Microsoft's 23-year growth streak ends

Microsoft's 23-year growth streak ends

All good things come to an end: A lot has changed since Microsoft's IPO on March 14, 1986, but since that time there has been one constant truth: Microsoft would grow revenue in year-to-year comparisons.

After weathering the IT bubble in 2001, Microsoft's 23-year growth streak was finally ended in 1Q09 by the worst recession in recent history. Perhaps fittingly, the revenue decline was driven by the same business that gave Microsoft its start, Windows. Microsoft's product portfolio and revenue sources have increased dramatically over the past 23 years, but the Windows operating system business remains central to Microsoft's business and strategy in the software market.
Factors such as premium mix and netbooks may have played a role in the Client division's 15.4 percent year-to-year revenue decline, but widespread weakness in PC shipments was the primary driver. Microsoft's own success in growing the Windows business effectively ended its growth streak in 1Q09, as the vast scale of the business made dodging an estimated 7 percent to 9 percent decline in PC shipments impossible.

Windows 7 won't change cut-rate purchasing habits: With Windows 7 being released to public beta and ramping up for general release, there is some speculation that performance in Microsoft's core Windows business could turn around in short order. TBR believes the cautious spending and preference for lower-priced PCs are fundamental shifts in the marketplace that will not dissipate once the economy improves. As seen with Vista, Microsoft was running Windows under the "bigger is better" strategy, and the current recession is driving customer behavior in the opposite direction. Windows 7 capitalizes on this trend, delivering a more stable, lightweight, and intuitive interface, rather than continuing with the direction of Vista.
The end result may be that Microsoft sells more versions of Windows 7 at lower price points, but if Microsoft did not meet this emerging customer demand, Apple and Linux would. Windows 7 appears to be a truly customer-driven product design, which comes at a critical time when Microsoft needs to prove itself again to customers and partners.

Although 1Q09's revenue decline may have marred Microsoft's flawless growth record, the company remains supremely positioned to weather the recession. Microsoft implemented the first corporate-wide headcount reduction in its history during 4Q08, the company proved old dogs can learn new tricks, and reported its cost saving efforts were already ahead of plan. Microsoft is reducing costs in a number of ways, including top-down headcount reductions, travel curtailment, and reducing SG&A expenses, but one area the company is not willing to sacrifice is research and development. The company current has a number of critical products under development, including Windows 7, Office 2010, and Windows Server 2008 r2, and remains committed to meeting existing product road maps. TBR believes the decision is not simply a commitment to the status quo, but in reality a solid business decision. Microsoft retains an extremely stable financial position, with nearly $25 billion in liquid assets, and these products represents a huge stream of future cash flows for the company. Every dollar spent on developing these products on schedule will likely be returned at least ten fold over the next five years.
The recession also highlights Microsoft's ongoing failure in the Online Services Business. Revenue in the Online Services Group declined 14.5 percent during 1Q09, while operating losses widened to $575 million. In the last four quarters alone, Microsoft's operating losses in OSG were $2 billion. Although OSG losses represent a small portion of Microsoft's revenue and profit, the company's time and effort could certainly be better spent elsewhere.

Google is dominating both the traffic and monetization streams in the online search and advertising market, with no viable challengers in sight. TBR believes Microsoft has a ripe area of investment in the enterprise software market that presents lower barriers to entry and a much higher probability of success. Microsoft already built its Server & Tools business into a growing, highly profitable segment, and some strategic investments could yield large returns. Unlike the online advertising market, enterprise software is a distributed market, with thousands of companies operating profitable business models. By purchasing Salesforce.com, NetSuite, Intuit, or a number of other mid-sized software companies, TBR believes Microsoft could further scale its enterprise middleware and applications business.
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