One more turn in software story

Microsoft's attempt to buy the biggest maker of corporate applications represents an attempt at vertical integration as a competitive response.

EARLY in June, Microsoft shocked the global software industry once more. The company revealed that for months starting some time last year it was engaged in takeover talks with German software major SAP. The German company is no new kid on the block. Valued at more than $50 billion, it is the third ranking independent software company. Besides, it is a company unlike Microsoft. While Microsoft is technically a "hybrid solutions" company offering both software products and services, it is primarily into products that run the now ubiquitous personal computer. On the other hand, SAP specialises in enterprise services such as systems integration and maintenance and is a dominant player, along with Oracle and IBM, in the low-profile but high spending world of corporate back offices.

Although the talks were reportedly called off this spring, analysts are hard put to understand why SAP considered the option for as long as it did. The explanation offered by Henning Kagermann, SAP's chief executive officer, that SAP "routinely evaluates" mergers that would improve its competitive position, hardly clears the mist. What is obvious though is the set of factors driving Microsoft - an aggressive player hell bent on monopolising the software business.

On the surface, the attempt at acquiring a major like SAP seems to be a continuation of Microsoft's aggressive expansion that transformed it from a garage adventure into the world's largest independent software company. As its pockets deepened in the course of that expansion, Microsoft used its surpluses, estimated at $56 billion of cash-in-hand at the end of March 2004, to aggressively defend and extend its control over the market for PC software and direct-to-consumer accessories.

The evidence of such aggression is, to say the least, excessive. Examples include the use of threats of destructive competition to acquire innovative products and technologies generated by small start-ups. Thus the web-publishing software, Frontpage, was acquired from Vermeer Technologies and subsequently packaged with versions of Microsoft Office. In other instances, acquisition came after alleged infringement of patents on innovative technologies developed by small firms. Thus, it is alleged that Microsoft adopted without licence the touch-based technology used in video game consoles, including Microsoft's Xbox, developed by Immersion. Microsoft chose to go in for an out-of-court settlement with Immersion on a patent infringement case filed in February 2002. Interestingly, Microsoft paid $26 million to acquire a minority stake in Immersion along with licensing rights over the company's patent portfolio. This is one of many cases that Microsoft has settled out of court, and yet there are a few dozen patent-related lawsuits reportedly pending against Microsoft.

The interesting feature of this trajectory, however, is not the aggression that has always been visible, but the more conciliatory moves that Microsoft has been making ever since its extremely favourable "settlement" with the United States Department of Justice in 2002. Recently, in fact, the pace at which high-profile cases challenging the company are being settled out of court has accelerated. In April 2004, for example, a private anti-trust suit filed by Sun Microsystems was settled for nearly $2 billion, including a payment of $350 million in licensing fees. Similarly, a patent infringement complaint by InterTrust, which first developed the technology used to protect music, movies and other digital "content" on the Internet, was settled for $440 million.

But it is not always that Microsoft chooses to opt for quick resolution once the case is seen as unwinnable. In other instances, where the cost of settlement is seen as high, the case is dragged on so as to exploit a pre-existing position in the market and allow technology to make the issues on which anti-trust complaints have been filed irrelevant. Two cases where Microsoft has adopted this strategy with some effect have received quite some attention. These are its efforts to monopolise the market for browsers and media players, by bundling its own version of the required software with the Windows operating system.

In the first case, Microsoft fought a hard battle against the U.S. Department of Justice and managed a settlement that was far weaker than the outcome that was originally expected - a decision to break up the company and force it to license a stripped-down version of Windows to competitors so that they could offer it along with their own supportive software. The settlement came after Microsoft was indicted in 2000 for maintaining through illegal means its monopoly in personal computer operating systems. Although that decision was upheld in a Court of Appeal, the court watered down the original remedy to break up the company.

However, the court granted 17 U.S. States the right to pursue class-action cases on the grounds that the company had abused its Windows monopoly. Microsoft has been working on settlements with most of these States, nine of which accepted one without pursuing the case. To Microsoft's discomfiture, some States chose to pursue the case and demand disclosure by Microsoft of software interfaces, which would allow competitors to write programmes that inter-operate directly with Windows.

Although most of these cases are yet to be resolved, Microsoft's attitude of conciliation is already visible. A Minnesota lawsuit went before a jury in March this year. However, soon thereafter, the software company arrived at a settlement with the State. These settlements with or without a case have cost the company a packet, touching an estimated $1.1 billion in California and $202 million in Florida.

Outside the U.S. too Microsoft has been the target of a European Union (E.U.) anti-trust investigation over the last five years, triggered by Sun Microsystems and the Computer & Communications Industry Association (CCIA). The E.U.'s case also deals with Microsoft's tactic of "bundling" new software with its Windows operating system. In this case, the software concerned is Media Player, which the European Commission (E.C.) believes has been bundled with Windows to tilt unfairly competition against rival products, especially RealNetworks' RealPlayer.

Recently, the E.C. ruled against Microsoft on both these counts and imposed a heavy penalty. Microsoft has chosen to go on appeal. But here too, efforts at conciliation are visible. A recent legal settlement with Sun Microsystems is seen as part of an effort to reverse the E.C. ruling. This is because the settlement with Sun, under which Microsoft agreed to pay $1.6 billion to end anti-trust and patent infringement claims, silences the company's most vocal critic which had directed the attention of Europe's anti-trust regulators at Microsoft and triggered the E.U. investigation when it filed an official complaint in Brussels five years ago. Sun is also a leading member of the CCIA that had also lodged a complaint against Microsoft in Europe.

Not surprisingly, Brad Smith, Microsoft's general counsel, reportedly said that the Sun settlement "means that the only company that has had a formal complaint against us for the past five years has said that it is entirely satisfied". This, in his view, indicated that antitrust and patent disputes could be resolved through private agreements and did not require broad regulatory action.

Although as of now the E.C. is not willing to relent and sees its actions as being part of a wider strategy of promoting competition and protecting consumers, Microsoft's own strategy of conciliatory bargaining is clear. Microsoft's view is reflected in Brad Smith's statement that if a private settlement with Sun had been reached last year, it could have set the stage for a settlement of the E.U.'s case instead of last month's formal anti-trust ruling.

WHAT explains this conciliatory edge on the part of Microsoft, which has been the industry's most aggressive and disliked player? An analysis of software business trends indicate that the explanation lies in the changing nature of the business itself, which warrants both a closer link with rival players as well as a degree of consolidation that cannot occur if current anti-trust tendencies persist.

There are three trends that are significant for understanding Microsoft's loosening stance. The first is that despite Microsoft's efforts at dominating the PC software market linked to the Windows operating system, it is under threat because of the growing popularity of the Linux operating system. Microsoft sees the need to diversify away from software products that run PCs if it is to maintain growth and profitability.

Second, such diversification is also warranted by the fact that the software market is moving up "the stack", away from the operating systems and towards the "middleware" that ties different systems together and the applications that run on them. This is seen as the result of the emergence of a new generation in technology resulting from the growth of the Internet that requires far greater integration between software technologies than we had before. It is, therefore, an area where a greater degree of interoperability between software products is important, necessitating more cooperation and less rivalry between competing firms.

Third, in the search for dominance in the new technological context, firms are trying to restructure their operations. Thus, IBM is seen as having abandoned the applications business a few years ago in order to focus on middleware. On the other hand, Oracle is seen as seeking to extend its reach from middleware into applications, both through developing its own products and more recently through acquisitions, as its failed effort to take over PeopleSoft illustrates. Any firm planning to enter the middleware business must respond to these tendencies.

Clearly, Microsoft has responded to all these trends. It is choosing to move away from products. It is willing to "deal" with its rivals. And it is considering acquisitions to strengthen its position. Initially, it developed its own Dotnet technology to generate the "web" for a more decentralised computing world. This signalled rivalry, since its competitors were using the Java software standard developed by Sun Microsystems for the purpose. But such rivalry has been tempered in recent years with the company willing to work with competitors. The evidence quoted earlier indicates this new mood of cooperation.

The Microsoft effort to negotiate a takeover deal with SAP is a corollary of this new strategy of Microsoft. SAP invented enterprise resource planning software, with which a large number of companies manage back-office functions.

For Microsoft, which sells most of its software to customers through computer makers and resellers, entering this area on its own would have involved a major shift in the direction of an engineering-centric culture and a process of learning the rules of a new business. Firms in the "enterprise" market rely on direct sales and extensive maintenance and service operations.

Seen in this light, Microsoft's attempt to buy the biggest maker of corporate applications represents an attempt at vertical integration as a competitive response. It is another matter that the deal if worked out would have run into regulatory barriers that even Microsoft would have found difficult to break down. But the fact that it was even contemplated points to the process of transformation of the software business.