Personal Computer Dependency Weighing On Microsoft

By Jessica Hodgson

Microsoft Corp.'s (MSFT) dramatic revenue and earnings misses on Thursday validate the company's decision to expand beyond its core software franchises. But it remains unclear if new initiatives, like videogames and online services, will deliver significant profits anytime soon.

On Thursday, the Redmond, Wash.-based software giant posted worse-than- expected financial results for the second quarter, missing earnings by 11%. The company blamed the performance on falling sales of personal computers.

The results underscore Microsoft's symbiotic reliance on personal computers, a relationship that has been the cornerstone of its success but which may become a liability. Its Windows operating system ships on over 90% of the world's computers and Microsoft's relationship with manufacturers and third-party service providers who equip them for customers has guaranteed its sales and profits in the past. Now, with sales of PCs falling, so is Microsoft's revenue.

Unlike competitors that have transformed their businesses through diversification to reduce reliance on their original products, like International Business Machines Corp. (IBM) and Apple Inc. (AAPL), Microsoft's profitability remains tied to its core business. More than 80% of its $22 billion in annual 2008 profits came from either its operating system or the Office suite of software that runs on it. While Microsoft has made a credible success of moving into the server business, which generated $4.5 billion of 2008 profits, efforts to diversify, like its XBox game machine and Zune music player, have generated little in terms of profitability.

"Microsoft is a quasi PC company," said Israel Hernandez, an analyst with Barclays Capital. "Its fortunes are inextricably tied to those of the PC."

Analysts say Microsoft needs to draw profitability out of its other projects, particularly its attempt to become a force in Internet advertising. Hernandez said part of the reason investors pushed Microsoft shares to an 11-year low after the earnings announcement - shares closed 11.7% lower at $17.11 - was because they were worried by the company's revenue mix.

"There are some structural issues there," he said.

Microsoft's Xbox was a bright spot in an otherwise downbeat quarter, with revenues at the company's entertainment and devices unit growing 3.5%, ahead of expectations. But the entertainment and devices unit provided only a fraction of Microsoft's 2008 profit. Microsoft doesn't disclose whether the Zune, its two- year old music player, is profitable, but the digital music player market is dominated by Apple's iPod device.

Despite its efforts, Microsoft is unlikely to wean itself off of its reliance on PCs anytime soon.

"Windows is the air we breathe," Chief Executive Steve Ballmer said late last year at an analysts' meeting. "As many transformations happen in the PC business itself, we have to drive forward."

But investors are increasingly aware the company faces challenges from a broad range of companies that have a head start in the markets it's targeting. Those include Apple in the devices market and Google Inc. (GOOG), dominant in the Internet and moving aggressively onto Microsoft's turf through free software it offers that mimics the Office applications. Google has also rolled out an operating system for cell phones, challenging Microsoft in another area in which it had established itself.

All that makes observers pause when they look at Microsoft.

"Several emerging technologies threaten to displace Microsoft's Windows and Office franchises," Kevin Buttigieg, an analyst with Stanford Group, noted after the earnings. "Microsoft must deliver several new products and must execute well from a sales and services perspective."