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Rumors of Microsoft's Demise Are Premature...But Not Unthinkable

"The improbable is possible - leaders have been dethroned in the past"

Penguinistas have long loved to ruminate over a beer about the potential reversal of market share between Microsoft and companies offering open source solutions. But such ruminations were often left to discussions at the pub or the local LUG meeting because in a corporate business setting, even the most die-hard Penguinistas might be cautious about being thought of as wacko - at least in North American and European business settings.

Software market watchers are now taking more serious assessments of the penguin versus butterfly competition, as Microsoft matures and Linux continues to put large growth numbers on the board.

The more vocal observers' voices in this choir are typically located outside the United States. For example, Tectonic, an online open source magazine based in South Africa, recently quoted Novell SA systems engineer and business manager Allison Singh as going on record that Microsoft's Windows juggernaut will become an operating system for niche tasks while Linux takes over the mainstream desktop and server roles. According to Tectonic, Singh forecast that users who need specific applications written for Windows only will stick with the OS, but for most other users, the rapidly evolving Linux desktop will become the standard operating system. Here's the link for that story: www.tectonic.co.za/view.php?id=324.

But wait! Tectonic calls itself "Africa's Source for Open Source News," and Singh, a Novell SA employee, could not be called an impartial observer. Penguinistas might put stock in Singh's vision over a beer, but the kind of market observers who carry weight with Wall Street would never consider discussing open source as a serious competition for the software market incumbent, would they?

Perhaps not in such blunt terms, but renowned business scholars such as Harvard Business School Professor Clayton Christensen, the innovation guru, are taking a hard look at the prospects of open source taking serious market share from Microsoft.

In his recent book, Seeing What's Next, which he coauthored with Erik Roth and Scott Anthony, Christensen provides a sober, theoretical framework for circumstances under which companies offering modular open source solutions have a competitive advantage over companies offering the integrated architectural solutions such as Microsoft's Windows franchise.

In a nutshell, Christensen and his co-authors argue that when modular commodity products such as the Linux kernel are "good enough" for the jobs of price-sensitive market tiers, those commodity products are positioned to take market share from integrated solutions that "overshoot" the performance demands of customers in any given market tier, particularly the more price-sensitive lower market tiers.

The Christensen team writes that as companies race to meet the performance expectations of the more functionality-sensitive upper-tier customers, who are willing to pay a premium for the latest and greatest, those companies will inevitably innovate ahead of the performance demands of the more price-sensitive market tiers. For customers in the more price-sensitive market tiers, performance of the modular commodity is often "good enough" to win the job bid or close the sale.

Most industry observers are now coming to see that for the average desktop functions, the operating system and the office productivity suite are basically "done." In other words, the market leader has overshot the demands of customers such as schools, governments, and businesses who only need to provide their office workers with basic office productivity functions and Internet accessibility.

It's the Packaging, Stupid...

The secret is out. The value of open source business models is in the packaging - whether you are talking about the value-add of HP's SUSE Linux nx5000 desktop, or IBM's GNU Linux blade servers, or Google and Amazon.com offering access to their GNU Linux-powered search and merchandising services, or whether you are talking about the mass-customization of Linux software packaging and maintenance offered by Red Hat and Progeny.

Publishing whiz Tim O'Reilly believes that this new software business is so different from the traditional model followed by vendors like Microsoft that the new model deserves to be called a "paradigm shift."

For example, in his keynote speech at the Open Source Business Conference 2004 in San Francisco, he asked the packed room of business managers how many present used Linux. All but 20% raised their hands. He then asked for a show of hands as to who uses Google. Everyone raised their hands, at which point Tim noted that the 20% who didn't raise their hands the first time are still operating under the old paradigm. It's the packaging, stupid. Businesses will be able to challenge Microsoft because they are using new models to make an end run around the market leader's hammerlock on the desktop.

If this mode of software packaging is really a paradigm shift, shouldn't there be a fancy new theory explaining it all? Yup. And there is. It's what Christensen's team calls "the law of conservation of integration." Here's how Christensen and his coauthors explain this law in Seeing What's Next:

Conservation of integration holds that, when an interdependent system architecture is necessary to optimize performance at a stage of value added that is not good enough, the architecture of the product or service at the adjacent stage of value added must be modular and conformable in order to optimize the performance of what is not good enough. In simple terms, modular stuff must surround integrated stuff to optimize the integrated stuff.

Christensen's team says that the Linux kernel is a perfect example of innovating in ways that wouldn't work with Windows:

Consider the difference between Microsoft Windows and the Linux operating system. Windows is a highly integrated, interdependent operating system. To optimize the operating system, applications developers must conform their products to meet Microsoft's interface requirements. Efforts to try to modify Windows to improve individual applications would be disastrous; any individual change would have literally thousands of unanticipated consequences and operating system problems. Linux works the other way, because its goal is to enable optimized applications. The Linux operating system itself is modular. As long as you follow the rules, you can modify it to optimize the performance of an application.

This conservation of integration continues to drive the sales growth of Linux wrap-arounds. For example, in an article dated August 25, 2004, Michael S. Mimoso, senior news editor for SearchEnterpriseLinux.com, cited a Gartner study of the second quarter of 2004 showing that worldwide server revenue grew 7.7% to $11.5 billion. As of the end of that quarter, IBM remained the leader in global server revenue with 30.7% market share, HP was at 27.3%, Sun was at 13%, and Dell was at 9%, with Dell enjoying the biggest revenue jump (20.1%) year-over-year. The money is definitely there for those with a business plan to find it (http://searchenterpriselinux.techtarget.com/ originalContent/0,289142,sid39_gci1002420,00.html).

Microsoft Is Maturing

Here's another poorly kept secret: Microsoft is maturing. On July 20, 2004, Microsoft announced its intent to issue the largest stockholder payout in history in the form of a stock repurchase of over $30 billion and an increased dividend for a package that could total $75 billion over four years. Such an investor reward is more typical of a so-called "widows and ophans" stock, rather than the growth rocket of the Microsoft of yore.

In an article for the eCommerce Times dated August 21, 2004, Steve Lohr wrote that Microsoft's decision to turn its venerable Office Suite into an office "system" is an attempt to fend off challengers such as Sun Microsystems' StarOffice and its brother, OpenOffice.org. Steve Lohr concluded that such a decision was "key" to Microsoft's future in light of its slowing growth:

Although Microsoft's Office business grew 14 percent last year, analysts forecast the rate would slow considerably this year along with the financial impact of upgrade contracts that Microsoft pressed customers to sign a few years ago. The underlying growth rate of the business, analysts say, is 6 percent to 8 percent.
- www.ecommercetimes.com/story/35988.html

Melanie Hollands, an independent IT business journalist, thinks Microsoft might have peaked in October or November of 2002, according to her article in the online IT Managers Journal on July 7, 2004:

Yes, Microsoft has a ton of cash on the balance sheet. But it's not balance sheet cash or market share that propels a stock price upward. It's growth. And growth leveled off at Microsoft about 18 months ago, when the company went ex-growth and ex-cash.
- http://management.itmanagersjournal.com/ management/04/07/06/1351259.shtml

The best evidence of the effect that open source software is having on Microsoft comes from Microsoft itself. Consider this quote from a recent Microsoft SEC filing, as reported by Jo Best of the online journal Silicon.com on September 3, 2004:

For fiscal 2005, we believe industry-wide factors such as PC unit growth and the success of noncommercial software could significantly affect our results of operations and financial condition. PC unit growth was very strong in fiscal 2004, increasing approximately 13% from fiscal 2003. We do not expect similar growth to occur in fiscal 2005.

We continue to watch the evolution of open source software development and distribution. We believe that Microsoft's share of server units grew modestly in fiscal 2004, while Linux distributions rose slightly faster on an absolute basis.

The increase in Linux distributions reflects some significant public announcements of support and adoption of open source software in both the server and desktop markets in the last year. To the extent open source software products gain increasing market acceptance, sales of our products may decline, which could result in a reduction in our revenue and operating margins.
- http://software.silicon.com/os/0,39024651,39123685,00.htm

Microsoft has proven itself to be nimble in the past, especially in regard to its famed reversal of its view of the Internet. However, Clay Christensen notes in his book The Innovator's Solution, which he coauthored with Michael Royston, that 95% of all members of the Fortune 50 have stalled some time during their tenure on that list between the years 1955 and 1995. Consider this passage from Christensen and Roysten's book.

Probably the most daunting challenge in delivering growth is that if you fail once to deliver it, the odds that you ever will be able to deliver it in the future are very low. This is the conclusion of a remarkable study, Stall Points, that the Corporate Strategy Board published in 1998. It examined the 172 companies that had spent time on Fortune's list of the 50 largest companies between 1955 and 1995. Only 5 percent of these companies were able to sustain a real, inflation adjusted growth rate of more than 6 percent across their entire tenure in this group. The other 95 percent reached a point at which their growth simply stalled, to rates at or below the rate of growth of the gross national product (GNP). Stalling is understandable, given our expectations that all growth markets become saturated and mature. What is scary is that of all these companies whose growth had stalled, only 4 percent were able to successfully reignite their growth even to a rate of 1 percent above GNP growth. Once growth had stalled, in other words, it proved nearly impossible to restart it.

Of course, Microsoft still has lots of new revenue tools to pursue, but I do think that Microsoft has some really big problems in light of the fact that their growth is slowing and their two main revenue engines have been commoditized (Windows, Office commoditized by GNU Linux and OpenOffice.org/StarOffice). So the question might be posed as follows: Will Microsoft be able to increase revenue in its up-market defenses (Office "system") and its "peripheral" ventures (Home Entertainment Hub, aka the Xbox) faster than the wave of low-end disruption erodes its revenues from its revenue leaders (Windows, Office)?

It is counterintuitive to think that Microsoft could be reduced to a niche mar-ket player as boldly predicted by Novell SA's Allison Singh. But look at the long fall that undisputed market leaders RCA and Harley Davidson took when they were hit by the disruptive technologies of Sony's transistor radios and Honda's small supercub motorcycles. You would have been laughed at if you had suggested that RCA and Harley would have been displaced when they were in their prime. Customers in North America sneered at Sony and Honda at that time, but those market entrants thrashed the market leaders with their disruptive technologies.

The improbable is possible. Leaders have been dethroned in the past. The vast majority of Fortune's 50 largest companies stalled. Many of today's serious software market observers think it could happen again with Microsoft and open source software.

More Stories By Christian Einfeldt

Christian Einfeldt is an attorney in private civil practice in San
Francisco, and producer of the up-coming documentary entitled, "The
Digital Tipping Point", to be released in September 2005. The
film will show how open source will be propelled by the same
disruptive mechanism that brought Sony, Microsoft, and others to be
market leaders. Mr. Einfeldt is a serious groupie of Harvard Business Professor Clayton Christensen, and recently delivered a keynote address on the disruptive nature of open source software at the OpenOffice.org Conference 2004 in Berlin.

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