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Will Linux Save Microsoft?


By Hal Plotkin
CNBC.com Silicon Valley Correspondent

Dec 8, 2000 01:54 PM

In a week when the markets have battered every stock connected with the troubled personal-computer business, it is time to take a look at the company that, more than any other, has defined that industry. I speak, of course, of Microsoft Corp. {MSFT}. And I’m here to tell you that Mr. Softee has a bright future that isn’t reflected in its battered share price.

Long before softness in PC demand prompted the huge selloff in shares of Compaq Computer Corp. {CPQ}, Gateway Inc. {GTW} and Intel Corp. {INTC}, investors had decided that Microsoft was a bad bet. Many of them pointed to two huge threats: The first, of course, is the Justice Department’s victory in its antitrust suit, which could lead to a breakup of the software giant if the company’s appeals fail. The second is the Linux open-source operating system, which has the potential to replace Windows.

Investors have reacted to those concerns with considerable alarm, cutting Microsoft’s stock price from its 52-week high of 120 a share last December, all the way down to the 50 range. The stock got another haircut on Thursday, losing about 7%, after Goldman Sachs analyst Rick Sherlund lowered his fiscal third- and fourth-quarter revenue estimates by a combined $350 million. Sherlund also pared his earnings-per-share estimate for fiscal 2001 to $1.88 a share, 3 cents below the consensus analyst estimate compiled by First Call Corp. The analyst cited weakening growth in the sales of new PCs for his more-pessimistic outlook, noting that consumer purchases of computers that contain Microsoft’s Windows operating system generate about 10% of the company’s revenue.


One-year performance of MSFT

Sherlund may prove correct in the short term. But his warning comes just as it is becoming clear that the challenges Microsoft faces could just as easily turn into opportunities. For the record, the company also hasn’t retreated from its mid-October guidance to the Street of 15% revenue growth for fiscal 2001, which would bring the year-end numbers in much closer to First Call’s slightly higher consensus estimate.

Take a look a few quarters beyond that, and Microsoft’s prospects look even brighter, particularly as they relate to the twin challenges posed by Linux and the Justice Department.

Let’s take Linux first.

Unlike proprietary operating systems sold by companies such as Microsoft and Sun Microsystems Inc. {SUNW}, the vendors of open-source Linux make the source code of their products freely available. Armed with the source code, programmers can modify or improve the software without needing the help or permission of the original manufacturer. Because the software is free, the business plans of the Linux firms call for them to make their money by selling service, support, updates and documentation, some of which is subscription-based.

“Everyone who uses open-source software can benefit whenever the software is improved,” says Stacey Quandt, an analyst at Giga Information Group, based in San Jose, Calif.

Microsoft doesn’t talk about its Linux strategy very much. But it is an open secret in Silicon Valley that the company could rather easily steal the thunder from faddishly popular Linux firms, such as Caldera Systems Inc. {CALD} and Red Hat Inc. {RHAT}, at just about anytime it chooses.

Microsoft could, in fact, co-opt the open-source movement the way it co-opted the Web-browser business — after it found that its proprietary online technologies couldn’t compete with the Internet formats that Netscape was popularizing.

It reminds me of the lyrics from Willie Nelson’s wistful ditty, “Pancho and Lefty”: “All the Federales say, they could’a had him any day. They only let him go so long, out of kindness, I suppose.”

The moment of truth for the Linux companies will arrive if and when they start to succeed in any truly meaningful way. Students of Microsoft have no doubt that, if Linux really starts to catch on, Bill Gates & Co. will stop dissing the Windows alternative and get at the head of the Linux parade — if that is what it takes to keep its position in the software industry.

In 20 years of covering the company, I can’t recall a single instance when Microsoft ever voluntarily ceded market share to a competitor. That is why I am betting on a toe-to-toe battle over Linux, with Microsoft having by far the biggest toes. If you don’t believe me, ask Jim Barksdale.

The only thing Microsoft has to do is to release its own version of the Linux OS. There is no reason to do that now, given the still-small market share commanded by Linux software, particularly on the end-user side. But let that market continue to grow a little more and Microsoft will be faced with a choice: Either it cedes part of its core OS market to the Linux companies, or it competes with them head-to-head.

The irony here is that Microsoft can wait until the money-losing Linux companies finally perfect their upstart open-source operating system. That would let Microsoft leverage — some would say hijack — every bit of the costly research and development done to date by the open-source software movement. Most Linux developers would probably be aghast at the notion that Microsoft will eventually be selling what they created. But the company has left more than a few would-be competitors aghast in the past.

Now let’s look at the impact of the proposed breakup of the company. That already looks less likely, given the lengthy appeals process and possible pending personnel changes at the Justice Department.

If the breakup proceeds, however, the company would be split into two units, one that sells the OS and one that sells the company’s popular applications, such as Word and Office.

“The impact of this split would be to free the applications business to make decisions related to markets outside the Windows platform,” says Dan Kusnetzky, an analyst at International Data Corp.

Microsoft’s applications business could easily make Linux versions of applications such as Word and Excel available with scant development costs. That would open up an entirely new market for an existing product line.

It is hard to say when that might happen. But it could be sooner, rather than later, now that Linux is gaining momentum with corporate users. The Home Depot Inc. {HD}, for example, recently announced plans to roll out 90,000 cash registers and in-store terminals based on Linux. Similar deals are in the works at other large retailers, as companies embrace the idea of paying for software maintenance, rather than software licenses.

Not coincidentally, Microsoft’s latest software offerings also allow users to obtain regular updates over the Internet. The move positions the company to transition from sales-centered revenue to service-centered revenue streams, should the market continue to move in that direction.

What is more, the company continues to be focused around high-margin digital goods that can be manufactured in unlimited quantities at negligible incremental costs.

So what does all this mean?

It means Microsoft probably has a winning hand, even if it loses in court and loses market share to Linux.

With the market looking more and more like the television show Survivor these days, there is good reason to think that Microsoft will be the last player on the island.

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