When Microsoft announced its financial results for the second quarter last week, the market panicked. The firm's stock dropped 10 percent in after-hours trading, even though revenue and profits both topped their numbers from 2012's second quarter.
Why did the market freak out? The biggest reason was that Microsoft booked a $900 million charge for "inventory adjustments" for its Surface tablets. In plain English, Microsoft admitted that its heavily promoted tablet is selling poorly. And that's an ominous sign for the Redmond, Wash., firm's long-term prospects. Tablets and smartphones are the future of computing, and Microsoft is falling farther behind the market leaders, Apple and Google.
Even so, Microsoft chief executive Steve Ballmer shouldn't be too depressed. Microsoft probably won't lead the next generation of high-tech innovation. But history suggests that Windows and Office, its existing cash cows, will continue generating profits for years to come. The numbers bear this out: Second-quarter revenue was up 10 percent, to $19.9 billion. And profits were $6 billion, compared with a small loss a year ago.
Tablet computing is an example of what Harvard business guru Clay Christensen dubbed a disruptive innovation. While the term has become so overused as to render it almost meaningless, Christensen gave it a precise definition. Disruptive innovations are those that are dramatically simpler and cheaper than what's already on the market — in this case, the PC.
Tablets are less powerful than full-featured PCs. But their simplicity and low cost allow many more people to experiment with them — witness the hundreds of thousands of apps in the Apple and Google app stores. That has led to a rapid pace of innovation in mobile software. Over time, disruptive technologies like tablets outstrip the capabilities of the older technology like PCs, despite the latter's greater complexity and initial sophistication.
Microsoft has repeatedly tried to enter the mobile operating system market — with dismal results. The company introduced its first tablet PC more than a decade ago, and it was offering a mobile version of Windows for years before the iPhone came on the scene. But Microsoft was too invested in the PC business model to succeed in the mobile marketplace. It tried to offer the full capabilities of a PC in a mobile form factor, producing an interface that was too cluttered and confusing for small screens. And its business model of charging smartphone manufacturers for each Windows phone it shipped left the company flat-footed when Google offered Android for free.
Microsoft is due for a decade of stagnation as the computing industry shifts from PCs to mobile devices. Yet PCs aren't going away. Businesses are not going to put iPads on people's desks any time soon, and they're not going to ditch Microsoft Office in favor of Google Docs. So if Microsoft can keep its costs down, it can continue to be profitable for years to come.