Microsoft's Multiple Challenges: Is Its Size a Benefit or Burden?

Microsoft announces that it will spend about $2 billion to fend off rivals such as Google and thwart Sony's video game ambitions, and the company loses more than $30 billion in market capitalization in a day. Fair trade or overreaction?

By No Analyst or Consultant

June 06, 2006 — CSO —

Microsoft announces that it will spend about $2 billion to fend off rivals such as Google and thwart Sony's video game ambitions, and the company loses more than $30 billion in market capitalization in a day. Fair trade or overreaction?

Probably a little of both, according to experts at Wharton. Microsoft certainly isn't hurting financially. The company reported net income of $2.98 billion on revenues of $10.9 billion for the quarter ending March 31. But the big question is whether that performance will be maintained over the next decade. According to Wharton finance professor Andrew Metrick, the reaction to Microsoft's increased spending plans for 2007, which were detailed in the company's fiscal third-quarter earnings report on April 27, may reveal concerns about what has become an increasingly competitive landscape.

"Spending $2 billion doesn't lose you $30 billion in market cap," says Metrick. "Let's face it: $2 billion to Microsoft is like a pimple on an elephant. The reaction was the market inferring that the company is much more scared than investors thought it was about the future."

Indeed, Microsoft is a company in transition, and investors, customers and the entire technology industry would be wise to pay attention. At issue is whether Microsoft has grown too big to be nimble enough to compete with its long list of rivals on many fronts: Google in Internet search and advertising, Sony in video games with the launch of its Playstation 3 on Nov. 17, Linux inside the corporation, and Apple Computer in digital media, to name just a few. Meanwhile, Microsoft's Vista operating system will miss the peak holiday season; while it will be available to volume-licensees in late 2006, other businesses as well as consumers won't see it until sometime in 2007. By extending its reach into new markets, such as mobile communications and digital entertainment, Microsoft may be stretching itself too thin without getting sufficient returns, say analysts.

Not that those concerns have stopped the Redmond, Wash.-based software giant from investing heavily in new businesses, such as the money-losing Xbox game machine. For the nine months ending March 31, Microsofts home and entertainment division, which includes Xbox, had an operating loss of $848 million on revenues of $3.1 billion. Microsoft is a third-place player in search behind Google and Yahoo, and its MSN unit posted a small loss in the third quarter. And Windows Live, an effort to provide some features of Microsoft's Windows platform as Web-based services, is in its formative stages.

Don Huesman, senior director of information technology at Wharton, suggests that Microsoft's investments are designed to buy the company time to find a way to reinvent itself. By investing in new markets, Microsoft can "put itself into a holding pattern until it can remake the company," says Huesman. "The competition isn't just Google. Sooner or later in the future, you won't own software but have access to it [online]."

At a Silicon Valley event on May 11, Microsoft CEO Steve Ballmer acknowledged that the company's core businessselling Windows and Officecould change. "Software really is evolving to be software and service as opposed to software as some kind of stand-alone entity," he said.

Wharton operations and information management professor Eric Clemons says Microsoft's quest for new businesses may show that the company is a good student of history. IBM, for example, stayed with big mainframe computers too long and "missed both the rise of work-group mini-computers and the shift from hardware-based profitability to software-based profitability in the PC industry," says Clemons. "Maybe that's why Microsoft keeps trying to gain control in the net, gaming and other software areas. They don't want to be a big operating system company if the market moves to something completely different."

Given that Microsoft has no intention of losing its standing as a technology titan, it has an obligationnot to mention its $34.8 billion in cash as of March 31to invest heavily in new markets, says Wharton management professor Sarah Kaplan. "If [Microsoft] wants to make a transformational change, it will need to make a transformational investment," she notes.

Creative Destruction

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