Microsoft and Apple

A few days ago I briefly discussed Hewlett Packard and Intel. Today, I would like to discuss Microsoft and Apple.

HP and Intel both have strong existing franchises but both are caught in similar dilemmas where their bases are shrinking and they have been slow to react to a megatrend toward smartphones, tablets, and mobility in general. Apple, of course, has been the primary beneficiary of the trend toward mobility. It’s easy to argue that Apple almost singlehandedly created the trend with the iPhone and the iPad. As a result, Apple today is the largest company in the world by market cap. On the surface, Microsoft would seem to be caught in the same trap as Intel and HP. Indeed, the manufactured word Wintel is a merger of the Windows operating system and Intel microprocessors. It would seem that Windows is to Microsoft as the x86 processing technology is to Intel.  If that were the end of the story, then Microsoft would be doomed to the same slow death that faces companies like HP and Intel that can’t adjust fast enough. Fortunately, while the PC business may have peaked and may diminish slowly, it will remain a huge business for a long period of time. HP and Intel won’t die even if they don’t adapt quickly enough. But they won’t be attractive investments again until they find their way back to the point where they are piggybacking on tomorrow’s trends rather than yesterday’s. But there may be a twist to the story as far as Microsoft is concerned.

But Microsoft in looking up the ladder, failed to see what was happening below.

I’ll start there. For decades, PCs have been at the epicenter of the technology revolution as computing moved from the data center to the desktop.  Windows owned the market from the day of the first IBM PC. It still owns that market for operating systems with Apple and Linux based computers only having marginal shares. Windows has effectively moved up the ladder to the data center. Windows doesn’t quite dominate the server world as it does the desktop, but it is huge and has growing opportunity. Microsoft is doing just fine not only with the operating system, but with storage management, networking, internet browsers, etc. It has also annuitized its corporate revenue stream and begun to gain a significant foothold on the cloud, moving many of its applications and support software to the cloud.

But Microsoft in looking up the ladder failed to see what was happening below. Smartphones and tablets were replacing laptops and other mobility devices. None ran on Windows. Moreover, computing was becoming more internet centric rather than desktop centric. The internet browser (and Microsoft’s Internet Explorer is the leader) and social networks like Facebook became the conduit to send and retrieve information. The operating system was becoming increasingly irrelevant. Open architectures like Google’s Android operating system began to dominate the phone and tablet markets. Microsoft retaliated with Windows 8 and went after search with Bing but it was too little too late.  Microsoft was becoming irrelevant. It tried to regain some relevance with Windows 8, but even though the product has been well reviewed by some, it’s questionable how successful it will prove to be.

That sounds like Microsoft is headed down the path of HP and Intel. But wait. For Microsoft there is a potentially happier ending. While Windows was both Microsoft’s primary source of profits and at the center of all software development for many years, that isn’t true today. Its business applications, namely Microsoft Office, is now the company’s biggest line of business and its systems and support tools for the enterprise, data center and cloud will soon dwarf direct sales of Windows of PCs, laptops, tablets and phones.

One of the classic mistakes managements of embedded companies make, is to invest to protect the highly profitable legacy. For years, at Microsoft, that has meant that nothing could be fast tracked without the approval of key members of the Windows team. Nothing could be developed that didn’t integrate with Windows. Most importantly, nothing could get traction that lessened the value of the Windows franchise. A small chink in the armor happened when the Xbox proved successful, but that was considered a toy and never integral to the rest of Microsoft.

But let’s look at the math. About 700 million smartphones will be sold this year, about 350 million PCs, and about 100 million tablets. Within a few years, there will be well over 1 billion smartphones sold annually, perhaps 300 million PCs, and maybe 300 million tablets. Windows dominates the PC world but has a fractional share elsewhere. If you were in charge of Microsoft Office, for instance, would you want to barricade yourself in a Windows world and exempt yourself from an opportunity to sell applications to 1.0-1.5 billion additional devices every year?  I think there is a rather obvious answer to that question. Clearly, Microsoft Office functionality for the iPhone would be very different than Microsoft Office for the PC. No one would expect a phone user to start building extensive spreadsheets on a phone. But they may want to open one and tweak it.  Same with a Word document.  A phone might be a poor device for a PowerPoint presentation but a tablet would be ideal.  There are hundreds of millions of potential tablet buyers who dearly want the capability to do some level of word processing or work on spreadsheets while, at the same time, enjoying the tablet’s advantages of retrieving information and surfing the web.

For a time, one might argue that there is some strategic advantage to keep Microsoft Office off of the Apple or Android universe. Perhaps it would give Windows 8-centric devices a competitive advantage. But that plays into the classic mistake of defending the legacy franchise. Do you keep your superstar product off of more than a billion devices so that a couple hundred thousand more phones and tablets might be sold?

“But no longer do people buy computing devices based on the operating system the way they did in the past.”

Simply put, Microsoft is at a crossroads. Windows will continue to mature and future versions may improve upon what is now out there. But no longer do people buy computing devices based on the operating system the way they did in the past. With the computing world becoming more remote, more focus is on the cloud, and greater mobility without regard to operating systems, Windows faces ultimate extinction as a feature of choice.

The operating system has always been a platform for applications. Windows Office is the superstar. Its components, Word, Excel, PowerPoint, Outlook and Access, have become dominating standards. Windows 8 isn’t the key production tool, Office is. And if Office 2013 is to be the giant Microsoft wants it to be, it needs to be available across all platforms and all devices. To date Microsoft has said little about how versions of Office will appear on platforms other than Windows, butrumors strongly suggest that we will see it everywhere before long. Commercial users pay Microsoft a license. Those fees can only rise as the product gains greater utility by being available on any device at any location at any time.  Therefore as Microsoft’s world moves from operating system centric to solutions centric, Microsoft, despite all its past mistakes and oversights, has a unique current opportunity to not only right the ship but to get it back on course, full speed ahead. Perhaps there is more to the recent departure of the head of Microsoft’s Windows business than most of us have assumed. Perhaps Microsoft is finally ready to accept that the name of the company isn’t Windows for a reason.

This is Microsoft’s moment. Either it gets it right this time, or it faces a cloudy future. Its task ahead is easier than Intel’s or Hewlett’s but the consequences of getting it wrong are just as great.

Now to Apple.

Everyone loves Apple. And with good justification. iTunes and great industrial design changed the way we listen to music. The iPhone meant the phone was not just a telephone but a true Dick Tracy portable computer. The App store provided separation from other smartphones.  The iPad made ready and information retrieval a dream. What’s next?

That isn’t a throw away question. What’s next is the key to whether Apple remains a true growth company. Apple someday soon will sell about 200 million phones a year. It is highly unlikely that it will ever develop a product that can generate 200 million unit sales per year or anything close to that. More than one out of every two people on this planet has a phone. In time most will own a smartphone. When that happens the smartphone market will be mature like the PC market is today. Perhaps it will take another 2-3 years to get there, but it won’t take much longer.   iPod sales are already in decline and Apple PCs, although still gaining some market share, aren’t considered a growth engine. The tablet might have a brighter future. It is still early in its lifecycle and I expect more functionality to drive more sales over time. But tablets alone can’t be Apple’s growth driver long term. Apple’s success over the past decade is entirely due to a remarkable string of products that took existing technology and exploded it into mass market opportunities. There were MP3 players before there was an iPod and there was smart phone technology before there was an iPhone.

Over the next few years, TV offers some opportunity. Being able to bring programming from multiple sources (cable, over-the-air, the internet, one’s own PC, etc.) onto one HD viewing device as simply as possible presents big opportunities. Beyond that we can all dream. We know faster speeds and better technology will create products we can’t imagine today. Apple, without Steve Jobs, has to find those opportunities and has to make them easy enough for the masses to use easily. Sounds simple, but it isn’t.

“No one lines up anymore to get the latest version of the iPod.”

Apple will sell a record number of iPhone 5′s this holiday season and will continue to do so next year. Ditto for its various iPad models. But will the iPhone 5s, rumored to be coming by mid-2013, be another home run?  How about the iPhone 6?  At some point, we begin to ignore each increment.  How much lighter, sleeker and faster does each phone have to be to make me trade up?  No one rushes out to get the newest and fastest PC anymore. No one buys the latest version of Microsoft Word each year for some esoteric feature. The same is going to happen in the phone world.  No one lines up anymore to get the latest version of the iPod.

Apple, therefore, faces a few big questions:

  1. Can new products provide the tailwind necessary to offset the headwinds of product maturity for phones, iPads and computers?  This is more a 2014 and beyond question than a 2013 issue but it is very relevant to the price of the stock.
  2. Can Apple maintain premium profit margins? Right now the iPhone is considered superior to all other smartphones but the gap is shrinking.  If all the major apps are written for all platforms, will the platform ultimately matter as much?  Right now Apple has many more apps than anyone else but there are now more Android phones than iPhones.  What happens if app writers start by writing for Android phones first?
  3. Apple generates huge amounts of cash.  How will it be employed to the best benefit of shareholders?  You can see from the HP saga what happens when management decides to make bad acquisitions.  Apple has avoided that to date, but the question gets larger as the cash hoard grows.
  4. How much will Steve Jobs be missed?

None of these questions is completely answerable yet. The more that get answered favorably for Apple, the better its stock will perform in the years ahead. Most observers remain optimistic. But that could be false optimism based on past success. It may be years before Apple hits another product home run or it could happen as soon as 2013. Apple has maintained premium profit margin throughout its history but we are entering a world where the device matters less and universally available applications matter more. Steve Jobs is irreplaceable but Apple has a deep and highly respected team. They may not replace him immediately but they will come close.

2013 is a pivotal year for Microsoft. Either it breaks free of the Windows shackles or it is destined to become a second rate company. Apple’s pivotal year is probably further out. Its recent new products assure a good 2013. But its moment of truth isn’t that far away and Apple’s stock may reflect its ultimate destiny before 2013 is over.

On paper both stocks are cheap, selling below market P/Es and paying good dividends with room for growth. Both are so big that the days of megagrowth are coming to an end. But both still can be first class companies that provide great value to investors. But to do that, both have to make the right critical steps over the next couple of years. Historians will be watching.