Microsoft stock lost about 10 percent of its value in the wake of a quarterly earnings report on Thursday that investors deemed sub-par. Yet revenue for the second quarter was up 10 percent, to $19.9 billion. And the company's profits were more than $6 billion, compared to a small loss in the second quarter last year.
So why did the market freak out? The biggest reason was that Microsoft booked a $900 million charge for "inventory adjustments" for its Surface tablets. In plain English, Microsoft admitted that its heavily-promoted tablet is selling poorly. And that's an ominous sign for the Redmond firm's long-term prospects. Tablets and smartphones are the future of computing, and Microsoft is falling farther and farther behind the market leaders, Apple and Google.
But Microsoft CEO Steve Ballmer shouldn't be too depressed. Microsoft probably won't lead the next generation of high-tech innovation. But history suggests that Windows and Office, its existing cash cows, will continue generating profits for years to come.
Tablet computing is an example of what Harvard business guru Clay Christensen dubbed a disruptive innovation. While the term has become so over-used as to render it almost meaningless, Christensen gave it a precise and useful definition. Disruptive innovations are those that are dramatically simpler and cheaper than what's already on the market — in this case, the PC.
Tablets are less powerful than full-featured PCs. But their simplicity and low cost allow many more people to experiment with them — witness the hundreds of thousands of apps in the Apple and Google app stores. That has led to a rapid pace of innovation in mobile software. Over time, disruptive technologies like tablets outstrip the capabilities of the older technology like PCs, despite the latter's greater complexity and initial sophistication.
This pattern has played out before in the computer industry. In the early 1970s, the cutting edge of the computing industry were "minicomputers," which cost tens of thousands of dollars and were the size of washing machines. Then start-ups like Apple began introducing "microcomputers," known today as PCs. They were small enough to fit on your desk and only cost a couple thousand dollars. These early PCs had extremely limited capabilities. But millions of people who couldn't afford a minicomputer could afford a PC. And so the PC market grew much faster than the minicomputer market, making Bill Gates, Steve Jobs, and other PC pioneers wealthy men.
The computing industry is now undergoing a similar transition. Millions of consumers are foregoing relatively pricey and complex PCs in favor of Android phones and iPads. And the experience of Digital Equipment Corporation, the leading minicomputer firm in the 1970s, provides some clues to Microsoft's own future. The parallels between the two firms are striking.
According to Christensen, DEC tried to enter the PC market four times between 1983 and 1995. But each time, the firm's corporate culture proved an insurmountable obstacle to success in the PC business. A workforce that was used to making tens of thousands of dollars on each sale had neither talents nor enthusiasm for selling computers that would only fetch a few thousand dollars each. None of DEC's PCs were a hit with consumers.
Microsoft has repeatedly tried to enter the mobile OS market with similarly dismal results. The Redmond giant introduced its first tablet PC more than a decade ago, and it was offering a mobile version of Windows for years before the iPhone came on the scene. But Microsoft was too invested in the PC business model to succeed in the mobile marketplace. It tried to offer the full capabilities of a PC in a mobile form factor, producing an interface that was too cluttered and confusing for small screens. And its business model of charging smartphone manufacturers for each Windows phone they shipped left the company flat-footed when Google began offering Android for free.
DEC eventually fell on hard times, but it took more than a decade for the growth of PCs to seriously undercut DEC's business. The firm's relatively powerful computers continued to sell well throughout the 1980s. And the company continued to innovate. The Alpha processor, introduced in 1992, was widely regarded as a technological marvel. In 1995, DEC released AltaVista, one of the first full-text search engines. But none of these products proved profitable enough to replace declining revenues from its minicomputer business.
Microsoft is due for its own decade of stagnation, as the computing industry shifts from PCs to mobile devices. Yet PCs aren't going away any time soon. Businesses are not going to put iPads on peoples' desks any time soon, nor are they going to ditch Microsoft Office in favor of Google Docs. So if the Redmond firm can keep its costs down, it can continue to be profitable for many years to come.
The problem is that no technology CEO wants to admit that his firm is no longer capable of succeeding on technology's cutting edge. Selling Windows and Office may be profitable, but it's not as glamorous as writing the software that powers smartphones and Web apps. So just as DEC continued producing innovative but doomed products like the Alpha and Altavista in the 1990s, Steve Ballmer is likely to continue pouring money into money-losing projects like Bing, the Zune, and Surface. That's probably not good for Microsoft's shareholders, but it could be great for consumers.