Published: November 23, 2009

Microsoft Corp. (Nasdaq: MSFT) reported a strong quarter at the end of October on the back of resurgent demand in the PC market. But the key issue to watch is the important transition in the company’s major technologies.

Microsoft just launched its very successful Windows 7 operating system, which has produced a major new upgrade cycle in the industry. In England, for example, Amazon.com Inc. (Nasdaq: AMZN) had more success selling Windows 7 packages than it did Harry Potter books. Windows 7 has major advantages over Vista, including speed, simplicity and booting time. This is prompting Vista users, as well as those who skipped Vista, to upgrade.

Windows 7 will be closely followed by the launch of Office 2010 in the first half of next year. Microsoft will herd businesses and consumers through a gauntlet of sales products: First, an upgrade of the operating system and then the core applications suite. The company is also releasing Windows Server 2008 R2, which will bring new cash flow.

Microsoft is also looking forward to challenges facing its distributed computing platform concept by setting the launch of its cloud computing initiative with Windows Azure for Jan. 1.

All of this change is taking place at the cusp of a major new technology cycle that will have a profound impact on the industry. So lets review these initiatives and their impact on the market and Microsoft stock.

The Cloud Computing Revolution
The thing to remember about the technology sector is that revolutionary changes, when they catch on, are superlative sources of profit. Therefore, there is a high premium associated with producing the new technology that will gain widespread acceptance. When this occurs new technologies leapfrog the old ones, no matter how established they might have been.

In this paradigm lies both the appeal of investing in high-tech companies -- exploding profits -- as well as the danger -- the risk of sudden obsolescence. The result is volatility, as tech stocks reflect the shifting expectations of success in the endless fight for technological supremacy.

Hence, Microsoft, having reigned supreme in the PC market -- enabled by the ever-increasing processing speeds produced mainly by Intel Corp. (Nasdaq: INTL) and its challenger Advanced Micro Devices Inc. (NYSE: AMD) -- has succeeded in defending its dominant position against many challengers.

But in the fast-changing world of technology, the concept of cloud computing is gaining serious traction and poses a major long-term challenge to Microsoft’s core business. The pendulum between distributed computing and centralized computing has started to swing pronouncedly in one direction -- and it is not towards distributed computing.

In distributed computing, each user has its own machine that computes and stores all of the data. As users demanded more functionality, faster computing and more capacity to store data, the capabilities of computers had to improve.

But with centralized computing, most, if not all of those functions are performed in a centralized, remote location through the Internet. That means a user needs only a very simple computer with a very good Internet connection to the “cloud” where data is stored and operations are carried out. So instead of paying for an expensive computer, the user just pays for storage and capacity on a subscription basis.

That means the user can demand more storage or processing capabilities from the cloud instantly by paying more, or scale back instantly once needs decrease. The user also would have access to a huge array of software packages, which would be very expensive to replicate on a personal computer.

Lastly, and very importantly, there are huge economies of scale and quality issues from having the hardware and software in the cloud. The cloud could have the fastest computers available, with the latest versions of every software package, all professionally maintained, constantly updated, and secured and backed up to the highest industry standards. And because this is performed on a huge scale, the average cost per user would be much smaller than in the distributed model.

All of this happens seamlessly through the Internet without the user’s knowledge and in a simple, secure way. And it is all accessible through the Internet with cheap netbooks, low-end PCs, and even smartphones.

The widespread availability of wireless and broadband Internet access is facilitating the cloud-computing revolution.

Cloud Computing Competition
Microsoft, the leader in personal computing, now finds itself facing a major technological shift -- and a possible dilemma. It must position itself as a leader in the cloud-computing revolution, even though it is precisely this new technology that will ultimately cannibalize its distributed computing business.

History is full of examples of firms that became so successful in a certain technology, that when superior technologies later came, they were too slow to react and perished. And Microsoft’s success will depend on how it manages this transition over the next few years and its success on the new technology.

The risks in any new technology like cloud computing is that the winners are not easy to predict, and Microsoft is facing challenges there from other giants, like Google Inc. (Nasdaq: GOOG) and even Amazon, who have the resources to deploy very efficient clouds.

In mobile phone computing, Microsoft has been unable to keep pace with leaders, like Apple Inc. (Nasdaq: AAPL), Research in Motion Ltd. (Nasdaq: RIMM) and Google.

But the Microsoft’s Windows 7, Office 2010 and Windows Server 2008 R2 give the company a very strong short-term boost in its strongholds, the personal computing and server spaces. The Windows 7 and Office 2010 launches are integral to the new upgrade cycle in PCs, and the Azure launch puts the company at the forefront of the cloud computing initiative.

In fact, Azure has a strong possibility of catching on, and there is no doubt that Microsoft has all the internal resources it needs -- a rich balance sheet, tons of talent and strong management -- to build the extremely costly data centers and necessary infrastructure that few other industry players can.

And the transition to cloud computing might not be as fast as its cost and functionality advantages suggest. Cloud computing still has to overcome many hurdles, including corporate users’ attachment to their data and control of their systems.

What does all this mean for Microsoft stock?

Microsoft will continue delivering very strong results over the short and medium-term, beating estimates on the back of this new upgrade wave, as well as the nascent revenue and profits from Azure. These short-term catalysts are only partially priced into the stock right now.

We will continue to assess Microsoft’s success in the gradual transition into the cloud computing revolution as it unveils.

-- Horacio Marquez
Contributing Editor
Money Morning