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Capitalism as a Competitive Sport

by Rob Landley (TMF Oak)

AUSTIN, TX (April 16, 1999) -- When it comes to collecting profits for every scrap of value delivered to customers, the undisputed king of collecting is Microsoft (Nasdaq: MSFT).

The rule of law is a vital ingredient to any capitalist economy. Free commerce depends upon the legal right of a seller of physical products to prosecute anyone who steals those products. Companies need laws protecting their interests in order to survive.

Since Microsoft sells "intellectual property," the basis for its profits is a combination of copyright law and patent law, backed up by lawyers suing anyone who infringes on their exclusive right to use a specific idea (in the case of patents) or expression of an idea (in the case of copyright).

Most intellectual property is protected either by patents or copyrights. Whether it's a knock-off Bart Simpson T-shirt (copyright Matt Groening), or an illegal generic version of Pfizer's patented Viagra, intellectual property enforcement is the key to many business's profitability. Intel (Nasdaq: INTC) constantly engages in small lawsuits with other microchip manufacturers to resolve who has the right to do what, even though Intel's primary competitive advantages come from manufacturing rather than microchip design. Even some of their manufacturing techniques are patented.

Compared to copyright, patents offer much broader protection -- exclusive rights to exploit or license an entire innovative idea. The down side to patents is that they are much harder to get (often taking years), and the patent's protection expires after a couple of decades. A copyright lasts at least fifty years and is automatically granted.

A word processor probably could have been patented at one time (except that the ability to patent software algorithms was only legally established around ten years ago, and is still considered a bad idea by many legal scholars and industry insiders). Microsoft's Word word-processing software is a specific expression of the "word processor" idea, which is protected under copyright. Whether it's a patent or a copyright, the legal protection granted includes exclusive rights to use the intellectual property, or license it to third parties (generally in exchange for money). Without accepting a license from the supplier (and any legally enforceable terms of that license), the customer has no legal right to use the supplier's intellectual property at all.

A third option for protecting proprietary information is the use of "trade secrets," or simply not telling anybody else the idea. Microsoft's source code is a trade secret because a copyright would only stop others from using it verbatim; it would not prevent competitors from stealing ideas from the code. Coca-Cola's (NYSE: KO) formula is also a trade secret for similar reasons. The formula is really the patentable idea, while each can of Coke is the uselessly copyrightable expression of that idea, and any patent would only last a finite amount of time before expiring into the public domain. But Coca-Cola's brand name and logo are copyrighted (and trademarked -- a sort of official government stamp of approval for a copyright). Infringe on that, and Coke's lawyers will swarm upon you like a pack of angry bees.

If all of this legal protection sounds highly adversarial, that's because it is. Capitalism is a competitive sport. Collecting money from customers naturally creates an inherently adversarial relationship between buyers and sellers. The buyer would like to get the product as cheaply as possible, if not free. The seller would like to charge as much as possible. In many cultures the traditional method of resolving this tension is a ritualized argument over the price called "haggling." In the enormous economy of the United States, the individual form of haggling is too time consuming, and actual arguments over price are reserved for negotiating large contracts for bulk purchases. Individuals instead haggle by comparison shopping between different suppliers or distributors of the same product.

Much of the criticism surrounding Microsoft is based on the fact that Microsoft creates very little new value for customers, meaning that few, if any, of the ideas Microsoft sells are fresh contributions to the field originating from within Microsoft. The software giant copies successful ideas (word processor, spreadsheet, graphical user interface, online encyclopedia, Web browser, SQL database), and then uses its virtually unlimited capital to fund a more polished (if less stable) implementation. The company then focuses on integrating the product rather than innovating. A fun mix-and-match game played in the computer industry is to match Microsoft's new "research and development initiatives" with the company that did it first and proved it was a potentially profitable idea worth Microsoft's time.

But while Microsoft's actions may be considered unsportsmanlike conduct (and tends to put true innovators out of business), it's all perfectly legal. Everything in the software industry is based on copyrights rather than patents, and copyrights can't stop competitors from independently expressing their version of the original idea.

When only one supplier of a product exists, haggling is much less effective, and some sort of government regulatory action ends up regulating prices instead. The most extreme example of this is an antitrust trial resulting in a breakup of the monopoly seller, thus restoring the buyer's ability to effectively haggle. The mere threat of a trustbuster-induced breakup may provide some negotiating leverage to buyers, and several less drastic (and less effective) regulatory methods also exist. But in the case of true monopoly suppliers, only the government is capable of effectively haggling. (This is also why haggling with the IRS isn't remarkably effective.)

Microsoft's antitrust problems are the natural result of being an aggressive monopoly supplier, exacerbated by unsportsmanlike conduct depriving them of any sympathetic competitors willing to lobby the government on their behalf. Microsoft also suffers from its inherent inability to innovate. A predator that dominates the ecosystem is in trouble. These days, when looking for fresh ideas from innovative competitors, Microsoft is going after plankton. (This sort of situation is exactly what antitrust was designed to address, much to Microsoft's chagrin.)

As the king of collection, Microsoft has innovatively pioneered new areas of profit, charging for things that other companies would provide for free, such as technical support, "beta test" preview releases of products, and bug fixing "service packs." In this way, it has turned traditional expenses such as technical support and R&D into profit centers, but this came at the expense of customer satisfaction. No grass-roots anti-antitrust lobbying effort has emerged -- quite the opposite, in fact.

Yet, the value-generating but profit-less Internet start-ups (which, incidentally, are some of the plankton Microsoft is going after with The Microsoft Network) can learn important lessons from the king of collection. A healthy, sustainable company must both create value and collect profits from that value, balancing the value it offers to customers with the profit it receives in return. Ideally, both sides come out ahead, and the sustainable cycle continues to the benefit of investors and customers alike.

- TMFOak

News, Updates, and other Stuff

Want to have lunch with Tom Gardner? The Fool co-founder is participating in an Excite Charity Auction in support of Red Cross relief efforts in Kosovo. The auction ends on April 20.

Rule-Maker stocks took it on the chin this week, falling more than 6% in what has been a very tough week for growth stocks. Today, Pfizer (NYSE: PFE) continued to slide following yesterday's "disappointing" earnings. After reaching an all-time high this week, Wall Street sent the drug giant's shares tumbling for a 15% slide. I took a closer look at the first quarter results in today's Fool Plate Special.

Finally, in the Foolish spirit of not worrying too much about near-term stock prices, here's a humorous take on Pfizer's quarter by "ToddK1" of the Pfizer message folder.

Have a great weekend!

Matt (TMF Verve)

04/16/99 Close
Stock Change    Bid
AXP   -3 3/4    129.94
CHV   +3 1/8     98.88
CSCO  -4 5/8    105.69
EK    +6 7/16    73.00
GM    +1 3/8     87.94
GPS   -  5/8     68.25
INTC  -1 3/16    57.25
KO    +1 7/16    65.69
MSFT  -2 1/4     86.63
PFE   -3 1/16   126.94
SGP   +  7/16    52.50
TROW  +2 1/4     33.25
XON   +2 3/8     79.94
YHOO  -5 7/16   189.19


                  Day     Month  Year    History
        R-MAKER  -0.75%   0.96%  12.45%  42.29%
        S&P:     -0.29%   2.54%   7.62%  33.14%
        NASDAQ:  -1.50%   0.91%  13.29%  50.28%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     86.63   121.35%
    5/1/98   55 Gap Inc.      34.37     68.25    98.58%
   6/23/98   34 Cisco Syst    58.41    105.69    80.94%
    2/3/98   22 Pfizer        82.30    126.94    54.24%
   2/17/99   16 Yahoo Inc.   126.31    189.19    49.78%
   2/13/98   44 Intel         42.34     57.25    35.22%
   5/26/98   18 AmExpress    104.07    129.94    24.86%
   8/21/98   44 Schering-P    47.99     52.50     9.39%
    2/6/98   56 T. Rowe Pr    33.67     33.25    -1.26%
   2/27/98   27 Coca-Cola     69.11     65.69    -4.95%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     79.94    24.25%
   3/12/98   17 General Mo    72.41     87.94    21.45%
   3/12/98   15 Chevron       83.34     98.88    18.64%
   3/12/98   20 Eastman Ko    63.15     73.00    15.60%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4158.00  $2279.55
    5/1/98   55 Gap Inc.    1890.33   3753.75  $1863.42
   6/23/98   34 Cisco Syst  1985.95   3593.38  $1607.43
   2/17/99   16 Yahoo Inc.  2020.95   3027.00  $1006.05
    2/3/98   22 Pfizer      1810.58   2792.63   $982.05
   2/13/98   44 Intel       1862.83   2519.00   $656.17
   5/26/98   18 AmExpress   1873.20   2338.88   $465.68
   8/21/98   44 Schering-P   2111.7   2310.00   $198.30
    2/6/98   56 T. Rowe Pr  1885.70   1862.00   -$23.70
   2/27/98   27 Coca-Cola   1865.89   1773.56   -$92.33

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1598.75   $312.05
   3/12/98   17 General Mo  1230.89   1494.94   $264.05
   3/12/98   15 Chevron     1250.14   1483.13   $232.99
   3/12/98   20 Eastman Ko  1262.95   1460.00   $197.05

                              CASH     $70.09
                             TOTAL  $34235.09

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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