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Tech giants Microsoft (MSFT, $27) and Google (GOOG, $705) are locked in a multi-front struggle whose outcome will have enormous implications for the shareholders of both companies as well as technology customers around the world. In many ways both companies find themselves at a vital crossroads: what to do when the cash cow upon which the organisation is built comes under mortal threat? The answer that both have settled upon, leveraging areas of strength to force their way into adjacent markets, is both uninspired and fraught with risk. The Roots of Strength
Microsoft was for a time the primary corporate beneficiary of the PC revolution. The insight of co-founder Bill Gates that maximum profit could be generated from sale of the software that ran computers, rather than from sale of the computers themselves, was a simple but profound idea that led to a gusher of profitability that continues to this day.
Using its strength in operating systems, first with MS DOS and then with Windows, Microsoft successfully pushed its way into productivity software, leading to the Office suite of products, as well as more high-end enterprise tools such as the Exchange, SQL Server, Sharepoint and Great Plains products.
Today the company boosts imposing financial health. Revenue and cash flow came in at $73.7 billion and $31.6 billion for FY12. Additionally, management has demonstrated a focus on returning cash to shareholders, with $10.7 billion returned in FY12 through stock buybacks and dividends.
Google came of age at a fundamentally different time and in a different competitive landscape. Whereas Microsoft’s management intuited where profitability would concentrate in the PC ecosystem and positioned themselves to reap maximum gains, Google entered a crowded market (search) that few thought was in need of improving and revolutionised it with a superior product.
Google has demonstrated considerable earning power, with LTM revenue of $47.5 billion and operating cash flow of $15.9 billion. Nonetheless, the company is considerably less diversified than Microsoft, with 77% of Q3 revenue coming from Google.com and Google’s network partners.
Understanding the fundamental differences between Microsoft and Google comes down to the different paths each company took to dominance. Microsoft is a company that determined where best to place the mousetrap, and improved its products over time after securing advantageous placement. Google is a company that built a better mousetrap, and over time learned how to make placement irrelevant. Microsoft utilized Moore’s Law to sell software with ever more bells and whistles, Google utilized Moore’s Law to sell advertising and give away software as a loss-leader.
Pressure on Multiple Fronts
Both companies are pressing, and being pressed, on multiple fronts.
- Operating Systems:This traditional area of strength for Microsoft is under siege as innovation in computing moves from the PC to smartphones and tablets. With Windows 8 being considered more trouble than it is worth by many prospective buyers and both Windows Phone and Surface lagging in the smartphone and tablet race, Microsoft is witnessing its traditional source of power melt before its eyes. Additionally, Google’s Android OS has considerable share in the smartphone and tablet markets. Google may not be maximizing the profit potential of this growing market share, but it is coming at the expense of a powerful rival. Advantage: Google.
- Enterprise: The announcement that Google would revamp enterprise pricing for Google Docs was taken by many as another indication that Google is prepared to make a deep foray into a second area of Microsoft dominance. I think the market is misreading Google’s intentions here, and to a certain extent I think Google’s key management may be seeking to mislead Microsoft. To win in this space, Google only needs to gain share among those enterprise customers seeking “good enough” productivity or other enterprise offerings. Google could gain a foothold and Microsoft could still remain dominant in the enterprise. Advantage: Microsoft.
- Search: Bing trails Google by a wide margin, but Google has reason to be concerned. Through its partnership with Facebook (FB, $30), Microsoft is working with a company that knows more about its members than Google does. This advantage cuts at the very heart of Google’s core search offering, on which Google is far more dependent than the more diversified Microsoft is on either Windows or Office. Additionally, Bing is a viable search alternative. Google has reason to be scared. Advantage: Microsoft.
- Acquisitions/Partnerships: Both Microsoft and Google have tied themselves to a struggling hardware partner in order to between compete to the integrated hardware/software approach that Apple (AAPL, $500) has used so successfully. Each is likely to have experience considerable trouble from their choice of partner. For Google, the acquisition of Motorola Mobility has saddled a software company accustomed to selling advertising with a massive hardware operation and the distrust of all other smartphone and tablet makers currently using the Android OS. For Microsoft, the choice of Nokia (NOK, $4) has the considerable flaw of neither party possessing much strength in the market being targeted. Advantage: Neither company chose well, and both are likely to regret their choice of partner.
The free cash flow problem has perhaps never been better illustrated than it is with these two companies. Both sit on massive cash piles ($66.1 billion and $44.6 billion for Microsoft and Google, respectively), but the market niches they dominated to generate that cash hoard are undergoing rapid change. Whether it is within the power of the management of either company to more aggressively return cash to shareholders remains an open question. With the pressures these two have the ability to place on one another, the prospect for value destruction in the near-term appears considerable.
About the Author – David Johnson
David Johnson is a partner with ACM Partners, a boutique financial advisory firm providing due diligence, performance improvement, restructuring and turnaround services. He can be reached at 312-505-7238 or at [email protected].
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