Microsoft (Nasdaq: MSFT) is a fantastic cash machine of a company.
It also has a strong position in a sexy growth market – cloud computing.
And it’s finally rid of a boss – Steve Ballmer – who was arguably holding the company back.
Hopes are high for new chief executive, Satya Nadella. The company’s stock has risen by more than 10% since Ballmer said he would step down.
Compared to other tech giants, Microsoft is relatively cheap. It even pays a healthy dividend (by US standards).
So why wouldn’t I touch it with a ten-foot bargepole?
The biggest challenge facing Microsoft’s new boss
Microsoft looks like it has a lot going for it. And maybe it does.
But it also faces a serious long-term challenge that may prove very damaging. I can’t see a simple solution to this challenge, and I suspect Nadella may struggle too.
What is this challenge?
I’m not talking about Microsoft’s weak position in smartphones and tablets. That is certainly a major problem.
But what really concerns me is that Microsoft’s near-monopoly on desktop operating systems is under threat.
This week, Asus launched a budget desktop PC in the US that is retailing for just $179. As The Motley Fool points out, this is almost 50% cheaper than the cheapest PC produced by Hewlett-Packard.
How can Asus sell a PC at such a low price? Simple. The Asus computer uses Google’s Chrome OS operating system, which Google gives away free. (For the non-techies among you, Chrome is basically Google’s version of Windows – it’s the software that allows you to use everything else on your computer.)
By contrast, the Hewlett-Packard PC uses Windows. That’s not free: Hewlett-Packard has to pay a licence fee to Microsoft.
Now, I’ll admit it’s still very early days for Chrome OS. But momentum is beginning to build, especially in the laptop market. Two of the three top-selling laptops on Amazon.com over Christmas were Chromebooks – powered by Chrome OS – and I expect that trend to continue.
And on a purely anecdotal basis, people I know who’ve switched to Chrome are positively evangelical about it. My colleague Phil Oakley here in the office thinks we should switch our entire IT system over to Chrome, while Bengt Saelensminde regularly waxes lyrical about his Chrome conversion experience in his The Right Side newsletter.
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How Google could drink Microsoft’s milkshake
If Chrome OS continues to grow and seizes significant market share, that could affect Microsoft’s wider business.
You see, if you’re not using Windows on your desktop PC at home, you’re much less likely to use Microsoft Office (Microsoft’s office tools software package – word-processing, spreadsheets, and the dreaded PowerPoint, for example).
That’s a serious concern in itself. But the rise of Chrome OS could be even more damaging if it starts to affect demand for Microsoft products from commercial customers.
That might seem alarmist. After all, many companies have Microsoft software deeply embedded in their systems. Who wants to go to the hassle of changing that?
But think about it: once a company’s staff gets used to using different operating systems and software on a personal basis, the need to keep splurging big money on Microsoft software may become less obvious.
Don’t get me wrong, Microsoft’s enterprise business will generate plenty of cash for some time to come. But I’m pretty sure that we’re going to see a decline in Microsoft’s home computing business and that will be followed by a gradual decline on the commercial side.
In operating systems, Microsoft faces a transition from operating a near monopoly to coping with competition from a very wealthy rival that is offering a competitive product for free.
In short, the bedrock of the company is being slowly but surely eroded away. And it’s not clear what will replace it.
I’m not confident enough to back Microsoft in this fight
So how can Nadella respond?
He needs to focus on Microsoft’s best businesses. That means Microsoft’s cloud offering. This is the unit that Nadella had been running until his promotion, and the fact that he won the chief executive job shows clearly the direction that Microsoft thinks it needs to go in.
Microsoft’s cloud-based products such as Azure should be very lucrative and should help Microsoft defend its position with large commercial customers. Trouble is, Microsoft faces aggressive competition here too, notably from Amazon’s web services business.
Bill Gates moving from being chairman to a technology adviser also makes sense. Hopefully he can ensure that Microsoft becomes more innovative with Windows and Office. That way it’s more likely to hold off the challenge from Google.
And – given the scale of the challenge – Nadella should consider dumping some of the non-core businesses. That would include the Bing search engine, Skype and the Xbox gaming business, and perhaps even the recently acquired mobile business from Nokia as well as Surface tablets.
But whatever Nadella does, I’m sitting this one out. On a 3% yield and a price/earnings ratio of 13, Microsoft might look cheap. But it’s cheap for a reason. It’s a great cash cow now, but there’s a real question mark over its long-term future.
If you’re looking to invest in a tech giant, I still prefer Google (Nasdaq: GOOG). It can hardly be described as cheap, and if you’re not in it already, I’d perhaps wait for a better buying opportunity – but I’m holding tight to my Google stock.
As for cloud computing – my colleague Bengt (the Chrome evangelist I mentioned earlier) – has an intriguing, if risky play that he favours.
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