Microsoft Needs Acquisition Spree

After positive quarterly results from IBM and Apple, it looked as though we could see the beginning of a tech stock recovery. But yesterday’s report from Microsoft (NASDAQ:MSFT) cast a shadow on those hopes. The truth, however, is that Microsoft is making a grand display of bad products and bad strategy.

Last quarter, Microsoft recorded its first ever year on year revenue decline, and this time around they recorded their first ever drop in annual Windows sales. Q4 revenues fell a significant 17% over the year to $13.1 billion and missed analyst estimates of $14.5 billion. EPS of $0.34 was short of the Street’s expectations of $0.36 and fell 26% over the year. Revenues for the year came in at $58.44 billion, 3.3% lower than the previous year, while earnings fell 18% over the year.

There was gloom across all divisions this quarter, not just the PC segment. Windows sales fell 29% over the year to $3.1 billion while PC shipments fell 5%. This, of course, has nothing to do with the recession, everything to do with a terrible product and the competing excellence flowing out of Apple.

Microsoft’s overall PC market is expected to have shrunk between 5%-7% over the year, and sales of traditional non-netbook PCs have fallen nearly 16%-18%. Netbook sales amounted to 11% of the total PC market in the quarter. Netbooks, which are priced very low in a bid to compete with and provide an affordable option to the Linux OS, run on highly discounted versions of Windows XP. As netbook sales grow (and they are expected to rise 12% in the coming year), their increased market share is sure to hurt Microsoft’s numbers.

In other segments, Clients revenues fell 22% over the year, Business revenues fell 13% to $4.56 billion and Server, Software and Development revenues fell 6% to $3.5 billion. Over the year, server shipments fell 24%, Entertainment revenues fell 25% and Online Business revenues fell 13% to $0.73 billion for the quarter.

Despite these disappointing numbers, Microsoft claims to have seen some positives. There was a sequential rise in both Windows and Windows Server units for the first time during the year. The company was also pleased with the results of their cost-cutting exercise, which helped save nearly $900 million for the year without affecting the launch of their new releases of SQL Server 2008, Office Communication Server R2, Exchange Online, SharePoint Online, and of course Bing.

Bing was one of the company’s most significant launches during the quarter and demonstrated particular strength in the shopping and travel verticals. Visitors to Bing Shopping have almost tripled and Bing Travel traffic has grown 90% month over month since the search engine’s launch. Search revenues, though, remained flat during the year.

This could change in the coming quarters if Microsoft’s deal with Yahoo! goes through. Yahoo! is expected to get $3 billion up front, with share from revenue that its searches get after traffic acquisition costs in the first two years increasing from 11% to 90% in the third year.

Microsoft should improve their vertical focus through the acquisition of companies such as Kayak, SimplyHired and Trulia. They will have more cash in their coffers through the sale of Razorfish, which is expected to fetch $600 million to $700 million, and through other expense-saving measures such as the recent shutdown of the Soapbox service, considered by many to be a YouTube clone. The video sharing site was launched in 2006, a few days before Google acquired YouTube, but never managed to overtake YouTube’s popularity. Microsoft expects to address the online video segment through MSN Video, which already has 88 million unique users who watch 480 million video streams each month.

Search is not the only battle Microsoft is fighting with Google. With Google’s open source versions of Google Apps, Google Chrome and now Google Chrome OS in the pipeline, Microsoft is being forced to launch their own limited Office version that will be available free to Windows Live users. Further, many believe that netbooks could also soon migrate to the simpler and cheaper Google Android platform, possibly poking a hole Microsoft’s dream of dominating the OS market for the segment.

Things are also heating up with Apple, as was evident in the recent ad war which prompted Apple to lower some of its laptop prices. Microsoft is set to open retail stores in the neighborhoods in which Apple’s stores are located to directly compete with the more expensive Macs.

In the coming months, Microsoft is planning a series of new releases for Windows, Windows Server and Office. Of course, Windows 7 is the big one and is expected to be out in October of this year. Windows 7 will be able to run on low-power devices and provide better performance on high-powered devices, which should make end users happy while expanding the OS’s leadership. Hopefully Windows 7 will not be as big a disaster as Windows Vista was.

Microsoft’s stock fell 8% in the after-hours session to close at $23.80 with a market cap of $227.5 billion. Microsoft has plenty of cash, and the simplest thing to do right now would be to go out and acquire a portfolio of vertical search engines, and another set of SaaS companies. A good starting point for the latter would be Seattle-based Concur (NASDAQ:CNQR).

The two strategies would align Microsoft nicely with the Web 3.0 era.