Devil's Advocate: Redmond's dilemma

Regular silicon.com Columnist Martin Brampton, a director at consultancy Black Sheep Research, this week argues that Microsoft could find itself at the mercy of customers who are turning against it.

Why is Microsoft fighting its biggest customers? There is always some tension between buyers and sellers, but when we see a major company antagonising the largest and most influential purchasers of its products, something's wrong.

Ironically, despite the apparent strength of Microsoft the root of the problem is financial. The company has recently made much of its ability to innovate, contrasting its own profitable situation with other major IT companies. Stock markets look for companies that can deliver growing profits, or failing that at least a steady stream of profits. Share prices are very sensitive to changes in the perception of future profit and historically Microsoft has relied heavily on share options as a means of rewarding employees.

It is quite true that Microsoft remains hugely profitable with exceptional margins on its overall sales. But there are really only two mutually reinforcing pillars in Microsoft's financial position and both of them are showing signs of weakness. Despite the diversity of its broad portfolio, the core of Microsoft's business is the Windows operating system and the Office Suite. Operating systems flourish when there are many good applications for them and applications thrive on the most popular operating system. Windows and Office have long helped one another to market success.

In the drive for profit and thereby share price growth, Microsoft has kept the prices of both core products high. One measure of this is that while PC makers struggle to make money, the operating system has been a rapidly increasing proportion of the total price. In office suites, the Microsoft product is much more expensive than only slightly inferior alternatives.

While economies were booming, and there were perceived benefits to innovations in both operating system and office suite, the situation was stable. Now, both of those considerations are under pressure. Budgets are being squeezed and companies are less impressed by the advantages offered by upgrades. Microsoft has attempted to forestall the problem of repeatedly persuading its customers to upgrade by shifting its software to a rental basis. The costs involved are at the root of current antagonism.

In this situation it is hard to see how Microsoft can win. If it backs down over pricing and licence flexibility revenues are liable to fall sharply. If it continues to take a hard line customers start to question their reliance on Microsoft and this could be highly damaging to Microsoft's hopes for real diversification.

IBM still bears the scars of its earlier market dominance and the reaction against it that took place over a decade ago. While IBM has rebuilt much of its strength, largely through shifts in its product mix, it still faces customers who ask how to avoid lock-in before they commit to major purchases. The more people question Microsoft's role in the supply of technology the harder it will be for the company to sell products based on proprietary standards that restrict future purchasing.

This problem is highly relevant to Microsoft's hopes of being a major force in future internet developments. It has pinned high expectations on web services and will no doubt have successes. But the Java camp is also very active in this area, and most of the key standards are currently remaining open. The more Microsoft is in conflict with its large customers, the more it will be forced to work with standards that leave it vulnerable to competition.

Historically, Microsoft has often seemed paranoid even when it has been strongest. Now, faced with both US and EU judicial processes and public arguments with leading customers, perhaps the paranoia is justified. Software markets can quickly tip in new directions and at present there is growing talk of how to desert Microsoft. It could yet join the ranks of IT companies struggling to make profits.