Journal: Innovation and Leverage

There has never been a technology company to last for more than 20 years on a single family of technologies, and, more to the point, the failure of technology companies has never come from having their dominance in what they do well attacked. Technology companies fail because someone else steals their avenues of growth.

If you look at IBM, it went through waves of changes, starting in the digital age with mainframes, which dominated the marketplace from 1960-1980; selling to enterprise customers digital computers that would dramatically change their business. It saturated the enterprise with mainframes by 1980 and had, starting in the 70's, tried to maintain their growth rate by selling mainframes to middle market (500-5000 employee) companies who had not purchased mainframes.

Along came Digital Equipment Corporation, with the VAX, which just completely took that midrange market by storm, sapping the growth from IBM. IBM built the PC and launched a new market targeted at small business, but Apple, Compaq and a host of clones sought that market and, in the past 15 years, largely took that growth away from IBM.

IBM has been growing it's services business and it is paying off, driving an increasing portion of revenue. They are in year 8 of fantastic growth, but already, they are making noise about trying to sell services to businesses in the middle market; a sure sign that something else is about to come along to meet that need.

Why the history lesson? Because it illustrates the fundamental forces at work that are affecting the Linux and the Microsoft worlds.

The technology industry is characterized by several constraining forces; the innovation force, that seeks the best solution for a given problem, and leverage, the drive to extend technologies from one market to another to extract the best return on investment for that innovation.

Best solution is a subjective term, but in this case, it refers to the solution that is most applicable to a given problem, with the required supportive ecosystem around it and with the lowest cost of aquisition and the cost of ownership over the life of the technology. Hold onto those four points, they will become important.

Microsoft truly came up with the best solution for desktop productivity. Windows was a unique technology in that it brought the ease of use of the macintosh (meeting the test of applicability) that had the lowest cost of acquisition (OEM pricing included it with the computer), the required ecosystem (cheap PC's, compared to expensive proprietary Apples) and a decent cost of ownership (compared to the alternatives at the time, like DOS, which required extensive training).

Fast forward to today. Microsoft is now limited by the slowing growth rate of the personal computer industry, so it seeks to adapt its technology to other markets, in the name of leverage (internally) or compatibility (externally). So we see Windows in the Pocket PC format, where it is touted as an embedded system for extending the productivity brought by your PC. This embedded systems market is large, and fractious, as it extends from cell phones to pda's to robotic industrial arms to game consoles.

Linux is a contender for this market, using our criteria of best. Linux has the best applicability, as it is a modular OS that is compiled for the specific use. Want to use it in a robotic arm? Ditch the graphics processor and X-windows, strip it down to just what you need. Cell phone? Take out large portions of the OS that support complex sound and graphics, devices, hard drives, etc. Game console? Build up the graphics processor support and sound, device drivers and ethernet, get rid of the general use stuff that isn't needed for running really fast games.

Windows isn't nearly as modular, you can turn off functions, but it causes the OS to behave in funny ways because it was never meant to have these things turned off. So, Linux wins the applicability aspect of it.

As far as supportive ecosystem, this is where the battle really lies for embedded systems. Microsoft has brought it's armada of partners to the Pocket PC, to the XBox and to other embedded system projects, but these partners suffer from the same applicability problems that Microsoft faces. Do you really need MS Money running on your PDA, or would a simpler checkbook program that can interface with MS Money easily be better? Do you really need MS Access running on the PDA, or could a simpler program do the trick more efficiently.

In general, it is always more advantageous for the customer and more costly to the provider to innovate for a specific use than to stretch innovations across uses. As the embedded systems market grows, the viability of applications in this space will grow along with it, especially as standards for hardware coalesce.

Between Windows and Linux, the ecosystem criteria is a tie for now, but what about cost?

For manufacturers of hand held devices and specialty use devices, like game consoles, cost is a primary concern. When you are building super computers, the cost per component is a moot point, but for consumer goods, it becomes paramount. Cost of aquisition for Linux is not, as commonly percieved, zero - there is a cost in modifying the OS to get what you need and the cost of support, which is the very business model of Red Hat, but it is substantially lower than the cost of aquiring OS licenses from Microsoft.

Cost of ownership is another issue, as Linux isn't as remotely upgradable yet as it needs to be for these uses, but that innovation is coming for both Microsoft and Linux in time.

Over all, looking at just the embedded device market, Linux presents a credible threat to Microsoft, sapping the growth rate needed out of this marketplace that would have gone to the Windows hegemony as Microsoft tried to leverage it's existing innovation.

Looking at the server market, it is more bleak for Microsoft. In short, Linux wins the applicability (due to customization capabilities - want a fast database server? Build the OS to specifically run the database). Linux loses the ecosystem argument for now, but ecosystems are far less important the more you move away from mass production markets; this one is shifting towards Linux rapidly. Linux wins the cost of aquisition aspect hands down and cost of ownership is being proven to be the Achille's heel of Microsoft.

If Linux saps away a significant portion of Microsoft's growth, what impact does that have on the company? Microsoft, even in this down economy has a P/E ratio of 51. This means that a tremendous expectation of earnings growth is built into the company's stock price and if that growth doesn't materialize, the stock is in jeopardy. Microsoft stock is priced in the market expecting a 30% growth rate in earnings. If their market growth is capped by competition, they will need to cut costs and raise prices in their existing markets to keep the stock price up, which will exacerbate the situation. In short, the embedded systems market and the server market represent two rocks, and their shareholder expectations are the proverbial hard place.

So what if the stock drops? Microsoft has underpaid it's employees by as much as 30% compared to market wages, compensating them with stock options. Lose the option value and the operating expense for the company goes up 17%, further depressing earnings, or they lose employees. The dastardly side of losing employees is what IBM learned - when a company is in trouble, the highly valued employees (ie. the ones that can get other employement quickly), scatter first, leaving the undesirables behind to screw things up.

Additionally, losing the stock value takes Microsoft's credit card away. Microsoft has, to a large extent, built it's new businesses through acquisition of other technology companies (webTV, Foxpro, Great Plains, etc.) and the ability to swallow new technologies on credit (stock given away in exchange for future accretive earnings) goes away, leaving them with the challenge of paying cash, which is abhored by Wall Street for a variety of reasons (screws with earnings, risk no longer tracks reward during the acquisition process, etc.)

So, where does this leave us? The PC market is a graveyard, software for consumers is relegated to games and utilities and the whole IT industry is in a slump. Microsoft is a big, fat juicy target for a lot of IT directors looking to cut costs and, as Geoffrey Moore pointed out, markets shift when the early majority customer base makes their move. Amazon is clearly not an early adopter or an innovator (in the sense of the Moore term). Where there is one early majority customer, there are typically many many others at work.

Want to beat Microsoft? Give up on the wasted energy behind creating a better desktop; there is no growth in that market to do any real damage to Microsoft. Instead, build a better Xbox with Linux, build a better PDA, build a better server (oops, already there) and sap the growth from the company. The efforts in the Linux community to innovate is best exerted in the direction of markets to come, not markets that are.