their companies on top of Microsoft's creations. Critics may carp, but each time Microsoft gives users another reason to buy Windows or Office, it gives its partners another opportunity to sell their wares as well. That's why Ballmer bridles at criticism that Microsoft doesn't pioneer new markets. Important innovation, he says, is not simply dreaming up a new idea but also refining it enough to get people clamoring for it.

"The thing that is most important is to be the guy who can come up with the innovation that gets the category to explode," he says. "The guy I really want to be is the category exploder." Perhaps more than any other company, Microsoft exploded the markets for PCs and for productivity software, such as Office's word processing and spreadsheets.

Now, however, the company seems to have misplaced its dynamite. The U.S. PC market is largely mature, so Microsoft has moved into new businesses. But these categories, such as online services and video-game consoles, already are dominated by large rivals -- and they know Microsoft's tactics. So instead of opening new frontiers, Microsoft finds itself in pitched battles for existing territory. "Microsoft is the only company in the world that can afford to take fortified hills -- and that's almost a disadvantage," says Richard E. Belluzzo, ex-Microsoft president and now CEO of data-storage player Quantum Corp. (DSS ). "They have too much money, too many good people, too much time -- all of which can hurt [them] in some ways."

To bust out of this rut, Microsoft may need to put more focus on creating something altogether new. The company has spent a total of $32.6 billion on R&D since 1990, more than the next five largest software companies combined. Yet tech-industry observers marvel that it has produced so few breakthroughs. After all, it was Apple Computer Inc. (AAPL ) that stole the show in digital music with its sleek iPod. And two Stanford University grad students came up with the search technology behind blockbuster Google Inc. "Plowing millions of dollars into me-too technology because you think there's indirect money you can make [through Windows and Office] is pure foolishness," says Cusamano.


Some question whether Ballmer is doing enough to encourage innovation. In April, 2002, the chief divided the company into seven business units and gave each leader profit-and-loss responsibility. But he didn't give them complete independence. As part of integrated innovation, they're all supposed to coordinate their activities and align with the core Windows strategy. "They don't own 100% of their own destiny," says recently retired treasurer and deputy CFO Jean-Francois Heitz.

Autonomy isn't the only issue. Ballmer's intense focus on financial details forced managers to spend untold hours boning up on the minutiae of their businesses. He backed off after they complained, but some former execs think the planning process is still too much. "In the past, the system was optimized for people who could get [stuff] done," says a former exec. Now, "everybody is always preparing for a meeting."

Microsoft says these frustrations are just part of the growing pains of becoming a mature organization. Ballmer gives the new management system an A-. "I know it's absolutely the right thing for the long-term health of the company," he says.

Gates and Ballmer have led Microsoft through minefields before. In the 1990s, Gates engineered the company's powerful response to the Internet challenge, while Ballmer built a sales operation that penetrated corporations worldwide and ended the company's overdependence on desktop computing. Today, Microsoft is pushing hard on many fronts. Among them: applications for small and midsize businesses, the Xbox game console, Web-surfing cell phones, software for wristwatches that can get news updates, and most recently, speech-recognition systems. In each case, prospects for meaningful revenue growth are modest -- at least for the next four years, for which analysts have done projections.


With $53 billion in the bank, Microsoft could buy its way to faster growth. Indeed, it already has made a move in that direction, spending $2.5 billion over the past three years to move into the market for business applications for small to midsize companies. It could follow that up with acquisitions in a host of promising areas, such as security, collaboration, and game software.

But many analysts expect Microsoft to shy away from large deals and dole out more cash to shareholders -- just like a mature company. It started paying a dividend last year and now spends $1.73 billion annually on it. While shareholders have clamored for more, the company has said it needs the cash as an insurance policy against the European Commission antitrust probe and an antitrust suit brought by Sun Microsystems Inc. On Apr. 2, Microsoft settled the Sun case, paying its longtime nemesis nearly $2 billion. Now analysts expect Microsoft to start forking more cash over to shareholders, either in the form of a higher dividend or a big stock buyback. "Microsoft is growing up," says John Linehan, portfolio manager for the T. Rowe Price Value Fund, which recently became one of the company's top 10 shareholders. "It's a very attractive investment in the value camp."

Without acquisitions, however, Microsoft may struggle in new markets, given the shortcomings of its me-too approach. Consider Web access. Microsoft poured more than $10 billion into its MSN business in the past eight years, estimates Sanford C. Bernstein & Co. (AC ) analyst Charles DiBona, much of it trying to catch America Online in attracting dial-up Net subscribers. While Microsoft succeeded in becoming AOL's most ferocious rival, the market has begun to evaporate as consumers migrate to broadband Net connections. Now, the money-losing business is dragging down the rest of MSN's numbers. "Some of that investment in MSN was not the best use of cash," says DiBona.

In some cases, Microsoft's track record of gobbling up profits has made potential partners leery. That's what's happening in the market for souped-up cell phones that can handle Web-surfing, e-mail, and photo-swapping. After four years of effort, Microsoft has persuaded a handful of mobile-phone makers to use its software, including Motorola Inc. (MOT ). But market leader Nokia Corp. (NOK ) and other major players are determined to thwart Microsoft's attempts to dominate their business the way it has the PC industry. Nokia and Sony Ericsson Mobile Communications use competing software from Symbian and have even taken equity stakes in the London company. "The name for this in the industry is ABM -- anybody but Microsoft," says David Nagel, CEO of PalmSource (PSRC ), another maker of mobile-phone software.

Microsoft does better in markets adjacent to businesses it dominates. An example: Its foray into applications for small and midsize businesses. These companies typically own its Windows and Office products. Microsoft jumped in three years ago, buying two accounting-software companies, Great Plains Software and Navision. The business is growing at a healthy 20% a year, hitting $567 million in revenues in fiscal 2003.

That's little more than a rounding error at Microsoft today, but the plan is to keep offering ever-more-powerful software to these smaller businesses. Last year, Microsoft released its first homegrown application: customer-relationship management software for handling sales forces and customer-service staff. "It's all green fields," says Douglas J. Burgum, senior vice-president for Business Solutions Group. To stimulate demand, Microsoft is offering a promotion through June. It's selling its year-old CRM package for $99 per user for the first five users -- a nearly $300 discount per user -- if customers also buy Microsoft's $1,500 server product. It's classic Microsoft -- and a tactic its rivals can't match, since they don't sell server software.


Even here, though, Microsoft probably won't be able to add to overall revenue growth in a major way. Gartner expects the CRM market to rise an average of 5.5% a year through 2007, to $966 million. To add to Burgum's challenges, the next major version of his products, code-named Project Green, which meld the Great Plains and Navision products, won't be out until Longhorn debuts.

Indeed, Longhorn is becoming something of a logjam. Its delay is holding up the other products Microsoft usually debuts with a new operating system. A new version of Office often is released about the same time, with its applications fine-tuned to the new system's capabilities. Windows chief James E. Allchin pulled engineers off Longhorn to address security concerns in current products. That delayed what is already the most complex operating system Microsoft has ever built. The giant is debuting a new user interface, overhauling the way people store and retrieve files, and adding technology to let traditional applications interact with a new generation of programs called Web services. "Longhorn is an extremely ambitious project," says Gates.

The most important change is to the file system -- the way information is stored on the PC. Microsoft is creating a new design not just for Windows but for all of its products that makes it easier to retrieve photos, documents, songs, and e-mail. That's important as users stash more and more files on their computers. If Microsoft gets it right, it will be simple, for example, for users to zip through thousands of pictures and sort them by date or by the people in them.

But Longhorn won't do everything Gates first envisioned. BusinessWeek has obtained copies of two internal e-mails showing that Microsoft is cutting some of the most ambitious technologies to get the product out the door. For example, Longhorn will now ship with a scaled-back version of the file system. The current plan, in practical terms, means people will be able to search their PCs for documents and information related to each other, but they won't be able to reach into corporate servers for similar files.

What's more, Microsoft is retreating from trying to link its two monopolies even more closely. BusinessWeek has learned that the company intended to develop the next version of Office so it would work only on Longhorn, not earlier versions of Windows. But in a videoconference with employees on Apr. 1, Microsoft's Peterson said such tight integration won't be possible given Longhorn's changes. "The great big version of Office that really takes advantage of the platform is something we're pushing out further in time," he said. "That's one big trade-off we've already made."

While Microsoft has been publicly vague on timing, Peterson wasn't. One e-mail said the company will ship the first beta version of the software next February and plans Longhorn's debut for the first six months of 2006. Microsoft confirmed the content of the e-mails and videoconference but declined to elaborate.

Getting Longhorn finished is critical because the delay is starting to take a toll. Customers who planned their software upgrades based on timing guidance from Microsoft must rejigger their plans. Those who can't wait for improved security and reliability will turn to alternatives, says Tony Yustein, a former Microsoft employee who now runs SoftCom Technology Consulting Inc., a Web-hosting company in Toronto. Yustein is adding Linux systems because of his growing frustration with his old company. "Microsoft has lost its perspective, concentration, and vision in operating systems," he says.


Linux poses the biggest threat to Microsoft since the Web burst on the scene in the mid-'90s. The 13-year-old operating system is attractive to tech companies and corporations alike because it gives them a viable alternative to Microsoft's products that they can modify at will. Also, since Linux computers run on the same processors as Windows and the software is available for free, for the first time Microsoft is confronted with competition that is cheaper to buy. Until now, Linux' momentum has come primarily at the expense of the Unix software in server computers.

But corporations increasingly are adopting Linux as a viable option to Windows. Robert W. Egan, vice-president for information technology at Boise Cascade Corp. (BCC ), is using Linux to run his company's internal Web site and network-maintenance programs -- things he used to run on Windows. Other companies may follow suit: In a recent survey of corporate tech purchasers by Merrill Lynch & Co. (MER ), 48% said they plan to boost their use of open-source software this year, and 34% of that subgroup are targeting applications that traditionally ran on Windows.

The place where Linux will likely have the most profound impact is in developing nations. Tech companies are staring hungrily at China and India as their next growth markets. Yet Microsoft likely won't dominate there, as it has in the U.S. Last November, China Standard Software Co., a consortium of government-funded companies, agreed to deploy a million computers in the next year using Linux on the desktop and Office rival StarOffice, made by Sun. "There are places, particularly in government, where people are making political decisions instead of right-minded decisions," says Ballmer.

The threat has Microsoft focused on Linux as Enemy No. 1. In the past two years, to win favor in China, Microsoft has pledged to spend more than $750 million on cooperative research, technology for schools, and other investments.

From Linux in China to Longhorn in waiting, Microsoft is increasingly stymied as it goes after new opportunities. But riding out the old businesses won't be enough. "The biggest challenge is to remain as tremendously successful as they have been in the past. That's a curse," says Hasso Plattner, chairman of the supervisory board at German software giant SAP. A lot of CEOs would probably accept Microsoft's curse and call it a blessing. But that's not good enough for Gates and Ballmer. "Some people actually say to us, 'There are no new things you can do,"' Gates says. "I know, at least for the next decade, that is just wrong. It's just wrong, and it will be fun to surprise them." There's no denying he has the will. Now he has to make it so.

By Jay Greene

With Jim Kerstetter and Peter Burrows in San Mateo, Calif., and Steve Hamm and Spencer E. Ante in New York

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