Microsoft faces tough road ahead

But while Bill Gates & Co. can only be relieved that 2000 is now history, Microsoft (msft) faces a tough road in the year ahead as the company tries to adapt its business model to the increasing importance of the Internet and the current slowdown in personal computer sales. (MSNBC is a Microsoft-NBC joint venture. )

Microsoft shocked Wall Street last month when it said its earnings and revenues would miss expectations due to the global slowdown in PC sales. The Redmond, Wash.-based company had a history of carefully managing analyst expectations and then exceeding them, so when Microsoft was forced to "confess" an earnings shortfall for the first time in more than 10 years it sent a shudder of fear through world stock markets. The technology-dominated Nasdaq composite index fell 14 percent in the four sessions after

Microsoft's warning as investors came to grips with the likelihood of a broad and deep downturn in PC sales growth.

Since year-end Nasdaq has rebounded and Microsoft stock is up 26 percent--rising from its lowest level in two years. And certainly there are reasons to think that 2001 will be a better year for the company, which officially reports its quarterly earnings Thursday.

The turning tides
To start with, the incoming Bush administration is ideologically opposed to the type of tough antitrust law enforcement that resulted in last year's judicial order breaking up the company. That does not mean a settlement of the long-running case is imminent, and Attorney General-designee John Ashcroft was careful to avoid taking a position on the case in a Senate confirmation hearing Wednesday.

But many experts are betting that the breakup order will be overturned on appeal. District Judge Thomas Penfield Jackson has hardly strengthened his ruling by openly discussing his negative feelings about Gates, Microsoft and even the appeals court itself in interviews that have been getting a new wave of publicity lately.

Also in Microsoft's favor is a cycle of new products due out this year: the first major update in two years for Office, a major new release of Windows, and Xbox, the company's highly anticipated foray into the video-game business.

"Personally my gut tells me they're going to have a good year--they had such a bad year last year," said Scott McAdams, a longtime Microsoft analyst and president of the Seattle brokerage McAdams Wright Ragen.

"Obviously PC sales are very anemic, but that's in the stock already," he argued. Still, he said investors have a right to be skeptical, particularly given Microsoft's past execution to date in new businesses such as interactive television and wireless technology.

Chris Le Tocq, a research director for Gartner Group, said Microsoft executives also have reason to worry about the shifting business model of Office, the all-purpose package of applications that historically has been the real earnings driver for the company.

Microsoft already has announced an option that would allow users to pay an annual subscription fee rather than a one-time purchase price for the new version, known for now as Office 10. This would cut into the initial revenue "spike" Microsoft generally enjoys from the release of new products but might boost revenues over the long run. At the same time Microsoft is working on versions of Office that would be delivered online in keeping with its ".NET" initiative, although the initial version of Office.NET is unlikely to be delivered until 2002, in part to avoid confusing customers, Le Tocq said.

Gartner Group recommends that its corporate clients upgrade Office only once every three or four years, roughly the life cycle of a personal computer, basically skipping a version since Microsoft releases new editions every 18 months to two years.

"There's not really enough value in each successive version" to justify the cost of an upgrade, Le Tocq said. As a result many users are satisfied to upgrade only when they buy a new computer, if at all. "From Microsoft's perspective, that's not good news in regard to their upgrade revenue."

Similarly, Microsoft has discovered that many corporate users are in no hurry to upgrade their existing computers to Windows 2000, the business-oriented operating system that launched about a year ago but got off to a slow start. Analysts say corporate PC sales slowed in 2000 in part because corporate buyers went through a major hardware upgrade cycle in 1999 to resolve Y2K-related problems.

All bets on Whistler
The upcoming version of Windows, code-named Whistler, poses a tough marketing challenge for Microsoft as it merges two existing product lines into a single code base, hoping to spark a new upgrade cycle for both business and consumers.

"They have to make it look like it's extremely trendy for consumers without scaring the hell out of IT managers who otherwise might buy it," said Rob Enderle of Giga Information Group.

Wall Street analysts are not expecting any surprises when Microsoft reports fiscal second-quarter results after the close of trading Thursday. The company announced a month ago that earnings will be 46 or 47 cents a share, about flat with year-ago levels, while revenues will be between $6.4 billion and $6.5 billion, an increase of 5 or 6 percent. Earnings are expected to remain flat for the rest of the fiscal year ending June 30--a huge comedown for a company that has grown earnings and revenues at rates of 30 to 60 percent or more in recent years.

For all its problems, the recent rise in Microsoft's stock price reflects the company's persistent status as a technology blue chip, analysts say.

"A lot of the market is beaten down, and when things get beaten down people still look to tech leaders, and Microsoft is still a tech leader," said Chris Galvin of J.P. Morgan Chase & Co.