After Microsoft announced on May 3 that it will drop its $44.6 billion bid to acquire Yahoo, many — including experts at Wharton — declared the decision to be a smart move. Microsoft, they say, has more pressing issues, including the need to make its flagship operating system Vista more popular among customers as it competes for attention against its predecessor, Windows XP, and rivals such as Apple’s OS X.

Nearly 16 months after Microsoft launched Vista, the company is still trying to convince some consumers of the operating system’s merit. Vista “is a disappointment,” says Shawndra Hill, operations and information management professor at Wharton and a Vista customer. “It’s too complicated. We had Windows XP and were using it fine. Then Microsoft decided to provide us with something new. But there wasn’t anything really new” about it.

Legal studies and business ethics professor Kevin Werbach says Microsoft faced multiple challenges with Vista. “Successfully building a software system as complex and interdependent as Windows Vista is a nearly insurmountable challenge, even for Microsoft. It’s hard enough to make the operating system run reliably with all the legacy connections and potential software and hardware combinations, let alone provide sufficient innovation to justify an upgrade,” Werbach says.

Although Microsoft executives disagree with the Vista naysayers, perception problems linger. Infoworld has an online petition urging Microsoft to keep XP in circulation. Dell is allowing professional customers to exercise their “downgrade rights” after June 30 when Microsoft will stop licensing XP to PC manufacturers. Downgrade rights, which come with Windows Vista Business and Windows Vista Ultimate, allow anyone with those software versions to downgrade to Windows XP Professional. Dell will install XP at its factories if customers choose. Other PC vendors have similar offers. Microsoft’s usual practice is to phase out an operating system as PC manufacturers and their customers move to the new one.

“Microsoft made a mistake with this one,” says Wharton management professor Lawrence Hrebiniak. “The company introduced something more complicated than XP and it requires more hardware.” Although Hrebiniak expects most Microsoft customers to move to Vista, he recently bought a new PC and decided to keep XP. “There is just a lack of enthusiasm for Vista among consumers,” he adds.

What’s unclear is whether Vista suffers from a perception problem that can be cured with better marketing or whether it faces more entrenched problems. In its fiscal third quarter ending March 31, Microsoft had client revenues (what the software giant calls its operating system sales) of $4 billion, down 24% from a year ago. After adjusting for a technology guarantee program that boosted revenues in the same quarter a year ago, client revenues were down 2%. In both cases, however, this figure fell short of estimates from Wall Street analysts.

Some of those analysts are beginning to worry. “The overall reputation problem that Vista has developed with both business and consumer users could be beginning to exert a material impact,” said Tsvetan Kintisheff, founder of Sofia, Bulgaria-based Kintisheff Research, in a research note.

Microsoft blames the client revenue figure on inventory issues with PC manufacturers and a jump in software piracy rates. CFO Christopher Liddell dismissed concerns about Vista and noted that the company has shipped 140 million licenses since the operating system’s launch. “There’s nothing in the third quarter that reflected a Vista-specific problem,” said Liddell on Microsoft’s earnings conference call.

According to Kendall Whitehouse, senior director for IT at Wharton, a larger issue facing Microsoft is the future of the operating system. “It may have just become too complicated,” he notes, adding that new technologies from Adobe and others allow software developers to create so-called “webtop” applications that only require a web browser or a cross-operating system runtime environment like Adobe’s AIR. Indeed, Google CEO Eric Schmidt declared at the company’s annual shareholder meeting on May 8 that “the shift from PC-centric to Internet-centric computing is the defining shift of our generation.” And Microsoft CEO Steve Ballmer has acknowledged that this shift was one of the primary reasons for Microsoft’s bid for Yahoo.

Meanwhile, another technology called “virtualization,” which allows multiple operating systems to run simultaneously on one PC or server, is diminishing the importance of products like Vista and raises questions about its future. “What is an operating system and what role should it serve?” asks Whitehouse. “The OS was originally intended as an abstraction layer between software applications and the computer’s hardware. But with the new abstraction layer between the hardware and the OS provided by virtualization and products like Adobe’s AIR that sit between the OS and desktop software applications, the role the operating system once played is becoming increasingly diminished.”

For its part, Microsoft has been hedging its bets with more web-aware software, including Windows Live Mesh, unveiled at the Web 2.0 Expo on April 22. Live Mesh combines Microsoft’s software and web services to allow various devices like PCs and smartphones to synchronize data with each other. Microsoft also recently introduced Silverlight, a web-based technology designed to deliver multimedia content and browser-based software applications. Silverlight will be used by to deliver video from the summer Olympics in Beijing in August.

Despite these new developments, Microsoft finds itself at a crossroads, according to Werbach. “The platform for most uses of PCs today is the Internet, not Windows. Windows plays an important role in the ecosystem, but it’s not the center of the world in the way it used to be. Microsoft has made several attempts to integrate Windows and the web, but the center of gravity for innovation and monetization keeps moving to the network. Microsoft needs to decide whether it cares more about the next 5 to 10 years, or the 20 years after that.”

The Yahoo Distraction

Viewed through the prism of its potential operating system worries, Microsoft’s pursuit of Yahoo, carried out over a three-month period, seemed like an unnecessary detour for the software giant, say experts at Wharton. Wall Street analysts generally agree. For example, Peter Misek, an analyst for Vancouver-based investment bank Canaccord Adams, says Microsoft can “focus on competing against Apple and Google instead of being preoccupied with merger integration” now that plans to acquire Yahoo have evaporated.

In a letter on May 3, Ballmer told Yahoo CEO Jerry Yang that Microsoft would walk away from a proposed merger. The biggest issue was price, according to the companies. Microsoft said it wasn’t willing to pay the $37 a share that the Internet company wanted, although it had indicated it would increase its original bid from $31 a share to $33 a share.

“I am disappointed that Yahoo has not moved towards accepting our offer,” Ballmer stated in the letter. “A combination of our two companies would have created real value for our respective shareholders and would have provided consumers, publishers and advertisers with greater innovation and choice in the marketplace. We will move forward and continue to innovate and grow our business at Microsoft.” Yang, in his response, argued that Yahoo was worth more money than Microsoft was offering.

The end of Yahoo talks can be viewed as a positive development, says Hrebiniak. “The Yahoo [merger] was a distraction. It was taking Microsoft’s eyes off the ball. Microsoft was trying to develop new software, buy Yahoo and deal with its Vista problems. It’s good that Microsoft is looking for new opportunities, but the downside is that [the juggling] becomes too complex. Microsoft needs to save its operating system. This is the core of what Microsoft does. Even if the company looks at new opportunities, it has to maintain the OS so it can diversify. It can’t give up on that.”

Hill says that Yahoo would have been a mixed blessing for Microsoft. On the one hand, Microsoft merging with Yahoo would have brought in “new blood and a different way of thinking.” But the other side of the equation is that integrating the two cultures would have been a distraction. Also, she notes, it’s unclear that Yahoo would have given Microsoft enough heft to beat Google in online advertising.

An Elaborate Bulking Up

According to Werbach, Microsoft will have to leverage its Windows platform to become a bigger part of the Internet. “Over the near term, the Windows and Office revenue streams will continue to be fabulous cash cows. Creative solutions to leverage Windows into the Internet ecosystem, of which Live Mesh is the latest, will help Microsoft stay relevant in that time period. Eventually, Microsoft’s desktop dominance is in danger of being hollowed out by network-based alternatives.”

Indeed, Microsoft’s traditional approach has been to add more features to Windows to keep customers happy, but that strategy doesn’t work as well with the rise of web-based software applications, Whitehouse adds. Meanwhile, Microsoft ensures that any new operating system can use older software dating back more than two decades. These two initiatives have collided to make Windows too complex.  

“Far from its original role as an abstraction layer between the computer’s hardware and software applications, operating systems now include music players, photo browsers and many other features previously provided by separate software programs,” says Whitehouse. “It’s too elaborate.” The operating system, he adds, has become a bloated Swiss Army knife that tries to be everything to everyone. Meanwhile, as Adobe AIR and virtualization software from companies like VMware supplant functions previously performed by the operating system, it becomes easier for customers to switch to Windows’ rivals such as Linux and Apple’s Mac OS X.

At a conference on April 7, Gartner analysts Michael Silver and Neil McDonald argued that Windows is collapsing under its own weight and suggested that it change radically to become lighter and modular so that customers only have to use features they need. Microsoft “keeps making Windows do things it was never designed to do” and delaying new releases. Meanwhile, customers get “increasingly nebulous benefits.” For Microsoft, its ecosystem and its customers, “the situation is untenable,” the two analysts stated.

In Hill’s opinion, “Microsoft needs to evolve. It has a ‘business as usual’ approach, just building on to what it has. But any time you force people to switch, they evaluate their options. Microsoft had an opportunity to make Vista superior to the other options and it didn’t.” She agrees with Silver and McDonald, noting that Microsoft’s operating systems need to be lighter and able to follow customers around no matter what device they use. For instance, Microsoft has Vista and XP for PC, but uses Windows Mobile for smartphones. Hill argues that Windows should have one lightweight operating system that can bridge devices and then allow customers to add on features that they choose.

Another radical shift for Microsoft would be to make Windows a more open platform where the company would give away the software to collect revenue from transactions and advertising. “The only long-term solution is for Microsoft to make a radical shift and turn Windows into a truly open platform,” says Werbach. “Eventually, the big money is going to come from services and transactions, not software licenses. Microsoft understands this and is moving in the right direction, but it will eventually have to go much further. As long as it has the DNA of a software company, it will be weighed down in the new era.”