Microsoft showcased its Windows 8 on tablets at the BUILD conference this week. We wrote previously about how Windows 8 will be the single most important factor to the company’s revenues next year.
Microsoft confirmed these thoughts as it has ambitiously redesigned much of Windows 8 functionality and made it more flexible in order to work on tablets and traditional desktop computers as well as sync easily with Windows Phone 7.
Given the developments so far and adoption by large tablet manufacturers such as Samsung, we believe that Windows 8 could eclipse the 450 million licenses sold by Windows 7 and could prove to be a challenger to iPad’s iOS in a couple of years.
The Windows division is one of the main revenue generators for Microsoft and accounts for about 25% of its Trefis price estimate. We currently have a $28 Trefis price estimate for Microsoft, which implies a near 10% upside to the current market price.
Windows 8 Could Gain Significant Market Share in Tablets
In 2010 Apple launched the iPad which was a runaway hit and created a whole new market for tablets. While Microsoft and others had tried tablets before and failed, the market has matured and Microsoft has learned from its past attempts and competitors successes. Gartner predicts that more than 300 million tablets will be sold by 2015 presenting a nice growth opportunity for the largest OS in the world.
Apple has more than 80% of the tablet market share currently with Google’s Android coming second. HP recently discontinued its Touchpad tablets and RIM’s Blackberry Playbook has seen dismal sales. Android hasn’t seen as much success with tablets as it has with smartphones and so this leaves a window of opportunity for Microsoft to gain traction in the tablet market.
If Microsoft moves quickly, it could potentially capture a meaningful portion of the tablet market in the next couple of years. Manufacturers are looking for alternatives to Android, which could help them beat the iPad. Windows 8 will be launched for tablets as well as computers and will support both the X86 and ARM architectures.
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Windows 8 will also offer better integration with Windows Phone 7, and together, they will offer a complete ecosystem just like Apple’s Mac OS X and iOS, which should make it the platform of choice for hardware manufacturers looking for a non-Apple unified solution.
With the growth in the personal computing space slowing down, tablets are the new market that offer tremendous growth potential. With Windows 8, Microsoft has a chance to capture significant market share if it can move quickly. However as analysts expect Microsoft to launch the new version in mid-2012, this gives Apple another year to make further inroads.
No, Windows 8 WILL MAKE Microsoft WinARM (and perhaps Wintel) tablet contenders a year from now, when Windows 8 actually becomes available. This combination of updated operating system and hardware products does not yet exist in the present. For now, it’s just hype and vaporware, and not yet a competitor. And even if and when when Windows 8 does finally ship, Redmond’s take on their copy of Steve Jobs’ portable touch screen concepts still will be five years behind Apple’s product development.
Not one Windows 8 tablet has been sold and probably won’t be until the end of next year and yet the prognosticators are already yelling “iPad challenger”. These are the same knuckleheads that yelled “iPad fail” when Apple first released the iPad into consumers’ hands. They said that Apple wouldn’t sell a million tablets in a year and three million tablets would never be sold since there weren’t that many iSheep in the world.
There is not one reason in the world to think that consumers will take to the Windows 8 tablet any more than they’ll take to the Windows Phone 7 smartphone. These prognosticators really understand nothing about what consumers are looking for. Microsoft shows some potentially powerful Windows 8 OS and the tech-heads go nuts about how consumers will jump all over this without ever so much as holding a Windows 8 tablet in their hands or how a production version will be. It’s amazing how tech pundits yell “Success” and “Fail” without really knowing anything except a handful of specs. In another year, Apple will have totally dominated the tablet market and I doubt if consumers will be in all that much of a hurry to switch to Windows 8. I’m sure the tech-heads will jump because they’re always looking for more power. I know they can’t wait to run Microsoft Office and Photoshop on their tablets, as if any consumer in their right mind would ever think of doing such a stupid thing.
VALUATION HIGHLIGHTS
1. Microsoft Office constitutes 29% of the Trefis price estimate for Microsoft's stock.
2. Windows Operating System constitutes 25% of the Trefis price estimate for Microsoft's stock.
3. Windows Server & SQL Server constitutes 13% of the Trefis price estimate for Microsoft's stock.
POTENTIAL UPSIDE & DOWNSIDE TO TREFIS PRICE
Below are key drivers of Microsoft's value that present opportunities for upside or downside to the current Trefis price estimate for Microsoft:
Windows Operating System
* Microsoft's Market Share of PCs: We currently forecast Microsoft's market share of PCs to increase slightly from about 75% in 2010 to 76% by the end of the Trefis forecast period. We believe that success of Windows 7 and improved anti-piracy efforts could benefit its market share. However, the benefits of anti-piracy could be more gradual as Microsoft expands its product offerings to emerging markets, where piracy is more prevalent. There could be a downside of more than 5% to the Trefis price estimate if its anti-piracy efforts does not materialize as it expands its offerings, and its market share decline to 60% by the end of Trefis forecast period.
* Global Notebook & Netbook market: We conservatively forecast global notebook and netbook market to increase from 203 million in 2010 to 264 million by the end of the Trefis forecast period, an average growth rate of around 4%. This growth is much less than the average growth of 24% achieved in the past few years. We believe the primary reason for this slow growth will be the advent of tablets, which could cannibalize low cost notebooks and netbooks sales. However, there could be an upside of more than 10% to the Trefis price estimate if the notebooks & netbooks market grows at an average growth rate of 12% annualy.
* Widows OS Operating Margin: We currently forecast Windows OS operating margin to decline from about 66% in 2010 to nearly 59% by the end of the Trefis forecast period. Although the growth of netbooks has benefited Microsoft by selling more Windows licenses, however, netbooks OS license pricing is typically lower than a notebook or desktop. This has caused margin declines in the past. However, the rapid rise of tablets could cannibalize netbooks growth in the future. This will mean than although Microsoft will lose volume business, it could benefit by boosting its margins. There could be an upside of 3% to Trefis price estimate if it is able to maintain its margins at around 66% in future.
Windows Operating System
* Microsoft Share of Productivity Software market: We currently forecast Microsoft's market share of Productivity software to decline from about 95% in 2010 to 88% by the end of the Trefis forecast period. We believe that increasing competition from cloud computing players like Google could cause market share declines. However, Microsoft has released ‘Office Web Apps’, a free web-based version of its Office productivity software to better compete with Google. There could be an upside of more than 1% to the Trefis price estimate if Microsoft is able to maintain its market share throughout. However, if Google is able to capture large market share at the expense of Microsoft, there could be a downside of 5% to the Trefis price if Microsoft's market share declines to 60% by the end of Trefis forecast period.
* Microsoft Office Operating Margin: We currently forecast Windows OS operating margin to decline from about 61% in 2010 to nearly 54% by the end of the Trefis forecast period. The margins declined at a faster rate in 2010 due to the introduction of lower priced office web apps. Microsoft is forced to offer lower cost products due to increased competition from Google Apps. There could be a downside of 7% to the Trefis price estimate if its margins declines to around 40% by the end of Trefis forecast period.
BUSINESS SUMMARY
Microsoft makes money primarily through the sale of business productivity software and the sale of operating system software. Microsoft's business productivity software suite, known as MS Office, is used for word processing, spreadsheet preparation, presentations and email. MS Office is sold primarily to businesses worldwide. Microsoft's operating system software, known as Windows, is sold primarily to PC manufacturers (such as Dell, HP, Acer), which sell Windows-based PCs to consumers and businesses.
In May 2011,Microsoft agreed to acquire Skype Global for $8.5 billion in cash. This acquisition is the largest ever done by Microsoft. Skype is an internet phone company that enables phone calls to be made through internet for free or for a nominal charge. It has about 663 million registered users. We believe Microsoft can use Skype to strengthen its enterprise, search and mobile businesses.
Microsoft could make use of Skype by integrating its voice, video and sharing capabilities with Microsoft Office, as a way for businesses to collaborate better. Microsoft could leverage such large user base to promote its search advertising business through Bing. Finally, Microsoft could integrate the Skype calling service into its own operating system Windows Phone 7 to enhance its features.
Microsoft Company Overview
SOURCES OF VALUE
We believe Microsoft Office and Windows Operating System are the most valuable segments of Microsoft for the following reasons:
High MS Office License Volume
We believe that Microsoft will sell close to 800 million licenses of its productivity software globally in 2011. Of the 800 million licenses, we estimate that around 40-50% of these licenses will be sold to businesses
Windows OS Market Share and Piracy
Microsoft's Windows is the predominant operating system with ~90% market share within the global installed base of PCs. Despite it's high installed base market share, Microsoft does not make money off of all copies of Windows that are installed. Due to piracy of Microsoft software, we estimate that only 75% of PCs sold have Microsoft operating systems that are paid for.
High Profits for Windows OS
We believe that Microsoft's operating profits will be around 65% in 2011.
KEY TRENDS
Microsoft' declining operating margins
Microsoft Office operating margins have declined from around 67% in 2007 to around 61% in 2010. Microsoft released Office web apps, a cloud-based software, to compete with Google Apps. Under the cloud-computing model, Microsoft would store Office programs on its own servers and deliver them to customers online. Although this is more cost effective for its customers, cloud-based Office software will cost Microsoft more when compared to supplying software that is installed on the computers and servers of customers. If Microsoft willingly ends up cannibalizing some of its own business productivity products, it could be due to fears that competition and mobile apps are a serious threat to its business long-term and would pressure margins anyway.
Microsoft faces headwinds in tablet market
Microsoft is reportedly working on development of Windows 8, which will be better suited for touch screen tablet devices. However, Windows 8 is expected to be released by 2011-end, by which time the tablet market will be more competitive.
Nokia partnership could benefit Microsoft
Microsoft recently announced a strategic partnership in which Nokia will adopt Windows Phone 7 as the main operating system for its smartphones.
Nokia still leads the global mobile phone market, but its market share has been declining in recent years. Microsoft has also seen struggles in the smartphone market, with its smartphone operating system market share dropping from around 9% in 2009 to 4% in 2010.
According to the deal, Microsoft’s Bing search will power Nokia’s smartphones and Nokia’s app store will be integrated with Microsoft marketplace. Nokia has a large presence in emerging markets, which is also attractive to Microsoft.
Through the Nokia partnership, Microsoft not only stands to gain licensing revenues for its operating system, but also search advertising market share.
Windows Pricing / Market Share Threat from Emergence of Netbooks
Netbooks took shape as a phenomenon in 2008 and are expected to be more than 10% of the PC market in 2011. Netbooks are targeted towards price-conscious consumers and are used to primarily run web-centric applications like email and the Internet, where the OS requirements are light. This has lead PC OEMs to be more willing to look at lower- priced, reasonably capable alternatives to Windows, such as Linux. If netbooks continue to be a bigger part of the PC mix, that trend will dilute either Microsoft's market share or it's pricing and margins
Piracy of Windows Remains an Issue
Piracy is an important issue for Microsoft regarding Windows. Software piracy in emerging markets is particularly problematic.
Growing Threat from Google Apps
We expect that Microsoft's Office suite will continue to experience challenges from hosted solutions like Google Apps, as well as open source alternatives, such as Star Office.
Increased Marketing of Microsoft's New Bing Search Engine
In June 2009, Microsoft unveiled its newly-positioned search engine called Bing. Microsoft is believed to have spent an estimated $80-100 million on marketing and promoting Bing-- and through channels as varied as the nytimes.com, wsj.com and even Google's own Adsense.
SOURCES
Information sources include annual reports, quarterly filings, and quarterly earnings transcripts. Company filings are available from the SEC.
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