Linux Nips at Microsoft's Heels

Reality check: Microsoft(MSFT Quote) is not on the verge of getting swept away by a Linux tsunami, as some open-source software enthusiasts have suggested. But Linux is a small wave slowly building every day, and threatens to dampen Microsoft's higher-growth server business.

Analysts differ over when the Linux wave reaches a critical crest, indicating that point has yet to arrive. But as it builds, Linux is putting Microsoft on the defensive, forcing the world's largest software maker to cut prices and consequently threatening margins.

"There's an immediate threat [to Microsoft] right now in the operating system space," says Scott Lundstrom, chief technology officer at AMR Research. Linux is "going to force Microsoft to spend more time on security and stability, and less time on adding new features. That probably has the effect of slowing revenue growth."

The combination of Linux-induced pricing pressure and slower growth prospects helps explain Microsoft's lackluster stock performance. The stock has gained only 15% in the past year, far short of the 54.8% swell enjoyed by the Goldman Sachs Software Index.

Linux is a "growing reason" for Microsoft's underperformance, said Tony Ursillo, an analyst with Loomis, Sayles & Co., which has significantly pared back its Microsoft holdings to about 250,000 shares -- a small fraction of its $10 billion in assets.

"I think many investors still look at Microsoft as a legitimate core holding in a company that still has reasonable growth ahead of it," Ursillo said. But "at this point in the economic cycle [and] at this phase of Microsoft's life cycle, we don't see it as a way you can materially outperform."

Some investors may still mistakenly believe Microsoft's desktop applications business -- namely Microsoft Office -- is at stake in the fight against Linux. But Linux faces an uphill battle there, at least over the next few years, given that Microsoft commands more than 90% of the market share in that arena.

What analysts are closely watching is the market for operating systems on servers, where Linux is showing far more strength.

Linux vs. Goliath Open-source wave builds but Microsoft still holds the top spot in the server market
	Linux	Microsoft
Q4 server revenue	$960 million	$3.9 billion
YOY Q4 server revenue growth	63.1%	16.1%
YOY Q4 server unit shipment growth	52.5%	23.3%
Market share*, 2002	23.1%	55.1%
Market share, 2001	22.4%	50.5%
*Market share of paid new software license shipments. Source: IDC