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Life Without Microsoft

Van Knapp's Take On Microsoft

Can Microsoft's R&D Efforts Save It?

Further Evaluation of Steve Ballmer

Ballmer Is Bad For Microsoft

Watching GOOG For Bargain Price

Google vs. Microsoft

Life Without Microsoft Part Two: Subscriber Feedback

Life Without Microsoft

The Case For Vista

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Life Without Microsoft
June 13, 2008

Wrapping up this week's look at why Microsoft's business has grown while its stock price has not, CJ sent along the story of how Mike Kavis worked for one year without Microsoft products in a Microsoft office environment. He has "not used a single Microsoft product at work. It has been one year now and I have survived with Thunderbird and Evolution, Open Office, Firefox, and many other open source replacements for Microsoft products."

The open source experiment was a success, "nearly flawless" in his words. He was especially enthusiastic about Open Office, which "worked remarkably well both receiving Microsoft Office files and creating files in Office format. I exchanged literally thousands of documents between Microsoft Office and Open Office. I never encountered a single issue with Word and Excel and occasionally encountered minor formatting issues with Power Point files. The formatting issues were nothing more then some minor placement issues which probably occurred less than 5% of the time."

That led CJ to say that, more than Google Docs, "the compelling threat to MS Office's revenues to me is your argument that users can easily convert between file formats these days."

CJ is not worried about Google Docs yet: "My first inclination is to think that until Google Docs has a strong off-line story, they will not put much of a dent in MS Office's revenues. Licenses with businesses is where the MS Office suite makes its recurring income, and I don't believe many businesses are going to get on board with the cloud computing concept anytime soon. Many businesses have their own in-house variations of cloud computing using a VPN connection. I have a hard time understanding how businesses will justify trusting third-party vendors with their vital data when they can do it themselves."

That last point is probably valid, but notice the hints at the idea that it might change in the future. This is not a criticism of CJ's point, just a confirmation in my mind that what investors are unsure of is Microsoft's future -- and have been for the past eight years. Its currently installed base of products is still growing revenue and profits, but the what-ifs are adding up:
  • What if cloud computing keeps growing in popularity and becomes as accepted as online shopping and online payments? I remember when people hesitated to buy from Amazon.com because it required using a credit card online. Then people said PayPal had no future because it wasn't a real bank. Online money? Who would ever trust that? How quaint those early concerns seem in retrospect, and we're only talking ten years ago. Now that Amazon.com has been hassle-free for so long and PayPal is bigger than American Express, nobody talks that way anymore. It could well go the same way for cloud computing. If so, the MS Office franchise looks shaky indeed.

  • What if people realize that they're finally free to use any operating system they want because they can use any applications they want online or freely downloadable ones offline? What if Mike's one-year experiment becomes the norm, not the interesting case study? Then, the Windows franchise looks shaky.

  • What if Google really does have the internet permanently locked up? It could keep growing revenues as its search share grows and leave Microsoft with no online business model because it has no serious advertisers to tap for an ad-supported online application environment and can't charge because all its competitors make their apps available to users for free.
This week has been a search for the reason investors have refused to pay up for Microsoft's growing earnings, a trend that has left the price of MSFT stock flat for the past eight years. I think the best answer is that Microsoft's business model is still working, so it hasn't changed. Pro-Microsoft investors would say, "Don't fix it if it ain't broke." Doubters would say, "It is broke but you just don't know it yet."

For the past eight years, the doubters have dominated in the market. We'll see down the road whether the pro-Microsoft gang is right that the company's business model is not broken.


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Van Knapp's Take On Microsoft
June 12, 2008

Continuing our recent look at why Microsoft has grown its business but not its stock price under Steve Ballmer's leadership, here's an installment from Dave Van Knapp of SensibleStocks.com:
After I read your article on Ballmer, and your readers' responses to it, I looked up MSFT's numbers...revenue growth, profit growth, P/E, all the usual stuff. Blended together, they seem to make a case for SCREAMING BUY! But then, as I always do, I asked, "How's it doing?" And you had already answered that: MSFT has been dead money for eight years or so.

You personalized that with Ballmer's tenure, concluding "no innovation, no growth, and Google's eating their lunch." But MSFT's growth numbers don't lie, there has been strong growth. However, as you pointed out yesterday, the P/E has shrunk, with the net result that the stock price is about the same as it was eight years ago.

I'd like to offer some points that have been overlooked in the discussion so far:
  • When MSFT was growing as fast as Google is now, let's not forget that they were cheating. I'm not referring to taking others' ideas and marketing them better, that's not cheating. No, they were breaking antitrust laws left and right. They made an art form of anticompetitive practices. They have been convicted by the U.S. government, several states, and Europe. I think (after years) they finally have settled everything on this side of the Atlantic, but I believe they may still be trying to settle a few charges in Europe. That's how they built their huge moat. As long as a significant part of the game stays the same (i.e., business software), they are going to continue to grow, because they dominate that sector and are essentially impregnable within it.

  • Their cheating -- along with some innovation, more copying, and great marketing -- gave them an essential monopoly in business software. Their operating system, Internet browser, and essential office products (like Word, Excel, and PowerPoint) all became industry standards. Except in a few niches such as graphic design and education, they completely swamped Apple. That gave them huge network-effect advantages. It doesn't matter that people don't line up overnight to buy Vista. What matters is that Vista is installed on all new PCs except Apple's.

  • MSFT out-maneuvered Apple in another way, and it was brilliant: They made their systems available to all computer makers. Remember when "PC" meant only the personal computer made by IBM, and all others like it were called "clones"? That's because IBM hooked up with MSFT first. Apple (except for a brief flirtation) closed themselves up and did not allow clones. They insisted on forcing users to buy their computer if they wanted Apple's (superior) OS and other programs. Apple boxed themselves in for years with this fundamental strategic mistake.

    I worked in huge companies, and there was never a question about buying Apple products. We had to have the business standard. The only question was who made the best/fastest/cheapest computer, and there were lots of choices. They all worked together. None worked with Apple. The IT choice was a no-brainer: PCs with MSFT software. This also contributed to MSFT's moat, and they deserve credit for a masterful strategic move.

  • Another area where MSFT out-strategized Apple was in their partnership with Intel. Remember "Wintel"? It's only in the past couple years that Apple has used Intel processors, and it has been one of the keys to their resurgence in PCs (a term that is now generic, not referring only to IBM products).

  • Meanwhile, MSFT was beaten down by Google in paid search, not just in search. MSFT tried (as did Yahoo and many others), but Google hit on the winning formula, tying ads to search results in an appealing and effective way.

    It's Google's strength and also their greatest vulnerability. I think more than 95% of Google's revenue comes from paid search (AdWords and AdSense). Google essentially did an end run. While others were trying to become "portals" to the Internet (which usually meant keeping you on their own site for as long as possible -- AOL, MSN, Yahoo, etc.) -- Google recognized that a simple search of the Internet was what most users wanted. That allowed them to take advantage of a ridiculously simple interface, which many found superior to the portals' hodgepodges. Google gets huge innovation credits for that, although it can be argued that appealing paid search is their only successful commercial innovation to date.

  • Google ideas that you are touting -- such as Google Apps -- have been around for years. (They were formerly called ASPs...application service providers). Google has no lock on winning that race, if indeed there is a race.

    Just in the past couple of days, I have seen Microsoft ads for their version of Internet-provided workspaces, just like Google Apps. Adobe has been doing it for a long time. There is no guarantee that working on the Internet will supplant working within one's own PC...although I personally think that will happen. I do know that there are many professions -- doctors and lawyers come to mind -- that have yet to come close to the trust needed that they would place their clients' confidential information "out there" on the Internet.

    Every time Google (the inaptly sloganed "do no evil" company) pulls a stunt like scanning and publishing copyrighted material, or publishing "geographic" photos so detailed that men can be identified walking out of strip clubs, they hurt their own cause in regard to Web-based applications.
What's the bottom line? I sold my MSFT 8-9 years ago when they were adjudicated to have violated antitrust laws...I happen to have strong feelings about things like that. I've never been sorry. I think the stock was about $31 when I sold it, and I don't believe it has ever re-attained that level.

Maybe it's paid its debt to society and is worth a look again. As I said earlier, it's a cash machine that apears to be a screaming buy. But I wouldn't buy it until it turns upward. As you said, there's something the market doesn't like about the stock or its prospects. Maybe it is Ballmer. (Those clips were priceless!)
It may be as simple as the realization that the monopoly power behind Microsoft's early success is waning. It's not gone yet as the business results show, and I suppose the company could post respectable numbers on just the fumes of its earlier achievements.

But when the future of computing is seen to be Internet-based, and Microsoft is seen as having bungled and continuing to bungle the Internet, then Microsoft's future appears cloudy.

For instance, while many people are not eager to put confidential information online yet, the fact that more and more people do it every day for free is itself a cause for concern. Between Acrobat.com, Google Docs, OpenOffice.org, ThinkFree, Zoho, and whatever else is in the works, there are a lot of ways to get work done without paying through the nose for MS Office. Perception: users don't need Microsoft to do work anymore.

Browsing the Internet is best handled by Firefox, and that just gets better every year -- for free. Perception: users don't need Microsoft to get online.

The Internet has quickly rendered compatibility issues moot (unless you're still tethered to Microsoft's proprietary formats), which means that more people are for the first time free to choose Apple's elegant products for their computing needs. That makes Apple's non-open platform strategy finally sensible because if you want an Apple computer you have to get one made by Apple. Perception: users don't need Microsoft Windows on their new computer.

And on and on. So far, even though people don't need Microsoft across these and other categories, they're still ending up using them or choosing to use them. For investors, though, the lack of need means that eventually Microsoft will need to prove that its products stack up to the competition, and win loyalty on merit rather than monopoly -- and it has a poor track record there.

Microsoft is not known for its innovation or quality, it's known for its business acumen at boxing users into having only one choice: Microsoft.

When that list expands to include others, Microsoft loses its edge. The perception that the list of alternatives to Microsoft is growing in all categories and that Microsoft's edge is dulling may be the dim future that has investors hesitating to pay much for the company's business results.


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Can Microsoft's R&D Efforts Save It?
June 11, 2008

Jack is back with further commentary on Microsoft. For background, read the most recent two articles under the MSFT label. Here's Jack on the free cash flow margin of safety:
From Reuters, we find that Microsoft has produced:

12.50% 5-year avg revenue growth
24.16% 5-year avg earnings growth
20.26% 5-year avg ROE

The interesting thing is that growth has accelerated in the last two years. How come? Perhaps because of the $6 billion for research and development spent in 2006 and $7 billion in 2007. These items compromise earnings in the short run but are a mechanism for this relentless growth. At this rate (24%), earnings currently double every three years, and in 13 years the company will earn as much as its current market capitalization in a single year. If the P/E were to remain the same, this means the share price will go up 17 times in 13 years. If Steve Ballmer keeps doing what he is currently doing, I have no doubts about MSFT reaching that level of earnings.

When Bruce Berkowitz invests in a stock he likes to think "of the worst things that could happen. What if a natural disaster, an attack, a dirty bomb, what if financing dries up, etc.". So what happens if Microsoft is incapable of growing forever? Thus Microsoft is essentially producing free cash flow (FCF) at the rate it earns at the present time, to eternity. Its current FCF yield is approximately 7%. But hold on, what is the point of R+D and growth CAPEX when there is no more future growth?
So adding back the R+D into FCF, we add the after tax R+D (7Bn * 0.7) = 4.9Bn back into earnings. What is the picture now? FCF yield doubles to a little more than 14%. That's a neat package to have every year.

Of course Microsoft faces intense competition in the market it is in. However the lack of erosion in its incumbent business (for 25 years!) means that its core earnings are very unlikely to change. Growth may be compromised in certain areas (such as search marketing, etc.) however, Ballmer has shown that he is still capable of increasing earnings at an increasingly rapid rate.

The only problem in my mind is MSFT generates too much cash and management does not know how to allocate it. (This is why ROE has fallen from historical averages of 50+% to 20+%.) I gave a great sigh of relief when MSFT cancelled its bid for Yahoo.
This looks like a pro-Microsoft day here, so I'll pass along comments from Justin, prefaced with his caveat that he thinks "Microsoft is a dinosaur" and that they "may have made a fatal mistake in not doing enough with the internet." Nonetheless:
But there are a few business segments in which Microsoft is still innovating. They are beginning to introduce a surface computing device that is simply awesome:

And in the long Microsoft tradition of stealing ideas from Apple, they are beginning to introduce multi-touch technology into other consumer devices. I think multi-touch -- along with voice recognition -- will be the next major revolution in user interfaces, the same way the graphics user interface replaced text-based inputs. Look at this:

And as you pointed out, the X-box is doing really well. There are actually a lot of young kids who think of Microsoft as a really cool company that makes games like Halo.
If all this planning for a better future has a good chance of delivering a better future to Microsoft shareholders, why then hasn't the share price risen to reflect the strengthening business? Jack is right that earnings have been growing. Because the P/E has been shrinking, however, the share price hasn't budged.

Is everybody just wrong about the glorious days ahead for Microsoft, or are they onto something? If the future is Apple stealing Microsoft Windows share with its computers and Microsoft Exchange share with MobileMe, and Google stealing Microsoft Office share with Google Docs and preventing Microsoft from ever gaining any meaningful hold in internet search, then investors are onto something. If Microsoft can innovate into new markets or keep its existing market dominance relevant and growing as Jack contends, then investors are missing a great bargain.

Which do you think is the case?


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Further Evaluation of Steve Ballmer
June 10, 2008

Last Friday's article on Steve Ballmer being bad for Microsoft generated a lot of reader commentary.

Jack wrote:
I disagree with your position on Ballmer. The reasons being:
  • Ballmer took control over Microsoft whilst it was at a huge premium to intrinsic value. Despite improving value of the business it was not enough to substantiate the large equity premium on top of intrinsic value. At current prices, this may not be the case.

  • Ballmer has grown the company considerably over the last few years (earnings + revenue wise), drawing attention to many value investors as you mentioned in your article. If you look at this website, it shows that Einhorn, Tweedy Browne, etc. have large holdings in the company. These investors are not to be underestimated.

  • After eight or so years with Ballmer at the helm of Microsoft there seems to be no significant erosion of Microsoft's economic moat. In fact their dominance in operating system software has extended to Mac, as I for one, like many others, install Windows on my Mac. Products such as Vista and Office are continuing to be a "necessity" on one's computer. Although OpenOffice and Google Docs have their merits, they are not very compatible with Office (sometimes the fonts get mucked up, etc.), further...try loading an ODS file on Office! Although Firefox has cut down Internet Explorer market share, that in turn has never been a material source of Microsoft revenue.

  • Microsoft gaming is experiencing huge growth. It currently makes up 11% of revenue, yet grew 68% last quarter. By next year I'm guessing that this division will grow up to 16% of revenue. Vista is experiencing large growth as well.
At a forward P/E of 13 and with significant levels of cash (they special dividended a fair bit!), the company may be undervalued. Ballmer has undoubtedly built up the intrinsic value of the business and for a true value investor, that is what it is all about.
Jack raises excellent points, some of which I hinted at last week. It's true that both revenue and earnings have grown on Mr. Ballmer's watch. Gaming has also flourished while he's been at the helm.

The question is: Why haven't rising earnings and revenue translated into a higher share price? The lack of capital appreciation means that investors dislike something at Microsoft.

Jack and others pointed out that it may not be fair to compare the price of MSFT in early 2000 with its price today because the early 2000 price came at the tail end of the internet bubble and all technology stocks were overinflated. However, even if we start examining the stock from the beginning of 2003 when the crash was over it fails to impress. MSFT began 2003 at around $28 and closed yesterday at $27.71.

It paid dividends, true, but that's hardly a compelling reason to own the stock. Its dividend yield is 1.6%. There are better stocks for dividend income, such as Pfizer with a yield of 7%.

In any event, it's clear that the market has paid a lower multiple on Microsoft's growing earnings, resulting in a flat stock over the past five years, during which time Mr. Ballmer has been in charge. Again, why is that?

My take is that investors are finding better futures elsewhere. Outside of gaming, what new territory has Microsoft claimed? It still puts out Windows and Office, and has improved their capabilities in marginal ways. Jack pointed out that he installs Windows on his Mac. That's not much of a growth story, though.

What I think Microsoft needs is another huge market to call its own. Per its usual approach, it has refused to invent anything or revolutionize any process. It's finding that its usual mode of copying and outmarketing the creator is not working online. Google has used the network effect to nullify Microsoft's strategy. Microsoft can copy Google all it wants, but there's no compelling reason for people to switch from Google to Microsoft, so the copycat sits lonely while the pioneer is overrun with users.

The ample cash that Microsoft has is apparently earmarked to buy Yahoo in a last ditch attempt to catch up with Google. Here again, what a head shaker. Buying Yahoo is Microsoft's internet strategy? That's some visionary leadership from Mr. Ballmer. It was not this kind of behind-the-curve reactive management that made Microsoft the wealth machine that it used to be.

In retrospect, it seems that making internet search faster and more accurate was an easy goal to have seen back around 2000. You may feel that rearview analysis is easy, but remember that Microsoft takes every opportunity to boast about its technology gurus and skillful team. Well, if they're such gurus and so skillful, why didn't they come up with something we've needed in the past eight years? It's a fair question. I haven't needed even one upgrade from Microsoft. Have you? I don't use Office to create new documents, and when somebody sends me an Office document I open it with an old version of the software. I never even considered upgrading to Vista. Did you?

Meanwhile, my personal life and business are increasingly run with Web 2.0 applications accessed by Firefox. Our next office upgrade will be to all Apple products, not because they bring capabilities that we can't live without but because it finally doesn't matter what machines and local software we use. Everything happens online anyway, so any machine can do the job, so why not go with the best ones? In our opinion, the best computers are made by Apple.

When we work with a new organization, we suggest that they coordinate with us easily by using Google Docs. Most are now already familiar with it -- which is pretty impressive in itself -- and those who are not have no trouble getting up to speed. Once they see that sharing information is as easy as logging into Google Docs and checking the file that we can all access, there's never a complaint. "Sure beats email attachments," is a typical comment.

In short, I think the market sees Microsoft losing its grip on computer users and having nothing to take its place when those users start leaving. Jack's right that they haven't started leaving in droves yet, but the market is a forward looking mechanism and senses that at Microsoft there's a greater chance of ramping down than ramping up.

If that's not what's going on, then what else? A long-term stock chart shows Microsoft stock forming a plateau after Mr. Ballmer took over. Something, caused its stock to lose relative appeal. The above reason is my best guess.

 I've looked just at the stock's performance when pointing a finger at Mr. Ballmer. Other readers have looked more closely at the man. Charles sent the following clips and wrote that it's "scary" to think of how many people are depending on this guy:


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Ballmer Is Bad For Microsoft
June 06, 2008

The Wall Street Journal ran a nice article on Microsoft's Bill Gates and Steve Ballmer yesterday. It was offered as a backdrop to the further departure of Mr. Gates on June 27 from his already reduced role at the company. The article, like many others on Microsoft, never asks the hard question that's central to seeing the software giant's future: Is Steve Ballmer another Bill Gates?

Look at the record.

Under the stewardship of Bill Gates, MSFT split eight times and rose 53,000% from early 1986 to early 2000. Under the stewardship of Steve Ballmer, MSFT split once and lost half its value since early 2000. Look at the sorry chart.

It has grown earnings under Steve Ballmer, but they haven't boosted the stock price because forward-looking investors refuse to pay a high multiple (price/earnings ratio) for a stock with a steadily dimming future. Value investors say Microsoft is a great bargain these days, better than when Mr. Ballmer took over, but they may be missing that it's cheap for a reason.

That reason is that Steve Ballmer has done nothing since he took over. What's new at Microsoft? There are marginal differences, but for most casual users Microsoft puts out the same software with different version numbers today that it put out eight years ago. Mr. Ballmer completely missed:
  • The importance of internet search.

  • That the center of computing was moving from the desktop to the internet, and that the migration would make all computer users platform agnostic. Increasingly, all that matters is that a computer can get online. That being the case, why would anybody choose clunky Windows over elegant Macintosh?

  • That people stopped needing any new features in their OS and productivity software about ten years ago, and had grown wise to the meaningless upgrade cycle.

  • That the only new capability in productivity would be putting it online, and that Microsoft needed to face that reality sooner than later or somebody else would get the edge. Microsoft took its eye off that ball, and Google picked it up and ran with it all the way to a goal called gDocs.

  • That online video was going to be a big deal. Again, Google beat Microsoft to YouTube and now controls almost 40% of the online video market. The number two site commands just 4%, Microsoft about 3%.
And so on. It's hard to see what Mr. Ballmer has been doing these past eight years. The Xbox has been successful, but that's hardly Microsoft's core income center. The company has lost its iron grip on computing since Mr. Ballmer slipped his hand into the control glove.

This is not the first time we've seen this. Think back: Steve Jobs was replaced by John Sculley at Apple, then had to return to save the sinking company. It took less than three years to see that Dell's Kevin Rollins was a disaster, and to get Michael Dell back in charge to resurrect his namesake firm. The man who put Starbucks on the map, Howard Schultz, had to return in January after an eight-year absence to get the coffee shop hot again. Charles Schwab sent David Pottruck packing in 2004 and re-took the helm at his namesake firm:
"I'm sorry," Pottruck remembers Schwab saying, "but the board has met and decided that they have lost confidence in the direction of the company and in your leadership. We've decided to make a change and have me come back to the office." Effective immediately, Pottruck was to step down, and Schwab would become CEO again. -- full Fast Company article
And so on.

We'll probably never witness such a dramatic return for Bill Gates. He hasn't seen fit to right the ship in the past eight years, why start now? He's off to greener pastures.

Microsoft shareholders are sure going to miss him.


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Watching GOOG For Bargain Price
March 04, 2008

Dan writes:
I see you haven't bought Google yet, despite all your positive articles about it. When do you expect to buy, and will you put on your website when you actually place the order?
The Kelly Letter has owned Microsoft and Yahoo for years, and is sitting on modest profits in each. My reason for owning Microsoft was to capture upward momentum from its Windows/Office upgrade cycle that started last year; for owning Yahoo it was an eventual recovery as it streamlined and improved its competitive position against Google. I thought Yahoo was a bargain compared to Google, and didn't like Google's over-reliance on advertising for profits. Remember, some 99% of its profit is from ads.

When Google kept climbing last fall to $747 on November 7, it looked far too overpriced to me. Its MACD was over 37 and its relative strength was 86 -- both stratospheric and screaming for a correction. Part of that rally came from Jim Cramer, who in October raised his price target to $750 but called even that "a total and unequivocal lowball estimate" considering the growth potential. He said a more reasonable estimate was $900. He'll be right someday, but there was no way it was going straight there from early November's precarious peak.

So, my initial hesitation with Google was two-fold. One, I was betting on Yahoo to get itself back on track. Two, I was convinced that Google was overpriced and vulnerable to some kind of setback. I was not prescient enough to know that the market would crash as far as it did in January, nor that Google would be so punished for its slowing click rates and so on. Thus, some of the good timing was just luck (and always is, no matter what anybody tells you). However, when a stock is as out of oxygen as Google was last fall, it doesn't take much to knock it down. I knew that, and held back until something happened to it.

Then, my attitude toward Google changed. What did it was Microsoft's bid for Yahoo. To me, that marked the end of Google's serious competition online because I believe that both Google and Yahoo are working on internet-based operating systems with the potential to make Windows unnecessary, and that that's the real reason behind Microsoft's buying Yahoo. It's not actually just about advertising -- although it is somewhat, of course -- it's really about bulking up for a long war against Google for control of software-as-a-service (SaaS) computing that's going to take the world by storm any year now.

I found on SnapSheet that Google Apps's revenue has gone from $0 to $400 million in just three years. It's up ten-fold from just a year ago. Granted, $400 million is still a small figure compared with Microsoft Office's $18 billion revenue, but with its blistering rate of adoption you can be sure Google Apps won't remain a mere annoying gnat for long. Also, have you used Google Apps or Docs? I already run my business with Google Docs and, let me tell you, it's fantastic.

Furthermore, I think Microsoft's proven ineptitude online is going to destroy or at least hobble whatever chance Yahoo had against Google. Thanks to Microsoft, Yahoo is on the same path to oblivion now sporting AOL's footprints. In a few years, I think we'll see the Microsoft/Yahoo conglomerate as an online dud with a smaller share of online search than they have now, an absurdly bloated online version of Office that's outflanked in every regard by Google Apps, and an operating system from Google that's a genuine alternative to Windows.

Aside from recent events, I'm fed up with Microsoft as an investment. Steve Ballmer is no Bill Gates, at least not judging by stock performance.

Microsoft has basically been dead money for five years. Since Steve Ballmer became president in January 2000, MSFT has lost about half its value. Now, he took over at the top of the internet bubble, but even if we clip off the bear market years and just examine the stock's price from, say, the beginning of September 2003, it's still down 4%. In that same time, the S&P 500 is up 30% -- even after the recent market trouble.

Given all of the above, The Kelly Letter is looking to sell both Microsoft and Yahoo at profits, and move the proceeds into Google at a cheap price.

We've been patient with Google and are hoping that investors see the Microsoft/Yahoo merger as a big threat to Google so that the GOOG share price keeps dropping. When it gets low enough, we'll begin buying.

As always, I will tell subscribers when we place the order and at what limit price. Join us!

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Google vs. Microsoft
July 27, 2007

I wrote Tuesday about trouble with Google's AdWords platform. I noted that it's not performing as well as it used to, and that that will spell short-term trouble for the company and stock because 99% of Google's revenue comes from its ads.

On Wednesday, Digg switched from partnering with Google to provide ads on its reader-powered news site, to partnering with Microsoft. Digg will still display small text ads, just like the ones previously delivered by Google, but now they'll come from Microsoft and are expected to be better.

How could this be? Google is supposed to be the cutting edge of all things Internet, yet it's grown relatively stodgy in the ad business, which is its only revenue-generating endeavor. Everything else it does is just to gather people around pages that show content and...ads. If it blows it in the ad game, it's in real trouble because that its only game.

Meanwhile, old crusty Microsoft is leading the charge in the ad category. Jay Adelson, Digg's CEO, said his company couldn't "think of a better partner to get to where we need to go. They're a young ad service, they're innovative, they're willing to work with us on the cutting edge."

Last summer, Microsoft signed up the social networking site Facebook. Now it has Digg. It's in the process of acquiring aQuantive to keep its adCenter division at, well, the center of advertising.

Rather than Google's plain-Jane pasted-on-the-page ad system, Microsoft is developing a more interactive approach. Users have been screwed by too many worthless text ads that have, in fact, little to do with what they're doing online. The context sensitive approach was nice five years ago, but has been worked to death to the point where fewer and fewer people bother looking at anything but organic search results (the ones that the web turns up by actually searching, not the ones that are placed as ads). Everybody's onto the text ad trick by now.

Steve Berkowitz, a senior vice president in Microsoft's online services group, says Microsoft is the innovator, not the copy-cat, in online advertising. "We actually now are in the forefront of what we believe is going to be the next generation of advertising."

True, Microsoft has a long way to go to catch up with Google, but it certainly doesn't lack the money to get there.

I've written for some time now that my interest in Google has to do with its endeavors to make Microsoft alternatives. I want to use Google Docs instead of Microsoft Office, for instance, and I'd like to see an entirely free operating system made available and amazing, just as Mozilla has made the entirely free Firefox the best thing in browsing. Try using Internet Explorer after Firefox and you can scarcely believe anybody's stupid enough to keep it.

Is Microsoft taking Google's encroachment onto its core turf in stride? No. The Redmond giant is well aware that its main business is threatened by web-based applications, online advertising, and other ventures.

Last night, Microsoft CEO Steve Ballmer told analysts that web services and consumer devices are vital parts of the company's future. He said, "Great things don't happen overnight. Most successes require long-term investment and innovation...and that's our perspective."

He said he sees more opportunities for growth in the next 10 years than in the past 30 years. Rather than hiding from new, disruptive technologies, Microsoft will embrace them. He referred specifically to the threat of web-based software versus Microsoft's traditional local hard-drive-based software.

"Every piece of software -- the basic core value in the way software gets created -- will change in the next three, five or 10 years," he said, and predicted that all software will soon use the desktop, Internet, and server to get its job done. He said that software will never switch to an Internet-only model.

What's going on here?

Google is an online advertising company that has plans to become a software company. Microsoft is a software company that has plans to become an online advertising company. They're both much better than the other in their current area of strength at the moment, but they're both looking a little uninteresting in that area as the other catches up in exciting ways. They both have a lot of money to get where they want to be.

Microsoft shares were stuck between $22 and $30 from mid-2002 to mid-2006. From early June of last year to now, the shares are up some 36%, but that's just the difference from $22 to $30, so the situation hasn't changed all that much. Pay no attention to what excited onlookers say about the percentage gain.

Google shares are the toast of the town, having gone up 400% from $100 to $500 in the past five years. However, there've been bumps along the way. From January 2006 to mid-March 2006, GOOG dropped 28%. Could we be on the verge of another such sale?

I think so. It reported earlier this month that it hired 1,500 new people. It now has 14,000 people on its payroll to support all of its new endeavors, not one of which makes money beyond providing pages for ads. It's little surprise, then, that Google's operating margin has fallen from 35% two years ago to less than 29% now, and it's still falling.

I'd steer clear of GOOG shares for a while. Keep using all of its amazing services, keep loving the pressure it's putting on Microsoft to innovate, keep hoping that it announces one day an entirely free operating system, but let the sale around its shares continue.

This Weekend To Subscribers: How our watch list is getting closer to our target buy prices in this falling market, the profit potential of Japan, whether this is the right time to start a permanent portfolio at sale prices, and a look at the stock we purchased on Tuesday for a price much lower than what Morningstar suggested for this 5-Star stock.

Coming Soon On This Free Site: Good investment resources versus ones that just generate noise, Panera Bread versus Starbucks, Blockbuster versus Netflix, what's wrong with U.S. health care, and more.

Disclosure: The Kelly Letter portfolio includes Microsoft, currently up 33% for us.

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Look inside The Kelly Letter

Life Without Microsoft Part Two: Subscriber Feedback
April 01, 2007

On March 12, I wrote an article called Life Without Microsoft that made these points:
  • Vista is not selling well
  • PCs and traditional software are a hassle to upgrade and maintain
  • Tech support is so unhelpful that it's non-existent
  • Open source, free software such as Firefox, Thunderbird, Linux, and Open Office are better alternatives to traditional software
  • Online-only software such as Google Apps is a better way to get work done with less hassle
At the end of that weekend's letter, I asked for feedback from my subscribers. I received a great deal of thoughtful, detailed, informative responses which I've sifted and edited down to a real-world follow-up worthy of your time.

Each subject presents my commentary followed by thoughts sent by Kelly Letter subscribers.

Use An Apple Macintosh
This is a great suggestion, and one that I'm considering for my next round of office upgrades in a few years. Macs are elegant, and they may finally have a chance to grab more market share now that the internet is erasing the compatibility issue. Anything you can do online with a PC, you can do with a Mac. Same site addresses, same applications, same scripts getting work done.

The main Mac issue is cost. Apple hardware runs about twice as much as its PC equivalent. A new PC notebook with a 17-inch screen and the usual specs costs about $1,400. The 17-inch MacBook Pro costs $2,800.

However, cost is measured in more ways than money.

At the moment my office has a brand new 17-inch Hewlett-Packard (HPQ) Pavilion Notebook that is a glorified paperweight until the rescue CDs arrive from HP. It is literally useless at the moment because Windows XP blew up so drastically that a complete re-format and re-install was necessary, but the rescue disks are corrupted so the rescue won't work! Turn it on, listen to it churn, get a corrupt data error message, repeat. That's all we can do.

Having relied on PCs long enough to have back-up plans for our back-up plans for our back-up plans, work continues as usual. But it took time to switch to a different machine, recover data, and hook everything up.

This example illustrates lost productivity caused by PCs that, if Macs are as reliable as Apple and its users claim, might end up justifying the extra expense for Apple hardware.

The line that I can't get out of my head is that Macs just work. So often in my life, PCs just don't. That simple comparison says it all.

Who cares which company is at fault, which driver is missing, which file was mysteriously vaporized, which virus just landed, or which DLL is out of date? The end result is that the user is fighting computer problems instead of working and it happens every darned day with PCs.

Impact to investors: If my small office is considering making the switch to Apple after more than ten years of PC history, others probably are, too. Although Mac has been around for a long time, only since the internet's recent advanced capabilities have broken compatibility barriers has it been a legitimate option. If more people and businesses switch to Apple products, it will harm Microsoft's core Windows/Office business.

Nikolas in New York wrote:
Because I work in the photography and design world, I can tell you that there is only one platform of interest to its people, which is Apple. I wouldn't be caught dead with a PC. I do use some Microsoft software on my computers, specifically Microsoft Office, which runs flawlessly on Apple. I travel a lot and do take notice of an increase in the number of men in suits sitting at airports with an Apple notebook.
Luigi wrote:
I've owned Microsoft for 12 years, and it's easily been one of my worst investments. The funny part is that I've used a Mac since 1986. You really should consider it. Macs run OS X, Windows, and Linux, and they just work.

The learning curve on a Mac is nowhere near as steep as on Windows and, if you know any Unix at all, it is a piece of cake. More than anything else, the OS does not crash. Applications will crash, especially fly-by-night 3rd party, but they won't take the system with them (the Windows blue screen).

Plus, at least for the foreseeable future, no viruses, worms, etc.

I have been waiting to see what Vista would do for Microsoft, but got more and more discouraged as I saw all the problems.
Organizations Won't Switch From Microsoft
While we as individuals can make changes in our lives quickly, most large organizations can't or, at least, won't. This is an important point for us to consider as investors. Most of Microsoft's income is from corporate licensing.

The same way McDonald's (MCD) doesn't make cuisine for gourmets, Microsoft doesn't make software for discerning users. Both companies target the fat part of the bell curve, the bland middle where nothing is too courageous for fear of alienating potential customers. This same philosophy is to blame for cars having become so boring.

The approach doesn't win many awards, but it does create a great business. The question in Microsoft's case is whether or not alternatives have become safe enough for even risk-averse corporations to consider.

Impact to investors: In the immediate future, Microsoft can probably count on its traditional corporate licensing base for revenue. At some point, however, it will need to innovate and try a new model or else its competitors will end-run around it, as you'll read in other entries below.

Michael in New York City wrote:
I usually wait one year for the bugs to get out before I try anything by Microsoft because I have had such bad experiences in the past.

I suggested to Johnson & Johnson (JNJ), a client with a lot of folks in Belgium, that they try Skype. I explained how easy it is to share your screen with someone overseas as you open documents relevant to whatever you're talking about. It's free and even includes a video image of who you're talking to that isn't too bad. They were up for it, and had all vaguely heard about Skype. I said I'd been using it for over a year and never once had a problem. The only thing you need to pay for is bandwidth.

Now you would think this is a good idea that business would jump on. It creates better personal relationships and communications, causes fewer disruptions due to flights and jet lag and time away from families, and reduces travel costs. But noooo.

The way biz gets structured, as you must have seen at IBM, is that they seem more interested in minimizing risk than in being more efficient. Allowing users to load Skype onto their computers represents too much potential support headaches for IT, so it's not allowed. Same with Firefox. Our company just mandated we have to use IE. And I had to remove Skype. So I can't even demo my idea to the company president unless I bring in a personal laptop to do it.
Vista Is Not Necessary
Even if Microsoft continues focusing on large organizations with its traditional licensing arrangements, it's going to need software more compelling than Vista to succeed.

Organizations want to get their work done as cheaply as possible. They don't want to unnecessarily upgrade software and deal with all the hassles that go with doing so. That's probably why so many are opting to stick with Windows XP or switch to Linux.

On March 6, Information Week reported that the Commerce Department's National Institute of Standards and Technology barred its staff from installing Vista on any agency computer. The NIST technology team will meet on April 10 to air their concerns about Vista.

Previously, the Department of Transportation issued a similar ban. DOT CIO Daniel Mintz issued "an indefinite moratorium" on upgrades to Vista, Office 2007, and Internet Explorer 7. He explained that "there appears to be no compelling technical or business case for upgrading to these new Microsoft software products."

Impact to investors: If Microsoft doesn't create software that organizations want and/or need, it will wither away.

Tony in Houston wrote:
To most people Vista is just another OS. The people and businesses I've talked to aren't too excited about upgrading at this time.

I work for WesternGeco and our facilities contain several rooms filled with IBM servers. The latest talk of upgrades was about ridding ourselves of Windows and switching to Red Hat (RHT) Linux. There's no telling if Vista sales will pick up in the future to where business may decide to carry along Vista, but currently, I do not feel that Microsoft will make the impact it was expecting.

As for myself, I don't see the need to upgrade to Vista. I have either XP or Media Center varied on four different computers in my home. Frankly, I don't see the need for Vista.
Charles in Pennsylvania wrote:
I was just chatting with my friend about your switching to Linux. He thinks that's a great idea, and told me that the religious organization that he works with has been running Linux for a number of years.
Bob in Pennsylvania wrote:
I have XP and am using a 98 Microsoft Office package. I have been using Firefox and Thunderbird for the past two years. I have no desire to update to Vista as my current system does everything I need and more. I will probably get Vista with my next computer but that event is years away.

Microsoft needs to learn to put out a quality product that works immediately. Their customers should not have to help them get the kinks out.
Charles wrote:
Where I work, we just switched over to XP a short time ago, having had 98 for a long time. It was doing the job so we thought, why update?
Google Apps Is Closer To Prime Time Than You Think
I wrote on March 12 that Google Apps took us just 15 minutes to set up, gets around the need for data back ups, never needs installing or upgrading, makes our work available and usable from any internet connected computer in the world, and is cheaper than Microsoft's products.

What I discovered, thanks to subscribers, is that Google Apps is not as experimental as I thought. It's a real alternative right now, and entire companies exist that do nothing but help organizations change from traditional software over to the Web 2.0 framework of Google's applications.

This is a big deal because of the speed at which Google has proven it can change all the rules. Consider that Google didn't even exist ten years ago. For the first two years of its life, it provided only quick searches. Then, just seven years ago, it started its famous AdWords system that was the foundation of its current $137 billion market capitalization.

Google Apps was barely an idea one year ago. Today, you can run your business with it. What about two years from now? It took Microsoft five years to develop Vista, and few people appear to want it.

Sam Johnston is a Kelly Letter subscriber and the CTO of Microcost, a company that delivers complete enterprise Web 2.0 solutions based on Google Enterprise technologies such as Google Apps and Google Search Appliance.

He was amused by my proud claim to have set up Google Apps for my company in 15 minutes, and sent me a link to a Microcost video showing a user getting set up on Google Apps in just 60 seconds!

I looked at the video, and was impressed. I wrote back to Sam in our defense, pointing out that most of our set-up time was consumed by needing to create a CNAME for docs.jasonkelly.com at our site host. Even that was simple to do, and 15 minutes is hardly a lot of time. It's more than one minute, though, so I wanted to explain.

I share all of this not to endorse Microcost's product -- I've never used it -- but to reveal that an enterprise support industry is already on the rise around Google's alternatives to Microsoft's products.

How long will it be before companies are able to feel comfortable making the switch? Perhaps not as long as Microsoft would like to think.

Impact to investors: Google and other companies are working hard to create superior alternatives to Microsoft's products. Because they are online, these alternatives face few compatibility issues and are cheaper than traditional licensing. What's more, they are rapidly gaining acceptance and industry support. If Microsoft doesn't adapt soon, it will lose a significant portion of its revenue base.

Sam Johnston, CTO of Microcost, wrote:
Nice article about Google Apps. You wrote that "it took 15 minutes to set up." You might be interested to know that it can be done in under a minute, which is an impressive milestone for setting up an organization's IT infrastructure! Look at this video made by my company.

Your explanation about the CNAME set-up is typical. Getting the DNS set up is often far more difficult than it needs to be. Realizing the effort involved, we built a Google Apps optimized DNS infrastructure which takes only a single command to create all the records for the domain including the CNAME. The result is that within a few minutes you're up and running.

We take care of all this, plus provide training and support in our QuickStart product. There are a number of Google Enterprise Professional partners showcasing similar services alongside ours in the Google Enterprise Solutions Gallery.
Linux Is Not Yet Ready For Ordinary Users
Although Linux looks good for organizations with a professional technology staff, it's not yet a viable alternative for ordinary users.

It only takes a moment online to find this out for yourself. Try searching on Linux with the intent of installing it on your computer. You'll find:
  • There are countless versions of it from countless sources.
  • There's no one place that clearly explains what to do.
  • You need to gather notes yourself from bulletin boards, company FAQs, and other sources to create instructions.
  • You need to download what's called a distribution of Linux, many variations of which are out there, and you can choose whether to install it or run a "Live CD" version of it to boot directly from the CD.
I submit that we've already lost the typical person who just wants to sit down and check email before dinner. Yes, if you put in some time you can get your computer going on Linux, but few will put in the time.

I haven't personally found Linux to be terribly difficult to grasp or get going, but I also haven't felt yet that it's the way to go. It still feels like a curiosity to me, something that I can make my computer do but not really a place where I get work done. Maybe comfort will come with more exposure.

Impact to investors: While professional technology specialists can consider Linux as an alternative to Windows, most casual users cannot. For now, Apple appears to be a bigger threat to Microsoft in the individual user market than Linux.

Vannarith wrote:
I moved from a Windows operating system to Linux about a year ago.

Although I do use Linux as my everyday OS, every now and then I have to boot back into Windows. I've set up a dual boot system. The reason for this is that some programs don't exist in Linux or some drivers won't work with my hardware in Linux (webcam, printer). This is the reason I think Windows will remain dominant in most people's computers. All manufacturers make Windows drivers, but not all make Linux Drivers.

Overall, Linux is a great OS, but there is a learning curve, which is steep. You can't just double click to install stuff. I think the learning curve and the plug/play issues will prevent your average computer user from switching.

That said, there's lots of great open source software even for Windows such as VLC Media Player, PDF Creator, and Filezilla. Your readers should check out www.theopencd.org for more free and open source software.
Microsoft had better get cracking. It's taking too long to deliver software that:
  • People don't need
  • Is too expensive
  • Is a hassle to install and maintain
  • Is no longer necessary due to compatibility issues
Organizations with IT departments are considering Linux instead of Windows or are keeping with older versions of Windows instead of upgrading.

While organizations can't yet change whole hog to Google Apps or other alternatives, the barriers to doing so get smaller by the day. Companies like Microcost do nothing more than help organizations get their work done faster, cheaper, and safer with Google Apps than with Microsoft products.

Linux is not yet a threat to Microsoft among individual users, but Apple is. Apple finally has a shot at previously PC-shackled users because the internet's recent advanced capabilities have erased compatibility barriers. Whatever you can do online with a PC, you can do with a Mac. Not only that, Macs just work, which means a lot to anybody who's ever lost a day of work fighting PC troubles. One drawback with Macs is that they're expensive, but their benefits may justify the extra expense.

Thank you to everybody who took the time to send in their comments. As I wrote last week, we'll continue to hold Microsoft as I think it will do well in the medium term. Remember that sales and earnings are going to get a big boost as the deferred revenue from Vista and Office 2007 get booked this quarter.

That's not a future vision, though, and Microsoft is in need of one. The keep of its castle is under tremendous pressure as innovation spreads around the planet and fluid new business models immune to its strong arm tactics rise.

There may come a day when all of your work sits online, all of your applications are online, and you don't know or care how anything works or when software is upgraded.

You'll just buy a keyboard that works with any monitor hanging on your wall, connected to the internet. Go to a friend's home or office and use their keyboard. There won't be an operating system per se, any more than there's an operating system on your telephone.

Everything will be online and, at this rate, odds are not much of it will be at microsoft.com.


Look inside The Kelly Letter

Life Without Microsoft
March 12, 2007

Three weeks ago, when we were up 28% in Microsoft (MSFT), I wrote:
To be blunt, this stock has not lived up to my forecasts. Four-and-a-half years of ownership have produced returns far below what could have been achieved in a plain index fund, much less a high-powered strategy like our permanent portfolios.

A $10,000 investment in MSFT in August 2002 is today worth $12,800. A $10,000 investment in our Maximum Midcap strategy in December 2002 is today worth $30,537.
I mentioned that CEO Steve Ballmer has not lived up to expectations, and that his pronouncement that sales projections for Vista were overly aggressive was worrisome. I dug deeper into that and found that Microsoft had changed the way it was accounting for operating system sales, and placed some of the blame on that.

Too, perhaps Microsoft was keeping expectations low in order to surprise on the upside later. That's what Merrill Lynch thinks, as analyst Kash Rangan made clear. "We think management is being conservative at the start of the product cycle," he wrote. Merrill reiterated its buy rating and its $33 price target, implying at least 21% appreciation potential from Friday's close.

Since that article, more sales reports have come in. Vista is not looking good. Cowen's Louis Miscioscia wrote on Friday:
After a series of store and channel checks, we believe that Vista optimists will continue to be disappointed by the pace of PC sales post launch. After the consumer release on 1/30, retail PC sales were clearly well above seasonal norms during the first two weeks. But the surge proved temporary, and demand trends returned to more normal levels by the end of February. The lack of follow-through excitement suggests that consensus [estimates] for PC growth in [the first half] are at risk.
I was among those Vista optimists, and the release of the new OS has been a guiding theme for some of The Kelly Letter's individual positions for a little more than a year now. It played a part in our holding Microsoft longer, of course, but also in our buying our semiconductor equipment maker, our computer maker, our semiconductor maker, and our security software publisher. With the exception of the security software publisher, all have been slow. The fault in each case is not entirely Vista's, but some of it is. Each company faces its own challenges independent of Vista, but Vista's unremarkable debut has not helped.

I've been thinking about this a lot recently. The timing has been interesting because I began last fall an upgrade of my office that's still going on today.

I chose new equipment from Hewlett-Packard (HPQ) along default software configurations, which were Windows XP with the usual Office suite from Microsoft and Internet Explorer.

What a nightmare it's been. Migrating all of my company's data to the new equipment took forever because re-installing introduces new settings. Then came the inevitable DLL errors, corrupted data file errors, missing drivers, and the host of difficulties that all PC users know all too well. We needed to completely wipe a new hard drive and reinstall everything twice, were on tech support to India for hours, and then with HP USA for hours on a different occasion.

One night, while lying in bed, I stared at the ceiling after a completely unproductive day of chasing down computer problems. I thought back over my history of using computers in college, then at IBM, then in my own business. It's always been this way, I realized. I've always had to spend about 10% of my time fighting the equipment that's supposed to make life more productive.

Call the PC maker's tech support and they tell you to call Microsoft. Call Microsoft and they tell you that you'll need to call your PC maker, or the maker of some other software on your computer. Tech support, essentially, doesn't exist beyond being a marketing point to get you to buy. For instance, HP's tech support is a J.D. Power and Associates certified provider, yet they were utterly ineffective at solving even one of the issues faced in my relatively uncomplicated office.

Bottom line: in computing, you're on your own.

The advent of the internet has changed things dramatically. Over the years, I've moved more and more of my business online for safety. My goal was to set up my business so that if my office burned down, or all of my computers were stolen, I could still operate. I have accomplished that. My databases are online, my banking is online, my portfolio is managed online, my notes like this one are saved online, and so on.

On any computer connected to the internet, I can run my business. I could stop by your house tonight and, if you'd let me, sit down at your computer to conduct research and compose a note to Kelly Letter subscribers, then send it from right there. Even if you use a Macintosh, Sparc Station, or Linux machine, I could do it.

I'm not the only person in this position. Lots of people have made themselves machine independent. As Sun has said for years, "The network IS the computer."

How does this relate to Microsoft? Only anecdotally at the moment, but importantly. I have vowed that, from now on, my office will use only open source, freely available software whenever possible. I am no longer tied to proprietary formats such as Microsoft Word, Microsoft Excel, and so on. Internet Explorer is pathetic next to freebies Firefox and Opera anyway, so that switch is an easy one. Why use Outlook Express when you can use Thunderbird? It's free and better.

I'm also experimenting with the Linux operating system, which is free and, I'm told, better than Windows. A life without blue screen errors is the life for me.

Recently, Dell (DELL) introduced a new customer feedback forum on its website as part of its restructuring efforts. More than 100,000 people asked the company to offer Linux as an alternative to Windows. HP says that it, too, is preparing to offer Linux. One Chinese customer ordered 30,000 Linux laptops.

I wrote last September 9 that Google's (GOOG) free hosted software was not a threat to Microsoft Office. At that time, "Google Apps for your Domain" was clumsy and hard to use. In just six months, Google has made tremendous progress to the point that I signed up my company for its premium service this week.

For just $50 per user per year, all of my team can access all of our documents at docs.jasonkelly.com and edit them online anywhere in the world. It took fifteen minutes to set up. There were no downloads. No data backups. No upgrade hassles. No DLL errors. No corrupt files.

Soon, Jason Kelly & Co. will be running Linux, browsing the web with Firefox, checking email with Thunderbird, creating documents with free editors or Google Apps, maintaining websites with free HTML editors, hosting databases at AWeber, collecting payments with PayPal, banking online, and hosting websites at ICDSoft.

Not one of those activities cares what computer I use to get it done. Not one cares where I am. The operating system is irrelevant.

In short, Microsoft is no longer part of my life, I'm saving money, I'm more productive, and my customers haven't noticed one iota of difference.

All of which comes back to Microsoft as an investment. I would not say that it's over yet. My experience is not representative of Microsoft's core market, which consists of major corporations buying thousands of licenses.

However, my experience is relevant. If I can go non-Microsoft, so can you. If we can do it, so can other people. If they can do it, so can a bigger group. It begins like that. What corporation would choose $300 per user over $50? What company would rather pay an IT service department to handle data back-ups and upgrades than have Google do it for free? What organization would prefer waiting for years to get an expensive upgrade from Microsoft when it can get frequent, free upgrades from open-source developers?

I'm not pounding the table for Google Apps. I've just started using it. There are problems. It's not as full-featured as Office. Then again, most of Office's advanced features are never even known, much less used, by its users. Also, why pay even $50 for Google Apps when Open Office is completely free and quite good?

Beyond office applications, though, it's clear that corporations are already onto the non-Microsoft theme. Linux is spreading. Firefox is spreading. Alternatives are more viable than they've ever been.

What is Microsoft doing? Not much beyond its core Windows/Office cash cow. It has not been able to beat Google and Yahoo (YHOO) in the search advertising game. It makes software that runs on corporate computers and web servers that could keep getting business for quite some time, but in that realm dominated by savvy tech users, all kinds of alternatives exist. My web server, for example, runs on Apache and uses PHP scripting. Both are open source.

Finally, I want to share with you a note I received this week from long-time subscriber Ron, who is a Microsoft Certified Trainer, Microsoft Certified Technology Specialist, Microsoft Certified Professional Developer, Microsoft Certified Systems Engineer, among other Microsoft Certified designations. Here's a guy who knows a lot about Microsoft, and he wrote:
I work as an Enterprise IT consultant around the U.S. for large corporations. I have been casually surveying them and asking if they plan on upgrading to Vista. The answer is no. Not now and not until they are forced to upgrade as XP SP2 is stable and meets their needs. In today's market, the buzz phrase is "good enough computing" probably because all the blarney has come home to roost.

Then today I went to my favorite supplier and was buying some parts and asked about Vista and how they were doing on new laptop sales. He said candidly that it has been a disaster for them because the PCs go out the door then the users get them back to the office or home and there are so many hardware compatibility issues that they bring them back and demand a refund. He said they are literally falling off the return shelves and stacked ceiling high.
Ron's field report is consistent with press reports on Vista and analyst projections on PC sales. It looks like I'm not the only one whose computing needs have stabilized and who's future plans don't include Vista. I appreciate Ron's taking the time to send his report, and gave him two free months of The Kelly Letter.

This trend of not needing Microsoft's products is an important if nascent one. Long-term investors should examine it carefully.

If you have an existing position in the company, I would hold a while longer. Microsoft should improve in the medium term. Here's why:
  • Sales and earnings are going to get a big boost as the deferred revenue from Vista and Office 2007 get booked this quarter.
  • Vista is pretty and offers improved security. Those factors plus compatibility issues will see that both it and Office enjoy steady if not stellar demand.
  • Microsoft is getting better at its Xbox game business, its online offerings, its new Zune player, and other initiatives.
  • By P/E ratio, Microsoft shares are the cheapest they've been since 1990.
Those points will provide medium-term performance, but I have doubts about Microsoft's long-term prospects. It's a company with a smart history, but we need to see a lot more innovation and getting-with-the times to feel comfortable with it for the long haul.

As long as it remains a Dow component, Microsoft will be part of The Kelly Letter via our Double The Dow strategy. As an individual position, however, Microsoft must show some improving business prospects to keep its place.

To read subscriber follow-up to this article, click here.


Look inside The Kelly Letter

The Case For Vista
January 18, 2007

We bought Microsoft in Aug. 2002 at $22.50. So far, we're up 39%. I was too early in buying, however. Just last June, we were at break-even. All of the gains have come since then, which lends credit to my thesis of the past year that the Vista and Office upgrades would drive the stock higher. Last summer is when the press began covering Vista in earnest.

Last week, I received a note from longtime Kelly Letter subscriber Chris pointing me to a Techworld article troubled by Vista's protection of premium content. The ultimate worry is that people will hold off on upgrading, which was Chris's primary concern. It's a widely held and valid one.

My reply to Chris was:
Yes, there's commonly a refrain to wait on an upgrade. Every major OS stage has faced the same warning to avoid being an early adopter. There are good reasons for it, but the upgrade cycle eventually covers everybody, even if not in the first month or so.

I, too, have a perfectly capable XP notebook and I won't rush to upgrade. However, already, we're seeing gaps that Vista will fill nicely. They'll add up, and one day the only option available to new computer buyers will be Vista.

Quick example: you can't burn files to a DVD by just dragging and dropping in XP's file explorer, the way you can with a CD. In Vista, you'll be able to. With much more capacity and data files growing all the time, DVDs are preferable to CDs. With XP, you need third party software to burn a DVD.

Then, MS Office won't be backwards compatible forever with XP files. As others upgrade, so shall ye. That's how it's always gone.

So, while I recognize that there's a lot to be said for waiting, not everybody will. No company has proven better at getting money on upgrades than Microsoft, and Vista and Office together are the biggest release in the firm's history.
The events of last week confirm those ideas. Microsoft is widely despised in the computing business and much of that disdain comes from its lack of innovation. Microsoft's business plan most often consists of taking ideas from others and then outmarketing those others.

I've mentioned this before, but to jog your memory: DOS was purchased, Word copied Wordperfect, Excel copied Lotus 123, Windows copied the Mac OS (which was based on an OS developed by Xerox at its famed Palo Alto Research Center), Money copied Quicken, the Xbox copied the Playstation, Internet Explorer copied Netscape Navigator, and even Microsoft's mouse was a knockoff of other designs.

Microsoft makes no bones about it. If you have a good idea, they'll gladly take it and destroy you in the marketplace with their fabulous sales team, bottomless bank account, and a few well-placed pieces of proprietary software that favor their own products. It's what they do. It's good for profits, but bad for accolades. It makes more enemies than friends in the computing industry, which craves innovation. It's the reason everybody loves the dazzlingly innovative Apple.

Imagine, then, what a breakthrough it was for Microsoft to win the "Best of CES" award at the Consumer Electronics Show, and for an operating system no less. The OS is not usually where the oohs and ahs come from on a computer. That gives an indication that what's on the way is a needle-mover. Vista will do things that we'll all want to be able to do. That will boost sales of new computers, sales of software, and reliance on the internet. We own investments in each area.

Even if the doubters are correct and there isn't a massive rush to upgrade at the end of this month, there will still be an upgrade cycle. It might span months or even years. That would be fine for long-term holders of companies on the gravy train, like us.

Will there be problems? Sure. There always have been, but Microsoft has always dealt with them and managed to still bank its billions. It'll happen again.


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