What’s behind Microsoft’s fall from dominance?

What’s behind Microsoft’s fall from dominance?
Barry Ritholtz
Washington Post September 8, 2013

“Do you have an iPod?”

Steve Ballmer: “No, I do not. Nor do my children. My children — in many dimensions they’re as poorly behaved as many other children, but at least on this dimension I’ve got my kids brainwashed: You don’t use Google, and you don’t use an iPod.”

— Fortune Magazine, “CEO of Microsoft is ready to take the offensive,” March 29, 2006

The decade since Steve Ballmer took over as chief executive at Microsoft from his Harvard pal Bill Gates has not been kind to Microsoft: The company saw its stock price plummet, it made ill-advised acquisitions, demonstrated poor capital management and suffered a significant loss of market share. The once-dominant software giant lost its way.

The firm, considered the mac daddy of technology at one time, missed every major tech innovation of the new millennium. The Zune, its foray into portable music players, was an embarrassment. It let Apple gain a toehold on the consumer desktop, which Steve Jobs then leveraged to show consumers a superior alternative to kludgy Windows software. Microsoft was late to Web search and failed to monetize online properties. A belated attempt to jump into advertising by acquiring aQuantive for $6.2 billion led to its first-ever quarterly loss, in 2012.

It wasn’t just the existing software. Microsoft failed to recognize the impact of nearly every worthwhile development. It missed the rise of touch-screen technology and the mass appeal of social-networking sites (i.e., Facebook and Twitter). Perplexed by tablets, it lost more than $1 billion in that venture. Late to user-generated content and blogging, it built MSN Spaces — a Windows-only ghetto that failed to catch on or turn a profit. It blew its early lead in smartphones by failing to understand their significance. And it certainly never threw the same weight behind them as it did its mainstay PC business.

Indeed, it is hard to think of new technology since 2000 that Microsoft had a significant role in developing, marketing or monetizing — other than the Kinect device for the Xbox 360.

Much of the debate about its fall from grace focuses on two factors: Analysts have argued that its fade was part of the natural progression for all companies. The life cycle of innovation, adoption, missteps and irrelevancy is the inevitable fate of all companies. It suffered the “innovator’s dilemma” of overemphasizing its current business lines. This led to a failure to develop new technologies and profitable businesses. In the end, the thinking goes, it was a victim of its own success. (This is true for so many companies, though IBM is an exception; it morphed into a consultancy).

The counterargument is that a mediocre CEO allowed the company to slide into decline. Ballmer oversaw ill-advised acquisitions. He missed the tectonic shifts in technology. And despite the number of employees tripling over the past decade, many of the company’s most talented software engineers left for more-nimble rivals, a better lifestyle and more-interesting opportunities.

Both arguments are valid. Indeed, they are not mutually exclusive. But I believe there is a broader, overlooked explanation.

Microsoft’s greatest strength has always been its monopoly position in the PC chain. Its exclusionary licensing agreement with PC manufacturers mandated a payment for an MS-DOS license whether or not a Microsoft operating system was used. Because it made no sense to pay for two operating systems, it created a huge barrier to entry for any other software firm. No other operating-system maker could get a toehold in the PC market. By the time the company settled with the Justice Department in 1994 over this illegal arrangement, Microsoft had garnered a dominant market share of all operating systems sold. It held a lock grip on the market until 2008, when it fell below 90 percent desktop OS share for the first time.

Consider Microsoft’s huge cash flow: The former monopolist throws off nearly $78 billion in revenue and earns almost $27 billion in profit each year. Its three main product lines — Office, Server Tools and (now slipping into third place) Windows — account for three-quarters of its revenue and nearly all of its profit. It is not a coincidence that these business lines were the direct beneficiaries of the Microsoft monopoly. Indeed, none of Microsoft’s other businesses has achieved the success of its monopoly properties. Online service loses money each year. Despite enormous investments, its entertainment and devices division still earn less than $1 billion annually.

Gates’s true genius was not as a tech visionary. It was his business acumen in leveraging a monopoly position in operating systems to become the dominant U.S. tech company. IBM gave the world its first PC in 1980. The mainframe giant looked down on the idea of a personal computer for home or even business use. It thought the PC insignificant — it could never replace the big iron it made. In 1981, it happily outsourced the operating system to Gates’s squad of geeks, who themselves outsourced the OS code writing. By 1982, MS-DOS was released.

Embedded within that original IBM deal was the seed of Microsoft’s vast fortunes. Microsoft’s true genius was in its license agreements of MS-DOS (and, eventually, Windows) with PC manufacturers. They offered a variety of licenses, but the version that charged the least per copy included a clever kicker: Microsoft had to be paid for every machine sold — regardless of whether MS-DOS was the operating system. This brilliant, if evil, agreement with computer makers effectively blocked all OS competition. Microsoft became the standard adopted by corporate America.

Microsoft had its deal with the devil: Its lightning in a bottle was not some awesome technology or brilliant breakthrough – it was a clause in a contract that led to an enormously profitable monopoly. It then pre-installed Office in new PCs, creating a second monopoly and billions more in profits. By then, Office had become the dominant productivity software suite. Eventually, Microsoft’s server and tools division — which includes Windows Server and Microsoft SQL Database — also became a de facto standard.

Google’s motto, “Don’t Be Evil,” was a not-so-subtle swipe at how Microsoft had achieved its dominance.

Most monopolies, aside from baseball, eventually get broken. Microsoft was no exception. Once the Justice Department and the European Commission found the company in violation of antitrust laws, it was forced to compete fairly. It is no coincidence that as the company lost its vice grip on the desktop, its dominance faded. Revealed as a dinosaur, it was unable to compete with the smaller, more-nimble mammals.

And therein lay its current problems. In a fair and level playing field, the once-feared software giant has been revealed as a middling software writer and a mediocre competitor.

Ballmer oversaw a decade of missed opportunities, and he very well may have hastened Microsoft’s decline. But it might have been inevitable. The truth is that for all its claims of innovation, Microsoft never generated much in the way of profits by innovating. This then is a tale of the long, slow death of an enormous cash cow.

To quote London-based analyst Benedict Evans, “Just as overnight success can take a lifetime, so overnight collapse can also take a long time.”

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. Follow him on Twitter: @Ritholtz.