Microsoft's online woes hint at larger vulnerability

Does Johnson's departure signal bigger trouble in Redmond?

Microsoft Corp. has built its massive software business by watching other companies take the lead in emerging technology markets and then following fast with competitive products that eventually become dominant once those markets begin to pay out.

The company did it with IBM during the birth of the PC and Netscape during the browser wars, and it's currently making a strong showing against Sony and Nintendo in the game-console market.

However, Microsoft's inability so far to capitalize on online advertising and services and its inability to make any headway against Google shows that, despite its huge cash reserves, this strategy may no longer be effective.

In an unexpected move on Wednesday, Microsoft reorganized its platform and services division, which oversees its online services business (OSB) and its lucrative Windows OS business, into two groups to separate its distinct online brands. It also announced the departure of the president of the group, Kevin Johnson, who is reportedly leaving the company to join Juniper Networks Inc.

Both of the new organizations -- one that oversees Microsoft's online advertising and search properties and another that runs Windows Live services and Windows OS -- will report directly to Steve Ballmer.

This move shows the CEO taking firm control of a part of Microsoft's business that has been searching for an identity since the company launched Windows Live services in late 2005 -- in part as a complement to its MSN and search businesses and in part as a rebranding of previous online efforts.

"For the past two years, I've been totally confused about [the difference between] Windows Live, MSN and Windows," said Charlene Li, an independent technology industry analyst. "The messaging and product features don't pull together."

She said splitting up businesses is "a good thing" for the company because it will help clarify Microsoft's online strategy. "You start seeing some differentiation between what the Windows Live brand stands for and what online services is trying to do," Li said.

The move to divide its online brands follows the news last week on a financial conference call that Microsoft would invest "hundreds of millions of dollars" in its OSB group in light of its failure to close a deal to purchase Yahoo or at least its search business. OSB has operated at a loss for years and has shown only meager signs of life despite Microsoft's best attempts to revive it.

For Microsoft's fiscal 2008, OSB showed a year-over-year revenue gain of 32%, from $2.44 billion in 2007 to $3.21 billion in 2008. For the year, however, OSB lost $1.23 billion in operating income; a nearly 100% increase over the $617 million loss in operating income in fiscal 2007.

Last Thursday, Microsoft Chief Financial Officer Chris Liddell sketched out some vague plans for Microsoft's investment, which mainly will go into its search business to bolster online advertising revenue.

However, published reports say Microsoft's biggest shareholders aren't convinced that the company's financial bet will yield much of a return. Microsoft is hosting its annual meeting for financial analysts in Redmond, Wash., Thursday, and will likely shed more light on how it plans to revive OSB with the restructuring and with its renewed investment in the group.

Analysts will certainly be looking for some serious clarity on the topic, especially since Microsoft has been throwing money at online services for years.

"Microsoft's execution online has been poor," said Matt Rosoff, an analyst at Directions on Microsoft. "They've never had a runaway success with a product line ... nothing that has dominated the market or changed the game."

To be fair, the online advertising game -- which some analysts estimate will represent about a $50 billion revenue opportunity in the U.S. alone in the next few years -- is far from over, he said.

Rosoff noted that Microsoft only really began going after Google in earnest three years ago when it launched MSN Search, which was overhauled and rebranded Windows Live Search, and then simply Live Search shortly thereafter.

Microsoft takes a "10-year view of things," he said, noting that Microsoft made more than $60 billion in revenue last year, and the business continues to grow. The company has the "luxury of looking at this as a very long-term business," he said.

"If any other company had thrown this much money away online, they wouldn't be in business right now," Rosoff said. But because of its cash balance and the strength of its business, Microsoft "can invest a lot of money in it without having to worry about the short term."

Still, Microsoft is facing vulnerability in areas that have been a lock for the company for many years. For example, many attribute Apple Inc.'s modest growth in computer sales to negative publicity surrounding its Windows Vista PC OS. While the Windows client OS is still a cash cow and is in no real danger of obsolescence, Apple's success shows there are new chinks in the Microsoft armor.

The popularity of the iPod and iPhone may be showing Windows customers that there are credible alternatives, said Greg Sterling, principal analyst at Sterling Market Intelligence.

This so-called "halo effect," combined with Apple's aggressive advertising campaign that exploited problems users had with Vista early on, proves to PC users that they don't have to settle for what may be perceived as a subpar OS if they don't want to, he said.

"To the extent that people are less fearful of using alternative systems -- that gives them a sense they can stray from Microsoft products and still be OK," Sterling said. The growth of Google's search engine and other online services and applications also provides people with alternatives to Microsoft, he added.

This perception could hurt Microsoft in other markets it's attempting to dominate -- such as the one for virtualization software -- even if the company has the cash to play the waiting game.

Microsoft is chasing VMware in virtualization. To combat its giant competitor, VMware said on Tuesday that it would offer a free version of its basic hypervisor product -- similar to the Hyper-V product Microsoft now offers in its Windows Server OS.

If history is any indication, Microsoft should eventually be able to overtake VMware, especially since its hypervisor is tied to such a successful operating system.

But even Paul Maritz, VMware's new CEO and a former Microsoft executive, pointed out on a VMware conference call Tuesday that Microsoft is not completely invincible, especially when another company already has a substantial lead in a market.

Indeed, Sterling said, "I think there is clearly a perception in the market that Microsoft is not the invincible juggernaut it was."

Copyright © 2008 IDG Communications, Inc.

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