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Dow 30 Profile: Microsoft
Where It All Began
The January, 1975 issue of Popular Electronics, which featured the Altair 8800, a kit-based microcomputer, caught the attention of Bill Gates and Paul Allen. After reading about the Altair, the duo came to the conclusion that the price of computers was set to drop to the point where selling software for them would likely be a profitable business. The thought occurred that the Altair 8800 would be more attractive to the hobbyist market if it came with a BASIC interpreter—that is, with the means for it to be programmed via the BASIC programming language. They contacted Ed Roberts, one of the founders of MITS and the company selling the Altair 8800, and told him they were developing a BASIC interpreter and asked whether he would be interested in a demonstration. Roberts agreed to meet with them in a few weeks.
The only problem was that Gates and Allen did not have an interpreter or even an Altair system on which to develop and test one. However, their entrepreneurial spirits were far from damped. Allen had previously written an emulator for the Intel 8080 (the microprocessor used in the Altair) that ran on a PDP-10 time-sharing computer. (The PDP series of minicomputers was built and sold by Digital Equipment Corporation.) Allen modified his emulator to conform with the Altair’s program set, and they developed and tested their interpreter on Harvard University’s PDP-10 (At the time, Gates was a student at Harvard.)
Their BASIC interpreter, which could handle instructions for floating-point arithmetic and came complete with its own I/O and line editor, fit into four kilobytes of memory (yes, kilobytes), leaving lots of room for programs. Once completed, Allen copied the interpreter on to paper tape, and boarded an airplane to Albuquerque, New Mexico to meet with Roberts at MITS. En route and as an added twist, Allen realized he had not written a boot-strap program to read the tape into memory, and set about doing so in 8080 machine language (literally writing the program in the 1s and 0s that the Intel 8080 understood). To cut to the chase, the demo was a success, and Roberts licensed the interpreter (Altair BASIC) from Gates and Allen, setting the stage for the partnership that would become Microsoft (MSFT - Free Microsoft Stock Report), which soon set up shop in Albuquerque.
Over the next couple of years, the company released versions of a number of programming languages that worked with the CP/M operating system. As CP/M gained favor in the still unstandardized microcomputer market, Microsoft became the leading distributor of programming languages for microcomputers. By the end of 1978, the company had a sales subsidiary in Japan and recorded $1 million in revenues. Gates and Allen moved their company to Bellevue, Washington in the following year.
The Big Step Up
As 1980 rolled around, International Business Machines (IBM - Free IBM Stock Report) was in the midst of developing the Personal Computer (PC) and, at Microsoft’s suggestion, had contacted Digital Research to discuss the licensing of an operating system. The two companies were unable to come to terms, though, and IBM came back to Microsoft, and a deal was struck for an operating system. However, Microsoft did not have an operating system of its own, so it purchased the rights to one from Seattle Computer Products. Originally called Q-DOS (Quick and Dirty Operating System), Microsoft brought it up to speed for IBM’s purposes and renamed it MS-DOS (Microsoft Disk Operating System). The agreement with IBM turned out to be quite favorable for the software vendor. Indeed, Microsoft retained the right to sell the operating system to other companies and to consumers. As computer makers increasingly offered PC-compatible products and personal computing became a multi-billion dollar business, Microsoft’s revenues took off.
One could posit here that Gates and company grabbed hold and never let loose. At this juncture, Steve Ballmer, Microsoft’s current CEO, arrived to help run the non-technical side of Microsoft, and some time later Paul Allen had to leave, after developing Hodgkin’s disease. Meanwhile, over the next four or five years, the company began the development of a series of Windows products (originally more a graphical user interface than operating system), released office productivity applications—for instance, Word and Excel (these also supported the original Apple Macintosh), and grew ever-more dominant in the software side of personal computer business. By 1986, the year Microsoft went public at $21 a share (not split-adjusted), the company recorded revenues of $197.5 million and net income of $39 million. To get a feel for what was happening from a business standpoint, one should compare this revenue figure with the $16,000 reportedly generated by the Gates/Allen partnership in 1975. In reality, Microsoft was just getting started.
The Windows operating system is up to Windows 7, the Office productivity suite is up to Office 2010, Microsoft has developed deep roots in the server and tools business, it is has a very successful gaming platform with Xbox/Kinect, it is making inroads in the Internet search business, it recently completed the deal with Skype that has the potential to extend its reach in mobile computing and real-time communication, and it is an active player in the move to so-called cloud computing. As it stands now, Microsoft is separated into five operating segments for financial reporting purposes.
The Windows & Windows Live Division develops and markets the Windows operating system, Windows Live, and Internet Explorer. The group is an important contributor to corporate profits—usually vying with the Microsoft Business Division for top honors. Clearly, its fortunes are closely correlated with the market for PCs, which is undergoing some changes. To wit, consumers are increasingly reaching for tablet-type computers, rather than the standard desktop or laptop. And in many cases, some have found smartphones to be more than sufficient for their needs. Meanwhile, the PC is likely to be around for sometime yet, particularly given the installed base at large corporations. Nonetheless, Microsoft’s traditional hold in the personal computing arena shows some signs of becoming less monolithic.
Products and services from the Microsoft Business Division include the Microsoft Office system, e.g. Office 2010, and Microsoft Dynamics business solutions (financial management, supply management, etc. applications). Historically, 90% of MBD’s revenue has been derived from the Office system, which brings the Office productivity suite and associated services into stark relief with respect to their importance to segment’s financial performance. Looked at another way, some 80% of the group’s top line is generated by sales to businesses, through volume licensing agreements. Like the Windows Division, MBD’s fortunes depend on PC shipments and the vitality of PC demand.
The Server and Tools group develops and markets server software, developer tools, and services to corporate IT environments. One also finds Microsoft’s cloud-based services here, an arena receiving increasing attention from businesses, as they look to harness computer system efficiency and improve the return on their investment in IT. Server and Tools competes with other well known software vendors—Oracle (ORCL), SAP (SAP), VMWare (VMW), Symantec (SYMC), and the like—for its share of the corporate IT budget. About 50% of the segment’s revenue comes from annuity volume license agreements, 30% from transactional volume arrangements of various kinds, with the rest coming from Enterprise Services. In terms of its contribution to corporate profits, Server and Tools is usually in third place among its five peers.
The Entertainment and Devices Division is home to the Xbox/Kinect gaming platform. One also finds Windows Phone and Windows Embedded device platforms here. In a sense, then, EDD is where Microsoft’s more recent consumer success stories have come, as evidenced by the popularity of Xbox and the follow-up hit with the Kinect sensor. On the other hand, the group has its work cut out for it, as Microsoft works to regain consumer attention in markets such as real-time communication, etc. As mentioned, Skype seems set to play a role here. Meanwhile, Entertainment and Devices is nicely profitable, with a seasonal peak in the December quarter. Nonetheless, the group’s margins pale in comparison to the company’s software businesses.
Finally, the Online Services Division consists of Bing, MSN portals and channels, and an online advertising platform. It is no secret that Google (GOOG) is the big dog in the Internet search business. Nonetheless, the technology underlying Bing looks to be quite good, and Microsoft reports that it is making headway in this business and is benefiting from its partnership with Yahoo! (YHOO). Still, this is likely to remain an uphill battle with a well entrenched and smart competitor for the foreseeable future. As it stands now, this group is showing operating losses of some $500 million to $700 million a quarter.
Although controversial at times, Microsoft, as a company, is a classic American success story, with its genesis in the ideas and hard work of Bill Gates and Paul Allen. In its rise to the top, the company not only demonstrated superior foresight, but it also took advantage of some of its competitors missteps. Yes, it was and is an aggressive competitor. From our perspective, Microsoft continues to operate as well as ever in its traditional markets. However, to date, it has had less success in such growth markets as mobile computing and real-time communications. Microsoft’s partnership with Nokia (NOK) has the potential to greatly extend the reach of Windows Phone, and its next Windows operating system, Windows 8, will support popular processing platforms used in mobile computing, which is a positive. Whether these or some additional set of future initiatives bear fruit is an open question. Indeed, Microsoft’s competitors are also aggressive and smart—and they have a lead. We note, however, that another American success story, though much older than Microsoft, had its share of problems a number of years ago, with many thinking its best days were over. Most would agree that things have been going pretty well at IBM for some time now, and that its eventual demise was premature. That said, we think the next couple of years will be both interesting and terribly important at Microsoft.
At the time of this article’s writing, the author did not have positions in any of the company’s mentioned.