There were two other critical elements. Firstly, IBM was persuaded to outsource vital parts of the PC, effectively ceding control over the key elements of its product. This was the first step towards open architecture, though IBM did not realise the significance of its actions at the time. The decision was influenced by the fact that software was what sold PCs, and software was more easily developed and had greater commercial prospects when programmers had knowledge of the systems. Second, Gates negotiated the right to sell MS-DOS to third parties. The stage was set for Microsoft’s later dominance in the software business; if IBM became the industry standard, Microsoft’s operating system would have to be purchased by all competitors. In order to avoid a potential litigation issue with Kildall, who had claimed MS-DOS made use of his work on CP/M, IBM offered a choice of operating system with its PC. However, as it did so with a significant price difference, the only rational choice was MS-DOS.
The relegation of CP/M was not initially obvious. CP/M had the dominant market share at the time and the support of most existing PC users. The key to what followed was that IBM was helping to create an entirely new user community, one which demanded a user-friendly environment, something to which Microsoft was attuned in a way that Kildall’s research-oriented company, Digital Research, was not. The eventual outcome was that MS-DOS gradually pulled away from CP/M as the industry standard. In 1991, Digital Research, now a shadow of its former self, was sold to Novell.
Send in the clones
By the early 1980s, the industry had almost evolved to a new structure. The number of producers diminished dramatically as the competitive pressure from IBM and Apple forced rivals out of business. While former high-growth companies such as Osborne Computer Corporation went to the wall, other companies with very different business models emerged. Rather than seek to develop their own computer, these companies produced machines that were broadly the same as the industry standard (the IBM PC) but cheaper and better in key respects. This was standard practice – the IMSAI had swiftly followed the Altair – and IBM clones swiftly followed the launch of its PC.
The most notable company to emerge was formed by three ex-Texas Instruments employees, with financial backing from Ben Rosen. Compaq built an equivalent PC from scratch and quickly garnered a following, with sales in excess of $100m in the first year. Compaq had not copied IBM’s technology; it had simply recreated it, thus making it relatively immune from litigation. Others followed suit, and soon it was possible to buy or license the information necessary to create an IBM-compatible PC. This was to change the industry to one where the importance of brand name diminished, while efficient production and rapid incorporation of the latest chip technology proved decisive. It also meant that while after-sales service remained important, particularly for the business user, sales and distribution could take place through virtually any channel.
9.11 – Fragile growth industry: computers have always been sensitive to changes in the economic cycle
Source: Montage – sources in art itself.
The computer industry exhibited very strong growth, but this did not mean that it was immune from either the economic cycle or from the impact of new competition. As the industry developed, so too did the capital commitment associated with the production of personal computers. Just as the automobile industry had gravitated to a mass production cost-based model, so the personal computer industry required an ever more expensive infrastructure to maintain competitive advantage. This meant that economies of scale became increasingly important.
Equally, while growth remained strong as the market expanded, a key feature of the market expansion was the continuing fall in the price of the product. This was not deflation in the sense of overall price declines. It was simply that the leaps in technology translated into ever lower unit costs and the competitive structure forced most of these to be passed on to the consumer. These leaps in technology also shortened the lifecycle of the product, and made the penalty for not keeping up a high one. Product obsolescence could easily translate into financial distress (for a company with a wide product portfolio) and bankruptcy (for a single-product company). At the root of this industry dynamic was the increasingly non-proprietary nature of the personal computer’s core. During the 1990s it was almost a hybrid industry, combining the characteristics of both growth and commodity cyclicality. In other words, despite the fact that it had strong underlying growth rates, it was not like, for example, the pharmaceutical industry, the products of which remain relatively immune from the effects of economic downturn. Once the IBM PC ‘standard’ hardware quickly became firmly established, the main differentiating factor proved to be what the machines were capable of doing, and the ease with which these functions could be accomplished. Although MS-DOS became the industry standard operating system, this did not mean it was necessarily the best system. That accolade went to the Macintosh computer, produced by Apple as a follow-up to the committee-designed, and ill-fated, Apple III. The Macintosh represented a significant upgrade in user experience, distinguishing it from the IBM product and its clones. The genesis of the Macintosh lay in a visit to the Xerox PARC facility by Steve Jobs.
The PARC (Palo Alto Research Center) facility had continued pioneering research work (e.g. GUI, objective-oriented programming, electronic paper etc.) demonstrated by Doug Engelbart 15 years before but had done relatively little to develop it commercially. The facility had been specifically set up as a research centre, and although Xerox did seek to enter the personal computer market in the early 1980s, it was to do so with a machine which failed to take advantage of PARC’s knowledge base and was unable either to take market share from Apple or to compete with IBM’s offering. The impact that PARC had was paradoxical in the sense that its concepts and research were to find embodiment not in a Xerox product, but in the product of competitor companies such as Apple and Microsoft. In return for allowing Xerox to invest in Apple, Jobs and his team negotiated visits to the PARC facility to see what they had been working on. PARC had not only developed the ethernet to link office machines, but also had working models of computers that used a mouse for navigation and for moving documents and text around the screen. Jobs also saw a GUI with overlapping documents on a screen and programs represented as icons.
The visits to PARC in 1979 showed Jobs the future. He changed the direction of development at Apple with the express aim of producing a commercial version of what he had seen at PARC. The result was the Macintosh computer. The Apple Mac, launched in 1984, met the requirements set by Jobs and was lauded by the technical press. It was not, however, a commercial success in its early years and the tension and financial stress this created led to a showdown between Jobs and the CEO, John Sculley, which culminated in Jobs’s departure in May 1985.
The Apple Mac faced two endemic problems of the early personal computer market. Firstly, it proved to be underpowered, despite carrying double the ‘standard’ memory. The time that elapsed before sufficient memory could be provided to cope with the computer’s needs was enough to dampen enthusiasm for the machine. Secondly, it was not easy to write software for; as a consequence, far fewer applications were available for it compared to the IBM industry standard. These problems were not insurmountable, and after posting losses for the first time in its history, Jobs’s machine was to propel the company to a highly profitable phase, albeit in his absence. The impact of the Mac was further enhanced by additional software for graphics and printing which effectively gave Apple a lock on the emerging desktop publishing (DTP) market.
That the Apple Mac and its successors embodied the future articulated in the late 1960s by Engelbart was not lost on others in the industry. Gates had visited Jobs at Apple and seen the prototype Macintosh in 1981. Microsoft grasped the superiority of the front end provided by the Mac and in it the ultimate demise as a standalone entity of Microsoft’s cash cow, the operating system MS-DOS. Understanding this, it had for some time been working on its own GUI; indeed, Microsoft had announced the product, n
amed Windows, before the Apple Mac launch. The product itself, though, did not arrive for a further two years.
Microsoft’s vision
Given the overlap with Mac, Microsoft sought to protect itself by negotiating a licence for the Mac operating system. It achieved this by threatening to cease development work on important Mac applications. The licence to the visual characteristics of the Macintosh was signed in November 1985. Microsoft was not alone in working on a GUI, but it had the distinct advantage of being the author of MS-DOS and having the best understanding of the Mac operating system outside Apple.
Although the first release of Windows (version 1) which arrived in October 1985 was unwieldy and slow, it was still better than the GUIs produced by others, including IBM. The software needed to be improved, but more than this it required substantially more memory and processing power to sustain it. The experience of the Apple Mac and Windows Version 1 was to become prevalent in the industry. That is, early estimations of the need for memory and processing power had been formulated on the back of an entirely erroneous set of assumptions. The tasks for which a PC could be used was expanding rapidly, but more importantly it was becoming increasingly easier to use, as the software now being written enabled the user to concentrate on the task being undertaken rather than on the computer itself. This process ate up memory and processing power, and as Intel and its competitors brought out new processors in accordance with Moore’s law, software developers scrambled to make use of the additional resource. VisiCalc had shown how software could sell computers, and Windows took this a stage further by becoming inseparable from the computer. It was no longer IBM that represented the industry standard but Microsoft. IBM maintained high sales, but clone producers took market share and the pricing competition was intense. The margins, though, belonged to Microsoft.
9.12 (a) and (b) – The visionary spells it out: Bill Gates on his future strategy
Source: Financial Times, 12 August 1983 and 13 May 1983.
The press articles of the time reveal the extent to which Bill Gates of Microsoft understood how the industry was likely to evolve and how he would position his company to take advantage. The evolution of Windows and later the ‘Office’ suite of programs was relatively straightforward, in the sense that each of them took the best features of existing products and sought to ensure their compatibility and ease of use. While Windows represented a rapid reaction to the development of the Apple Mac, Office was designed from the outset as a natural complement to Windows. Underpinning the strength of Microsoft was the original deal signed between Bill Gates and IBM, a deal that established Microsoft as the platform provider for the IBM-compatible market, and over which Gates’s vision of the development of the PC industry could be overlaid. The vision of Gates underpinned the company’s approach to development, in particular the need to provide product integration. Microsoft reacted quickly to market developments and from its powerbase, MS-DOS, was able to recreate the best attributes of rival products. Just as Apple had augmented the GUI work of Xerox PARC’s facility, so Microsoft eventually created Windows. Just as Lotus had improved upon VisiCalc, so Excel, within the Office suite of programs, brought an improved integrated alternative.
Microsoft
On 13 March 1986 the prospectus for Microsoft Corporation was issued by the joint underwriters Goldman Sachs and Alex. Brown. A total of approximately $60m was to be raised, with two thirds being capital raised for the company and the $15m remainder going to selling shareholders. Existing shareholders retained ownership of over 90% of the company. The IPO price was $21, giving the debt-free company a valuation of just over six times tangible book value, four times sales, 20 times historic earnings and roughly 14 times prospective earnings. The implied market capitalisation of the flotation was therefore some $520m.
The competitive environment at the time was outlined in the document, most notably the rapid pace of technology and the danger of obsolescence and the plethora of competitors, ranging from large corporations such as AT&T, Digital and Xerox to dedicated PC producers such as Apple and established software concerns such as Lotus Development and Borland International. On top of the competitive threats there was also outstanding litigation from Seattle Computer Products (SCP), the company from whose product MS-DOS had been developed. SCP was demanding relief in regards of its interpretation of the violation of the agreement it had signed with Microsoft in 1981. In the prospectus Microsoft noted its view that the interpretation of the prior agreement was erroneous and its belief that the outcome would not materially impact its business. Notwithstanding the guarded reassurance, given the importance of MS-DOS to Microsoft the legal threat would undoubtedly have been an issue for investors.
In terms of product development the major releases were Excel, a new integrated spreadsheet product for the Apple Macintosh, and Windows, the MS-DOS GUI. The prospectus did not place particularly strong emphasis on these products. They appeared simply as part of a long list of Microsoft operating and applications products. The spreadsheet package Multiplan, for example, received substantially more attention than Excel in the discussion, the latter being discussed in terms of its application as tool for the Apple computers.
The investor was therefore faced with a decision about a company with a multiple-product range in an evolving software industry where thus far longevity had not been a feature. The core product of the company was an operating system which constituted the industry standard, but only because of its adoption by IBM, a company which had in the past shown its ability to adapt and eventually create competitive products which would overtake the lead of new entrants (e.g. UNIVAC and later the personal computer). History would not have sided with a company the size of Microsoft on the presumption that IBM would seek to reclaim control of the operating system once its strategic importance and profitability became obvious.
The financial results of Microsoft, though, are testament to the ferocious way in which the company protected its position through both litigation and product development. The company saw rapid growth in sales combined with strengthening margins and stable returns on capital and equity. These stable returns were similar only to those earned by businesses who have achieved meaningful barriers to entry through some form of protection, whether it be by patent or market power.
9.13 – Microsoft: real staying power
Source: Microsoft annual reports. CRSP, Center for Research in Security Prices, Graduate School of Business, University of Chicago, 2000. (Used with permission. All rights reserved. www.crsp.uchicago.edu.)
The encroachment of Microsoft was not lost on Apple and it was not long before the question of patent infringement by Windows became the subject of litigation. The question was not about who had the original vision of an icon-based, user-friendly multimedia set-up; this belonged to Engelbart many years before. The question was a more simple commercial one. Did Apple’s copyright protect it from the development work of Microsoft? The legal question was more complicated than this because, while Apple sued Microsoft, Xerox was also suing Apple. The eventual outcome was that Microsoft was free to develop the Windows GUI.
It was not just Apple that sought to protect its position. Lotus Corporation filed multiple suits against competitors, including Paperback Software, Mosaic and Borland. The common theme in the increasingly litigious computing industry was the need to protect market share and margins. Just as previous technological advances had proved to be capable of being reproduced by large numbers of competitors, so the personal computer market became one with very low barriers to entry, particularly on the software side where the principal capital required was human intellectual capability rather than financial. As in all such cases, the most obvious response to encroachment was to seek the court’s assistance in the protection of intellectual property rights.
The irony is that virtually none of the major protagonists had actually developed their products from first principles. Most had taken the work of others and refined it to a commercial product. The
‘inventors’ were not engaged in basic research in the manner of, say, an Edison or a Bell. This does not negate the innovative work that they conducted, but it places it in a specifically commercial context. Gates’s vision was the clearest and he pursued it most aggressively. Microsoft also had the advantage of its control over MS-DOS, which others were simply unable to overcome. Most likely all these factors played a role, but the outcome was unequivocal: Microsoft emerged as the industry giant at the time, with margins that only small specialist niche players were able to match. Early leaders in the industry became very much second-tier players by comparison. Lotus, for example, was purchased by IBM in an effort by the previous industry giant to try and regain some of its former dominance. Not only did Microsoft emerge as the software industry giant, but it also successfully drove a wedge between hardware and software. Consumers could now purchase virtually any personal computer they wanted as long as it had Microsoft software. The commercial logic behind the personal computer industry was inescapable, and this allowed the emergence of new companies, the entire structures of which were built on the principle of cost-curve position. Most notable among them was the company formed by Michael Dell, who clearly articulated the financial proposition of the changing economics of PC production.
Engines That Move Markets (2nd Ed) Page 48