Microsoft’s Crisis in Perception (Part 3)

In the parts 1 and 2 of this series I made the case that Microsoft is mis­taken for a con­sumer prod­ucts com­pany when, at the core it is really an enter­prise soft­ware company.

This mis­align­ment between real­ity and per­cep­tion is largely self inflicted and con­tin­ues to be be dan­ger­ously rein­forced by Microsoft’s mar­ket­ing and PR machin­ery. The net effect of this ‘Cri­sis in Per­cep­tion’ has been an under­valu­ing of the company’s assets and a dis­trac­tion which has pre­vented the man­age­ment team from pur­su­ing a more focused strat­egy which would unlock that value. In this chap­ter I will dis­cuss some of the struc­tural chal­lenges fac­ing the com­pany today and how they com­bine to place lim­its on the company’s room for maneuver.

When I joined the Microsoft in 1994 the struc­tures and deci­sion mak­ing processes at the com­pany were quite straight­for­ward. There were prod­uct devel­op­ment groups who all answered to BillG and there were sales, mar­ket­ing and sup­port orga­ni­za­tions who all answered to SteveB. The COO was respon­si­ble for mak­ing sure the bills got paid and things like man­u­fac­tur­ing and dis­tri­b­u­tion were run as effi­ciently as pos­si­ble. There was only a small legal team and HR was there to help you iden­tify the best tal­ent to hire from out­side and then to keep the tal­ent happy when it joined the company.

Of course the com­pany was far smaller then and with fewer employ­ees oper­at­ing across a much smaller num­ber of geo­gra­phies. In 1995 Microsoft was ranked num­ber 250 on the For­tune 500 list with rev­enues of just over $4.5 Bil­lion. In the inter­ven­ing period the com­pany has become a behe­moth and will check in around $60 Bil­lion dol­lars in rev­enue this year (Dis­claimer: All the rev­enue num­bers I dis­cuss here are pro­jec­tions based on Microsoft pub­lished third quar­ter results and pub­licly avail­able his­toric data avail­able here. I have no knowl­edge of fourth quar­ter FY’10 per­for­mance.) It is illu­mi­nat­ing to com­pare the P&L per­for­mance for the 10 years prior to 2000 and for the ten years since.

In the period fis­cal year 1990 to 1999 Microsoft’s rev­enue grew 1665%. Oper­at­ing expense grew by less than rev­enue 1207% con­tribut­ing to a bot­tom line net income growth of a mas­sive 2787% over that ten year period. At the same time R&D invest­ment went up by 1641% dri­ven almost entirely by the company’s push to become a cred­i­ble player in the enter­prise. Scar­ily, the cost of admin­is­ter­ing all of this growth accel­er­ated faster than rev­enue at 1833%. Finally, sales and mar­ket­ing costs grew by 1079% as the com­pany expanded both its global pres­ence and enter­prise sales capabilities.

Now com­pare the period 1990–1999 with the sub­se­quent decade from fis­cal 2000 to fis­cal 2009. If you want to under­stand why the stock price has been depressed for so long these num­bers tell the story. The company’s top line rev­enue grew by only 255% dur­ing this period (Obvi­ously the law of large num­bers starts to kick in and a 255% growth on Microsoft 2000 base rev­enue is a huge amount of rev­enue.) How­ever, oper­at­ing expenses dur­ing the same period out­grew rev­enue at 319% (Ouch!) and as a result net income grew a pal­try 155%, exactly 100% less than rev­enue. At the same time gen­eral and admin­is­tra­tive (G&A) costs soared by 352%, sales and mar­ket­ing expense by 312% and costs asso­ci­ated with get­ting all the rev­enue (Sup­port, licens­ing, dis­tri­b­u­tion, chan­nel etc.) rose a whop­ping 405%. No won­der the stock hasn’t done any­thing in 10 years.

G&A costs as a per­cent­age of rev­enue are one proxy for the ‘Com­plex­ity’ of a com­pany. The sim­pler the busi­ness model, prod­uct line and orga­ni­za­tions struc­ture needed to take it to mar­ket the lower your G&A needs to be as a per­cent­age of income. In the period ’90-’99 G&A aver­aged 3% of rev­enue. In the period ’00-’09 that ratio had nearly tripled to 8%. G&A costs com­bined with the ‘Cost of Rev­enue’ and ‘Sales and Mar­ket­ing’ lines is also a very good met­ric for effi­ciency. The fact that all of those costs grew sub­stan­tially faster than top line rev­enue growth points to Microsoft fac­ing its very own ‘Malthu­sian cat­a­stro­phe’. The sit­u­a­tion is not sus­tain­able and needs rad­i­cal action today even more than it did in 2000.

One of SteveB’s first strate­gic deci­sions as CEO was the intro­duc­tion of a GE like P&L struc­ture. Each prod­uct group would become an ‘Inde­pen­dent’ divi­sion with it’s own P&L meant to rep­re­sent the true costs asso­ci­ated with build­ing, mar­ket­ing and sell­ing each of the prod­ucts. In my opin­ion, there were only one or two ‘Minor’ prob­lems with this plan.

The health care, light­ing and air­craft engines busi­nesses at GE really are inde­pen­dent of each other. There is almost not over­lap between the tech­nol­ogy in their prod­ucts or the mar­kets into which they sell. Each of the GE’s divi­sions has its own inde­pen­dent and ded­i­cated sales and mar­ket­ing resources. A strate­gic deci­sion taken by the pres­i­dent of the health care busi­ness can be taken with­out ref­er­ence to other divi­sions and with the knowl­edge that he or she has com­plete con­trol over the exe­cu­tion of the strat­egy. The only thing GE Group cares about is whether a divi­sion meets it’s rev­enue growth and prof­itabil­ity targets.

Microsoft’s busi­ness is almost the antithe­sis of GE’s. In 2004 the com­pany came up with the tag line ‘Inte­grated Inno­va­tion’ which almost per­fectly cap­tured Microsoft’s devel­op­ment phi­los­o­phy in one com­pact phrase. It also put a dag­ger in the heart of any plan to run devel­op­ment divi­sions as truly inde­pen­dent busi­nesses. The strat­egy of ‘Inte­grated Inno­va­tion’ cre­ates such a dense web of inter­lock­ing depen­den­cies between all of Microsoft’s prod­ucts that one divi­sion can­not sneeze with­out ask­ing the per­mis­sion of three other divi­sions first. ‘Inte­grated Inno­va­tion’ is absolutely the right strat­egy for an enter­prise soft­ware com­pany bent on meet­ing the needs of com­plex cus­tomers. How­ever the strat­egy puts a strait­jacket on any attempts to lever­age your assets into other mar­kets. Being held hostage to the ‘Inte­grated Inno­va­tion’ strat­egy is one of the pri­mary rea­sons why Microsoft’s pre­vi­ous Win­dows Mobile oper­at­ing sys­tems com­pared so badly to iOS and Android. (It remains to been seen whether Win­dows Phone 7 can break the bonds imposed by the ‘Inte­grated Inno­va­tion’ model.)  The ‘Inte­grated Inno­va­tion’ mes­sag­ing was also like red meat to the wolves of the Linux com­mu­nity and gov­ern­ment reg­u­la­tory classes who saw it as an attempt to lever­age Microsoft’s dom­i­nant posi­tion in one mar­ket to gain advan­tage in another.

The other dif­fer­ence between GE and Microsoft is how you get your prod­ucts to mar­ket. Microsoft has one sales force which sells through part­ners but has a direct rela­tion­ship with small, medium and large enter­prises. Each of the ‘Inde­pen­dent’ prod­uct divi­sions has to nego­ti­ate access to the sales resources required to get a prod­uct in front of cus­tomers. The life of a front line sales per­son at Microsoft has become unbe­liev­ably com­plex. They are the one point in the whole messy busi­ness where Microsoft’s prod­uct port­fo­lio comes together and has to be inte­grated into a con­sis­tent con­ver­sa­tion with the cus­tomer. Far from sim­pli­fy­ing the busi­ness the new P&L model likely added com­plex­ity and cost due to the over­head in resources now needed to man­age all the inter­nal nego­ti­a­tions. No won­der all those oper­a­tional expense items on the P&L have risen faster than income.

Then there’s the issue of lead­er­ship tal­ent. When Steve intro­duced the P&L model he made it clear that he was expect­ing the the divi­sional lead­ers to step up to the role of CEO for their busi­nesses. That of course requires that the com­pany had the skills in its exist­ing man­age­ment team to act and lead like CEOs. Its impor­tant to put the size of these busi­nesses in con­text. The Win­dows and Office divi­sions will gen­er­ate $18–20 Bil­lion rev­enue in 2010. If those were inde­pen­dent com­pa­nies they would rank no lower than 120 on the For­tune 500 list. The server and tools divi­sion is a $13–15 Bil­lion rev­enue busi­ness which would rank no lower than 177 on the For­tune list if it was a sep­a­rate company.

To be the CEO of any com­pany of this size requires: The abil­ity to define and artic­u­late a clear and excit­ing vision of the future, excel­lence in per­sonal com­mu­ni­ca­tions, an out­stand­ing abil­ity to select and nur­ture tal­ent, the con­fi­dence to admit your mis­takes and learn from them and a deft ‘polit­i­cal’ sen­si­bil­ity amongst many oth­ers. Not quite the skill mix you find in most great engi­neers and yet most of the pres­i­dents run­ning these mega-businesses today rose through Microsoft’s engi­neer­ing ranks. There are a few true super­stars in this role like Stephen Elop who is a breath of fresh air but was hired in from out­side where he already held a CEO posi­tion. As a share­holder I really do hope he can con­tinue to thrive and suc­ceed in the Microsoft culture.

As things were spi­ral­ing out of con­trol in the early 2000s Steve made another man­age­ment selec­tion which proved con­tro­ver­sial at the time. When it came time to pick a new Chief Oper­at­ing Offi­cer for Microsoft Steve reached out to an indi­vid­ual and an orga­ni­za­tion her knew well. His pick was Kevin Turner, then CEO of Wal-Mart’s Sam’s Club division.

Turner’s selec­tion was unortho­dox. Here was some­one whose entire mind­set and exper­tise was defined by a life­long career in a com­pany with a com­pletely unique world view; Sell sim­ple prod­ucts in huge vol­ume to con­sumers whose pri­mary value dri­ver is low cost, and squeeze every last cent out of your oper­a­tions no mat­ter what the cost in terms of morale or rela­tion­ship with your sup­pli­ers (If you are the largest retailer in the world then your sup­pli­ers depend on you, not the other way round.) Of course if you believe in the fal­lacy that Microsoft is or can become a con­sumer prod­ucts com­pany then Turner might be the per­fect COO. On the other hand, if the real­ity is that your busi­ness depends on sell­ing very com­plex enter­prise soft­ware solu­tions to com­plex cus­tomers who expect care and feed­ing for the mil­lions of dol­lars they spend with you, then per­haps you need a COO with a broader pro­fes­sional skill set.

Iron­i­cally, I defended the hir­ing of Turner at the time to my orga­ni­za­tion and any­one else that would lis­ten. My view was that the sales orga­ni­za­tion in par­tic­u­lar was in des­per­ate need of some dis­ci­pline and struc­ture if we were ever to get cost of sales under con­trol. To his credit, Turner did just that in his first two or three years, forc­ing every­one to adopt rigid new score­card and rev­enue fore­cast­ing processes. How­ever, as with all things there is a law of dimin­ish­ing returns and ulti­mately other strate­gic issues which need to be bal­anced. Unfor­tu­nately if you have a ‘Wal-Markian’ world view then there is no such thing as a dimin­ish­ing return. In the con­sumer retail busi­ness where mar­gins run at 5–6% one more penny squeezed from the cost line makes a dif­fer­ence. In the world of com­plex enter­prise soft­ware sales, squeez­ing another penny out of the cost line just demor­al­izes the tal­ent in your sales team who you depend on to explain the com­plex­ity of your prod­uct offer­ing to cus­tomers who spend mil­lions of dol­lars with you every year.

In my view its a pity that Steve did not take the oppor­tu­nity to shake Turner’s hand, thank him for his great con­tri­bu­tions and then let him go when his con­tract expired sev­eral months ago. If cost cut­ting becomes so endemic that the qual­ity of your sales tal­ent begins to decline and the ‘Tyranny of the score­card’ becomes so stul­ti­fy­ing that you leave no room for inno­va­tion and ini­tia­tive, then your enter­prise cus­tomer rela­tion­ships and rev­enue will fol­low. If that hap­pens Microsoft will enter a death spi­ral because there is no other busi­ness, not con­sumer, not on-line which can cover a shrink­ing enter­prise busi­ness. In my opin­ion, we’re enter­ing a very dan­ger­ous phase where the rigid­ity enforced by the net­work of depen­den­cies between prod­ucts, and the ever decreas­ing free­dom to inno­vate in the field, is severely imped­ing the com­pany from find­ing any cre­ative way out of it’s very seri­ous problems.

In the next and final chap­ter I will dis­cuss some bright spots on the hori­zon and give my per­sonal take on what strat­egy the com­pany needs to pur­sue in order to achieve it’s full potential.