December 15, 2000 10:10 AM PST

Slow adoption of new Office, Windows hurts Microsoft

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How can Microsoft rebound?
Chris LeTocq, analyst, Gartner
Microsoft's Achilles' heel is now clearly visible, analysts say.

While the company's dominance in operating systems galvanizes competitors and government trustbusters, analysts say 46 percent of the company's revenue comes from desktop applications, primarily various versions of the Office suite

But Thursday's unexpected profit warning from the software giant underscores a chilling reality: Office 2000 sales aren't taking off as expected, being dragged down by slower-than-anticipated adoption of Windows 2000.

"People typically only buy newer versions of Office when they upgrade hardware or the operating system," said Gartner analyst Chris LeTocq. "Office's features just aren't compelling enough to warrant upgrades more than every other version."

Microsoft had counted on strong Windows 2000 sales to help carry Office, LeTocq said. But adoption of the desktop version of Windows 2000, Windows 2000 Professional, has lagged throughout the year, at least according to industry analysts.

Before Windows 2000 was launched in February, Gartner projected that 15 percent to 20 percent of Windows 95, Windows 98 and Windows NT desktops would be converted to the newer version by the end of the year. The market researcher now expects a conversion rate of less than 10 percent.

In a conference call Thursday with financial analysts, Microsoft chief financial officer John Connors maintained that Windows 2000 sales are within expectations, and the company continues to win new customers. Connors did not say whether he was talking about Windows 2000 Professional, Windows 2000 Server or both.

Analysts have said throughout the year that Microsoft's Windows 2000 Server sales have not been up to par. The company has steadfastly refused to release sales numbers for Windows 2000 Server. In yesterday's conference call, Connors reiterated that Microsoft continues to move from the evaluation to the adoption phase with Windows 2000 Server.

Connors promised to talk more about Windows 2000 customer wins when Microsoft announces its fiscal 2001 second-quarter results Jan. 18.

But analysts see something different going on.

"It appears that Windows 2000 is not gaining traction at present and is not a compelling driver of PC upgrades given the tight macroeconomic environment," Merrill Lynch analyst Christopher Shilakes said in a research note.

Eric Rothdeutsch, a Robertson Stephens analyst, added: "Windows 2000 upgrades are not near what anyone expected." This will be an increasingly serious problem as the slowdown in U.S. PC sales spreads to other sectors, he said. "We're now seeing this affect commercial PCs."

Many analysts now project continued slow Windows 2000 adoption through the first half of 2001, in part because of sluggish U.S. PC sales and larger economic conditions. In its profit warning, Microsoft adjusted revenue projections downward by 5 percent through the end of its 2001 fiscal year, the first half of next year.

No sale
Microsoft's problems with Windows 2000 started right out of the gate. Initially, Gartner, IDC and other analysts cautioned their clients on switching to Windows 2000 before the release of the first collection of bug fixes, or service pack. Microsoft released Service Pack 1 in July, but the update failed to galvanize sales as expected.

"Switching to Windows Windows 2000: The next generation2000 turned out to be more difficult than many people thought it would be," said IDC analyst Roger Kay. "Many companies looked at Active Directory and realized it was tougher to get a handle on than they expected."

Active Directory allows technology administrators to more easily manage resources on a corporate network and speed the handling of their security access, according to Microsoft.

While Microsoft pushed Windows 2000's merits over Windows 95--the version used by most businesses--many companies focused more on problems with releasing the server edition of Windows 2000 rather than the desktop version.

For many companies, said Kay, Windows 95 or 98 was "good enough." Because many businesses had just bought new desktop PCs in preparation for Year 2000, there was no rush to switch to the newer version of Windows. Since the most compelling features of Windows 2000 Professional--the desktop version--required Windows 2000 Server, "many companies proceeded cautiously," Kay said.

Gartner projects one in four companies will face serious problems switching to Windows 2000 through 2003.

To encourage sales of Windows 2000 Professional, Microsoft has resorted to attacking Windows 95. A recent Microsoft print advertisement shows a Windows 95 screen after a fatal crash. The caption reads: "Goodbye blue screen, hello reliable Microsoft Windows 2000 Professional." In the past, Microsoft touted the reliability of Windows 95, but now it appears to be pointing out its faults to encourage Windows 2000 upgrades.

Analysts say that had PC sales not collapsed suddenly in the United States, Microsoft might have seen better Windows 2000 sales starting in the first half of next year. That is not expected to happen now.

"It is a meltdown in the PC environment out there," Robertson Stephens' Rothdeutsch said. "We don't see any pickup until the second half, which will result in part from increased sales of Windows 2000."

The ripple effect
With Windows 2000 sales slow, Office is taking a heavy hit, and this is something Microsoft cannot afford, analysts say.

Things might be better if Microsoft offered more "compelling reasons to upgrade to every new version of Office, but it doesn't," LeTocq said.

While Microsoft works on an 18-month to two-year cycle for releasing new versions of Office, "most companies wait three or more years," LeTocq said. The major exception is when companies move to a new version of Windows.

"Given the stock and the logistics for switching Office programs, it makes sense to make that change when you switch operating systems," said Technology Business Research analyst Lindy Lesperance.

With many companies delaying Windows 2000 upgrades, it's not surprising Office is similarly affected, she added. "If you're going to put off that change, it makes sense to put off the change to Office as well."

The slow adoption of Windows 2000 leaves Microsoft few places to turn in igniting Office sales, analysts say. While PC sales have dropped off in the United States, they remain strong in many overseas markets, particularly in Asia. But many of those markets remain closed to Microsoft, analysts say. The problem: piracy, which appears to be much worse for Office than for Windows.

"There's a culture of piracy in some other regions, particularly Asia," Kay said. "Because the code is so expensive, people are more tempted to steal it."

A new version of Microsoft's productivity suite, code-named Office 10, is in testing, with commercial shipment expected around mid-2001. But for many companies there may not be enough compelling reasons to upgrade, Lesperance and LeTocq said.

"Microsoft just announced they were going to remove some features they were going to include in Office 10," LeTocq said. "Those features, frankly, were a pretty good reason to upgrade."

Microsoft last week dropped Office Designer Tool and Local Web Storage System from the final product. Those features tied into Microsoft's broader .Net initiative.

Lesperance said that, in some ways, Microsoft is in a vicious cycle getting companies to move from one version of Office to another. "At TBR, we made the huge move from Office 95 to 2000," she said. "We might have switched sooner but had to stay with the version the majority of our clients use."

While Microsoft has tried to tackle file compatibility issues associated with different Office versions, companies still resist using, say, Office 2000 while places they do business with use older software, she said. "If no one upgrades, no one else upgrades."

With U.S. PC sales sluggish and Windows 2000 upgrades off the mark, Microsoft faces a short-term crisis, analysts say.

"The only way Microsoft can survive this slowdown is to get to .Net, bring in the .Net services, and persuade people to pay money for those services," LeTocq said. "But that is going to be a wait between here and there."

 

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