Microsoft Corp. is facing growing pressure from open-source software across every segment of its business—a competitive threat that could have significant consequences for its financial future going forward, the software maker said in its latest 10-K filing to the Securities and Exchange Commission this week.
“We continue to watch the evolution of open-source software development and distribution and continue to differentiate our products from competitive products, including those based on open-source software. We believe that Microsofts share of server units grew modestly in fiscal 2004, while Linux distributions rose slightly faster on an absolute basis,” the filing reads.
Increase in Linux distributions reflected some significant public announcements of support and adoption of open-source software in both the server and desktop markets in the last year, company officials said.
Among those recent wins are the Allied Irish Bank, one of Irelands largest banking and financial services groups, which said in June that it was set to transition its branch-dependent applications and migrate about 7,500 desktop users off Windows and onto Sun Microsystems Inc.s Java Desktop System over the next year or so.
Microsoft, of Redmond, Wash., recently has lost other business from European customers. In June, officials of the Norwegian city of Bergen said the city plans to move 100 schools and 32,000 users away from its proprietary Unix and Microsoft Windows applications platform to Linux by the end of this year, while Munich has also committed to Linux and open-source software.
Microsoft also again used its latest 10-K filing to float the possibility that it would have to lower the prices of its software products, with officials saying that “to the extent open-source software products gain increasing market acceptance, sales of our products may decline, which could result in a reduction in our revenue and operating margins.”
While Microsoft often mentions Linux and open-source software as a potential threat to its business, it seems to be treating the threat far more seriously and describing it as more pervasive than in previous official filings.
In a lengthy section of the filing that deals with competition, Microsoft officials noted that while the software business is intensely competitive and subject to rapid technological change, evolving customer requirements and changing business models in every segment means that the company was facing significant competition across all areas of its business.
“Our direct competitors include firms adopting alternative business models to the commercial software model. Firms adopting the noncommercial software model typically provide customers with open-source software at nominal cost and earn revenue on complementary services and products, without having to bear the full costs of research and development for the open-source software,” said Microsoft officials in the filing.
Company officials also again warned—as they had in February 2003—that “while we believe our products provide customers with significant advantages in security and productivity, and generally have a lower total cost of ownership than open-source software, the popularization of the noncommercial software model continues to pose a significant challenge to our business model, including recent efforts by proponents of open-source software to convince governments worldwide to mandate the use of open-source software in their purchase and deployment of software products,” officials said.
Next Page: Upgrades struggle to compete with current software versions.
Microsoft Sees Open-Source Threat Looming Ever Larger – Page 2
In the latest 10-k filing, Microsoft said that global software piracy was further depriving the firm of “significant amounts” of annual revenue. It also admitted that future versions of its products were competing with the current versions licensed to its installed base of customers.
“This means that future versions must deliver significant additional value in order to induce existing customers to purchase a new version of our product,” it said.
Microsoft also gave a detailed list of factors that could possibly affect its competitive position going forward, with Unix, Linux and other open-source software at the top of that list on the client side. “Competing commercial software products, including variants of Unix, are supplied by competitors such as IBM, Hewlett-Packard [Co.], Apple Computer [Inc.], Sun Microsystems and others.
“The Linux operating system, which is also derived from Unix and is available without payment under a General Public License, has gained increasing acceptance as competitive pressures lead personal computer OEMs to reduce costs,” Microsoft officials said, adding that the Microsoft Windows operating systems also faced competition from alternative platforms, as well as innovative devices that could reduce consumer demand for traditional PCs.
With regard to the competitive threat on the server and tools front, Microsoft officials said in the 10-K filing that “nearly all computer manufacturers offer server hardware for the Linux operating system. IBMs endorsement of Linux has accelerated its acceptance as an alternative to both traditional Unix and Windows server operating systems.
“Linuxs competitive position has also benefited from the large number of compatible applications now produced by many leading commercial software developers as well as noncommercial software developers. A number of companies supply versions of Linux, including Novell [Inc.] and Red Hat [Inc.],” the 10-K filing reads.
Microsoft also competed in providing enterprisewide computing solutions with several companies that provided competing solutions as well as middleware technology platforms. IBM and Sun led a group of companies focused on the Java 2 Platform Enterprise Edition. Commercial software developers offering competing server applications for the PC-based distributed client/server environments included Oracle Corp., IBM and Computer Associates International Inc., Microsoft officials said.
But Microsoft has not been sitting idly by as the Linux and open-source software threat has grown, It has started reaching out further to the open-source community with offers of joint development and testing.
It has been actively lobbying governments around the world to shun open-source applications and Linux. To that end, Microsoft in January 2003 announced a new global initiative to provide governmental agencies with access to Windows source code under its Government Security Program, designed to “address the unique security requirements of governments and international organizations throughout the world.”
And this January, Microsoft also launched a new advertising campaign, referred to as “Get the Facts,” that aims to give customers information about the advantages of using its Windows operating system versus Linux, its open-source competitor.
On the information worker front, the dominant Microsoft Office System also faced many competitors, including Apple, Corel Corp., IBM, Oracle, Sun, and local application developers in Europe and Asia. IBM and Corel had significant installed bases with their office productivity products, and both hade aggressive pricing strategies, Microsoft said in the filing.
Next Page: Supporting older versions vs. encouraging upgrades.
Microsoft Sees Open-Source Threat Looming Ever Larger – Page 3
“Also, Apple and IBM pre-install certain of their application software products on various models of their PCs, competing directly with our applications,” the filing reads. “Corels suite and Sun Microsystems StarOffice are aggressively priced and attractive for OEMs to pre-install on low-priced PCs.
“The OpenOffice.org project provides a freely downloadable cross-platform application that is gaining popularity in certain market segments. In addition to traditional client-side applications, Web-based offerings such as SimDesk provide an alternative to Microsoft Office System products,” company officials said.
Microsoft also addressed the tightrope balance it is walking between meeting the needs of the installed base that is running older versions of its products and the need to encourage them to upgrade. Company officials cautioned that revenue would be unfavorably impacted if customers reduced their purchases of new software products or product upgrades because new product offerings were not perceived as adding significant new functionality or other value to prospective purchasers.
Microsoft also cautioned that any pullback in customer renewals for its controversial Licensing 6 and Software Assurance program, which became effective in July 2002, could also adversely affect the company.
“A significant number of customers purchased license agreements providing upgrade rights to specific licensed products prior to the transition to Licensing 6.0 in July 2002. These agreements generally expired throughout fiscal 2004 and will largely be expired by the end of the first fiscal quarter in 2005. The rate at which such customers renew these contracts could adversely affect future revenue,” the filing said.
But the company is facing pushback from volume licensees whose three-year Licensing 6.0 and Software Assurance plans are about to expire. Many of the companys volume license customers, whose contracts have expired or are set to expire, are questioning the value they got from the programs and whether they should renew.
Microsofts licensing program, Upgrade Advantage, also reached the end of its life in July when the last customer contracts expired. Those customers can continue to use the software they acquired under the program, but they will not get further product upgrades and will now have to pay for full versions of Microsoft products or sign up for Software Assurance.
In the latest filing, Microsoft officials said they now expect to renew just 10 percent to 30 percent of the expiring Upgrade Advantage program revenue through conversions to Software Assurance or migration to Enterprise Agreements.
While Microsoft was also making significant investments in the next release of the Windows operating system, code-named Longhorn, it warned that if this system was not perceived as offering significant new functionality or value to prospective purchasers, “our revenue and operating margins could be adversely affected.”
While the filing said the development of software products was a complex and time-consuming process, “significant delays in new product releases or significant problems in creating new products, particularly any delays in the Longhorn operating system, could adversely affect our revenue.”
Just a week ago, Microsoft officials announced that the company would be scaling back the feature-set for Longhorn so that it could meet shipping deadlines of 2006 for the client and 2007 for the server. That move was not well-received by some developers and enterprise customers and is seen by some as giving Linux the boost it needs.
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