Reality check: Microsoft ( MSFT) 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
|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. |
Microsoft's server and tools business accounted for 20.3% of overall revenue in the six-month period ending in December. The server and tools business is an important growth engine, posting 14.4% year-over-year growth in that six-month period. That surpasses the growth of Microsoft's two cash-cow businesses, Office and Windows on the desktop. Linux is growing even faster, according to IDC (see chart). And while Microsoft still commands a significant market share lead, those figures downplay Linux's reach because IDC's tally includes only paid versions of Linux. (Linux is available for free online, but is also distributed by vendors such as Red Hat ( RHAT) under a service contract that includes certifications and updates.)
primarily replacing Unix systems rather than facing Microsoft head-to-head, says Dan Kusnetzky, IDC's vice president of systems software research. He believes Microsoft will start to feel the heat from such head-to-head battles when Linux becomes mainstream in all markets, by the end of 2005. Although Linux is most popular in areas like financial services, insurance, retail and academia -- which tend to be earlier tech adopters or have special needs -- others argue they're seeing enough skirmishes between Linux and Windows to declare Linux a clear and present danger. Lundstrom, for one, reports seeing Microsoft giving large discounts to a number of companies taking an aggressive stance with Linux. That's bad news for investors because lower prices hurt margins. Much of the price pressure comes overseas, another potential growth area for Microsoft. In fiscal year 2003, 23% of Microsoft's income before taxes came from outside the U.S.
Servers at 20 PacesWindows and Linux will continue to enjoy increases in shipment totals through 2007, but Microsoft will hold its lock on the No. 1 spot through then, IDC forecasts. Currently, Linux is
Microsoft would surely like to see its overseas revenues expand, but governments, universities and companies in countries like China and India simply can't afford Microsoft's prices, analysts say. How important are those markets? "They're not at all important in the next quarter," Lundstrom said. But "20 years from now, the global center of the software industry will be Asia." Another sign that the Linux wave is building is the increased backing it has attracted from behemoth IBM ( IBM), which recently unveiled an all-star marketing campaign -- featuring Muhammad Ali and Kurt Vonnegut, among others -- to spread the word about Linux. IBM also invested $50 million in Novell ( NOVL) when Novell bought No. 2 Linux vendor SUSE Linux. IDC's Kusnetzky likens IBM's Linux backing to a surfer preparing to catch a killer wave: "If you
see the good wave coming, the really good surfboard rider will really start pushing and start digging into the water so that when the wave hits he's able to ride it."
Arousing the GiantAs in the Internet browser wars, Microsoft was initially caught off guard by the Linux threat but is now keenly focused on responding. "We've tried to be very clear that Linux is a competitor and a challenge to Microsoft," CFO John Connors said at a conference in late February. "We've also been very clear that the open source and free software model is a threat to all commercial software vendors. ... It's a threat to everybody." In a telephone conference with analysts last week, Martin Taylor, Microsoft's general manager of platform strategy, addressed the issue of pricing overseas. "We do know that we need to work with these governments so that we do have software and the right offerings priced in a way that's relevant to them and their consumers and their constituencies," he said.
Taylor also said the company is countering Linux's unbeatable price tag by commissioning studies that show the total cost of ownership over the life of the software is higher with Linux than Windows. Finally, Microsoft execs cite one other advantage they offer over open-source software: tightly integrated products. Microsoft's next major operating system release, dubbed Longhorn, aims to integrate numerous products into the operating system and desktop, creating interdependencies that could further lock customers to Microsoft, notes Joshua Greenbaum, a technology consultant and principal with Enterprise Applications Consulting in Daly City, Calif. The problem for Microsoft is Longhorn isn't expected to be released until 2006. By then, Gus Zinn, an analyst with Waddell & Reed, expects Linux will have killed off most of the Unix market, setting the stage for the real showdown against Microsoft.