Microsoft: The Decline Begins

Microsoft disclosed that sales fell 6 percent during its third fiscal quarter ending March 31, its first ever year-over-year quarterly sales drop, and the start of an inexorable demise. Rome didn't decline in a day, and neither will Microsoft, but the graffiti is on the wall.

Microsoft CFO Chris Liddell sounded funereal during yesterday's earnings call, citing the toughest economic climate the company has seen in its 30 years, and cautioning analysts that while conditions had stopped worsening, he hadn't seen any indication that they were improving.

But unless Liddell has been living in a cave, or getting his news using a Windows Mobile smart phone, he knows that a range of tech companies, including Apple, Amazon and Google, described a much rosier outlook for the future. The difference is those companies are still at the front, while Microsoft is near the end of its life cycle of relevancy.

I'll explain what I mean by the life cycle of relevancy, but first let me lay out a few data points:

• Microsoft's performance would have been catastrophic were it not for annuity income from its Servers and Tools division -- licensing revenue that came up for renewal during the past quarter. And while those renewals were stable, customers weren't adding products as they usually do, nor were they adding seats; indeed, because of layoffs, many of them were in fact reducing seats.
• Revenue in the Client division, which includes Windows and Office, fell by 19 percent. Half -- half!! -- of Microsoft's operating income comes from sales of its Windows operating system. The preponderance of its remaining product portfolio, from Office to SharePoint, is built on top of that.
• Liddell said sales of premium products fell by 16 percent. Gulp.
• Microsoft's fourth fiscal quarter, ending June 30, is the really big one for annuity renewals. If Liddell hasn't seen any improvement in business conditions -- and he says he hasn't -- that bodes really badly for Microsoft's annuity business and thus the company overall.

Liddell tried to put a good face on the future, saying Microsoft is bringing a "large wave of products and services to market" over the next 12 to 18 months. But he also admitted that Microsoft's new SharePoint, Exchange, Windows, Office and "possibly" search products will be introduced "into soft demand." When the economy turns, he posited, "we will be going into that growth pick-up with a very, very good set of new products."

Perhaps, but the question is whether anyone will care -- and this is where the life cycle of relevancy comes in. Companies aren't swallowing Microsoft's marketing hype, and are renewing with the bare minimum in terms of product enhancements. In the long run, customers will come to realize that they don't really need everything Microsoft is selling. They certainly haven't bought into Vista and may well decide they don't need Windows 7 either, and customers may not be convinced that Office 2010 will buy them all that much more productivity than Office 2007 to to be worth the added cost.

Microsoft always figured its products were good enough to hold off the competition. Now, it's the competition that's good enough. Fortune 500 companies with thousands of seats are testing Google as an alternative to Microsoft Office that could save them millions -- and begin to chip away at Microsoft's foundation.

Microsoft is also banking heavily on its SharePoint document management portal; former Microsoft division chief Jeff Raikes boasted that SharePoint was the "sleeper" release of 2007. But in contrast to Office, Microsoft faces significant competition in the document management space from the likes of IBM, EMC, and Google, which can legitimately go after the small and medium-sized business segment with a very low-cost enterprise-class offering.

Office Communicator, a product that combines IP-based telephony with collaboration tools, also faces very stiff competition from Cisco, IBM, Avaya and ShoreTel.

Liddell also mentioned Microsoft's Azure cloud computing service, as well as online versions of Microsoft products, but admitted that those won't have a significant impact on revenue until Microsoft's fiscal 2011 or 2012. What will the world look like then?

The combination of a younger workforce with no attachments to Microsoft and a generation of IT administrators who will have been weaned off the Microsoft upgrade cycle by corporate austerity drives will mark the beginning of a secular decline in Microsoft's fortunes. It will hang around for years because it will not lose its installed base all at once. But it will pay for having failed to innovate for too long, as Rome rested on its laurels, with its own inexorable decline.