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Trees do not grow to the sky, and right now, the Redmond Redwood is about as close as it's going to get. Worse, it may be getting ready for a big fall. At least that's what Eric S. Raymond thinks, although as a gun enthusiast, he tends to favor firearm metaphors. Recently, the alpha hacker and libertarian economist shared some of his latest thinking in a conversation with Linux Journal Senior Editor Doc Searls.

Doc Searls: I heard you've been saying some new stuff about Microsoft. What's up?

Eric: There is a new section of my talk that I'm doing these days. It's called “The Seven Bullets Microsoft has to Dodge to Survive the Next Eighteen Months”. I haven't written it down yet. The bottom line is that Microsoft has much bigger problems than either the Department of Justice lawsuit or Linux. It's just that few people have noticed these problems yet.

Doc: To keep this short, what's the biggest bullet?

Eric: The margin crunch problem. Here's how it works: Microsoft's stock price has to rise every quarter. If that doesn't happen, two very bad things occur. First, the employee stock options stop rising in value. When that happens, their talent bails out. All those people stop working eighteen-hour days in Redmond, and go off to build mansions.

Doc: Which is already happening?

Eric: Yes. The other problem is that Microsoft makes more money playing option games with its own stock than it does selling software. Thirty six percent of its income, and that income goes away if the stock price doesn't trend reliably upwards. If stock prices must always go up, so must revenues, quarter to quarter. This is a problem. Every quarter, it becomes harder and harder to find the additional revenues.

Doc: Why?

Eric: They've got 91% of their market. There isn't enough room for them to get the revenue they're accustomed to.

Doc: But the overall market has tended to increase.

Eric: Not fast enough. And we know this without econometric modeling. Microsoft is raising prices on its high-end customers. In the long term, this is suicide because it will only drive customers to competing operating systems. It really only makes sense if they're caught in the short-term scramble for revenues, and absolutely must have the money.

Doc: I've heard from corporate guys in big companies that the real aversion to Microsoft has less to do with software than licensing fees: expensive licensing of NT servers that customers would rather avoid.

Eric: Today, if you buy a Windows NT server, they not only charge you per seat for the number of developers on your site, but they also charge you per seat for the number of simultaneous web accesses you want to support. You see where that's going. So we know market expansion won't work for them. Now, here is where it really starts to bite: the price of hardware is dropping like a rock. Microsoft makes money from the hardware vendors—the OEMs—they hold captive. These guys are caught in a bind. From one side, Microsoft has to take a bigger piece of their margin every quarter just to stay afloat. From the other side, the price of hardware is falling. If your total system price is $2500 US, it makes sense to pay the $80-$100 Microsoft tax. When your total system price is down around $600, the margin pressure becomes unsustainable. This implies that there is a price level in the PC and appliance market below which you can't make any money dealing with Microsoft. The key point is that this price level is not fixed over time.

Doc: Where does it stand now?

Eric: In appliance territory. Which is why you see companies like Nokia and GTE Sylvania defecting from the Windows CE alliance. They've figured out they can't make any money at that price point, given the license price of Windows CE. Over time, because the price of hardware is dropping, the functional point represented by that price point is going to rise into low-end consumer PC territory. When the price point at which you can't make any money dealing with Microsoft passes the average price point of a consumer desktop PC, the game is over. And I think this is going to happen before the justice department gets its final verdict.

Doc: Will Zachmann also predicted this quite a long time ago. He thought the margin squeeze would hurt their stock and then they would be abandoned by all those optioneers who have been working the long hours, waiting for a stock payout.

Eric: It's coming. Microsoft simply can't maintain their existing margins. Stepping back and looking at economic history, this is what always happens to monopolies unless the government props them up. They get comfortable at a certain price level, and get that level built into their whole financial structure, then collapse when they price themselves out of their own markets.

—Doc Searls