The Microsoft Decision:
Implications for Investors

"I'd much prefer to have market forces accomplish as much of the remedy as could be done."

- Judge Thomas Penfield Jackson

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Decision Recap

Although Judge Jackson says he would have preferred to have market forces accomplish a remedy in the Microsoft case, he "reluctantly" decided to break the company into two separate entities.

"Microsoft, as it is presently organized and led, is unwilling to accept the notion that it broke the law," he said. And for that lack of humility, he lowered the boom. Microsoft has four months to devise a plan to divide itself in two.

Of the two new companies, one will produce Windows and other operating systems software, including Windows NT, the recently released Pocket PC, the upcoming Windows Millennium Edition and Whistler, the planned merger of business and consumer editions of Windows. The other will produce Microsoft Office and everything else, including Internet Explorer, SQL Server, Expedia, Hotmail, the book division and MSNBC.

On top of that, Bill Gates will only be allowed to control one of the companies. And Microsoft will be barred from negotiating exclusive deals with other companies or from controlling the appearance of the Windows Desktop when pre-installed on new computers. Additionally Microsoft must reveal its Windows source code to software developers and must price its Operating Systems equally to all computer manufacturers.

For his part, Gates is unrepentant. The ruling shows that "the government can take away what you have created if it proves to be too popular," he says. Microsoft will appeal.

The case may be in limbo for a while, perhaps a year or two if it goes to the U.S. Circuit Court of Appeals for the District of Columbia as Microsoft is requesting. More quickly if the case goes directly to the Supreme Court as the government wants. Penfield is said to lean toward going to the Supreme Court. But the Supreme Court, historically, prefers to have a lower court hear appeals first. It can refuse to accept a fast track.

Implications for Investors

For now the decision will have little impact on the company's stock. Microsoft has already suffered a dramatic decline from $120 in December to a low of $61 before recovering slightly to the $70 level. Some of that decline was, no doubt, part of the general tech market drop. But some was due to the court case and its anticipated results. In fact, some analysts have suggested that the adverse ruling against Microsoft precipitated the rout on the NASDAQ.

But after the ruling came down Wednesday, the stock rose $1.50 in after hours trading to $72. The market does not like uncertainty and a ruling, even though adverse to Microsoft, is viewed as a step forward. Even Bill Gates says "This is the beginning of a new chapter in this case."

But what of the next few months, and indeed, the next few years? What are the longer term implications for Microsoft?

If Microsoft wins on appeal, it's business as usual. The stock will likely rebound to former levels and maybe even higher. It may well do that anyway if its recent slump is part of the general market slump and not specific to the court case.

But what if the break-up order is upheld? Then it's a whole new ball of wax.

First the stock will be split along with the company into two stocks, let's call them Microsoft OS and Microsoft Applications. Each shareholder of record would receive shares in the two new companies to replace them. Then each new stock would trade independently.

Microsoft OS

The fortunes of the company would be most affected by the ruling that the company must adopt equal pricing among competing computer manufacturers and that it must refrain from exclusive deals with manufacturers. The latter in particular will lead to companies like Compaq or Dell releasing both Windows and Linux versions of their machines.

With the advent of more Linux based machines could come an erosion of Microsoft OS's power. This could arise even if the company is not split up but these remedies are still enforced.

What will ultimately determine Linux's success, though, is the availability of compatible software. Microsoft has maintained its strong market position, in no small part, because there is so much more compatible software than there is for competing systems such as OS2 or Linux.

The mandated release of its source code would actually make other software even more compatible than it already is. This could actually benefit Microsoft OS.

Microsoft Windows will likely continue to be the dominant Operating System for many years to come.

Microsoft Applications

Riddle me this, Batman! How come a Microsoft Office Upgrade costs over three times as much as a Wordperfect Office Suite 2000 Upgrade, and yet it still outsells the latter by a huge (and I mean really huge) margin? It's not because you need to already have WordPerfect Office Suite installed, because you don't. You can have "any word processor, spreadsheet or office suite" from Microsoft, Lotus, Novell, Borland or Corel to qualify.

I know this, because, cheapskate that I am, I couldn't see paying three times as much to upgrade my Office Version 6 and switched to Corel's WordPerfect Suite. It is every bit as functional as Office and even imports Office based files.

One reason is the exclusivity contracts and pricing agreements that Microsoft now enjoys with computer manufacturers. Install Office on original equipment and save on all your Windows installations. Microsoft also has many package deals with corporate clients. Windows NT and Microsoft Office are often sold as a package deal to companies. A third reason is compatibility. Office benefits from a more closely integrated functionality with Windows NT.

But under the court's ruling, Microsoft Office would no longer enjoy favoured status. There will be more manufacturers opting to install WordPerfect and other manufacturers' software as original software packages on their machines. And with the opening of source code, competing products will be able to improve their compatibility.

Will Microsoft Applications win or lose as a result of this ruling? That is a tough question to answer. To a certain extent, there will be increased competition for Microsoft's applications software. But the competition will increase primarily at the manufacturer's level, not at the consumer level.

How a new Microsoft Applications company will meet this competition is anybody's guess. But I don't expect the company will sit twiddling its thumbs. There will certainly be more price competition, though, and this could cut into the Applications company's profit margins.

But, in another real sense, the Applications company will have a whole lot more going for it than the OS company. It will be and remain at the forefront of the Internet revolution.

The Applications company will have Hotmail, MSNBC, Internet Explorer, Expedia and more. According to the MediaMetrix online survey for April, Microsoft properties are the third most popular on the Internet after the AOL Network and the Yahoo Sites. And Yahoo enjoys a very slim lead over Microsoft - 48,592,000 unique visitors to Microsoft's 47,159,000.

The Applications company will have more breadth and scope than the OS company. It could and should continue to grow in dynamic fashion.

Conclusion

I believe that, even divided in two, the Microsoft companies will continue to thrive and be a formidable force in the marketplace. The OS division will lose some of its clout with manufacturers, leading to increased competition. But the existence of such a wide variety of compatible applications will continue to make Microsoft Windows and related OS's the preferred operating system for PCs.

The Applications division is already a leader in the Internet revolution with MSNBC, Expedia, Hotmail and Internet Explorer. It is the third most trafficked online property after AOL and Yahoo and closing fast on the latter. There is no reason this should not continue.

Although I oppose the split-up of Microsoft for political and ethical reasons, I do not believe it will have any negative effect on the ability of the companies to thrive and prosper post-break-up.

The market eschews chaos and uncertainty. A final resolution to the Microsoft affair will bring a resurgence to Microsoft's stock price.

Other Links of Interest

Judge orders Microsoft broke into two companies - Associated Press account of the ruling at the Canoe Website.

The Judge's Comments - The actual text of Judge Penfield's ruling.

Wall Street ignores Microsoft breakup - Market reaction to the Microsoft ruling as reported on ZDNet.

MediaMetrix Top 50 US Web Properties - Microsoft is number three among all Internet properties and closing on the number two spot.

See also the sidebars in the box at the head of this article!

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