The Coming Transformation of This Company
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It's no secret that Microsoft (NASDAQ: MSFT) is releasing Windows 8 in about a month. If you are interested in computers, tablets, or smartphones, the company hopes this release will unite the three under the same software. It's clear that Microsoft will be transformed by this release. However, one question still stands: What type of transformation can investors expect? Will Microsoft be transformed into a growth story again, or will the company continue to be a large albeit slower growing version of itself? In a recent interview with The Seattle Times, CEO Steve Ballmer sat down to discuss the changes and challenges his company faces.
Windows 8 Is Another Fundamental Change In How Users Interact:
In “Ballmer Trumpets Microsoft's Epic Year” Microsoft investors probably got exactly what they have come to expect from their CEO. Steve Ballmer is nothing if not brash, outspoken, and confident. With the company releasing Windows 8, it also happens that nearly every other major product is being refreshed as well. The company's popular Microsoft Office Suite is getting an update, as well as Windows Server, and of course Windows 8 Phone. Some might say that Microsoft hasn't taken a chance like Windows 8 before, but that would be incorrect. Ballmer addressed this, saying that this change is similar to the switch from Windows 3.1 to Windows 95. This required millions of users to retrain themselves on how to interact with their computers. However, at that time the computer industry was much different. Tablets were a non-market and smartphones didn't begin to become a factor until years later. With this as a backdrop, what should investors expect from Windows 8 and the future at the software giant?
PCs Will Still Run Windows? Well Duh!
One statement that seemed pretty safe for Ballmer to make was that Windows 8 would “propel” the volume in PC sales next year. He suggested that sales might be around 400 million. Since Microsoft still maintains over 90% market share between all of its operating systems, it's not hard to understand that most of these PCs will have Windows 8 pre-loaded. Assuming the company maintains this market share, that means at least 360 million PCs next year would be sold with Windows software. That being said, according to Gartner research, PC sales should reach about 368 million units in 2012, so 400 million would represent an increase of about 8.7%. Ironically, analysts are calling for long-term growth at Microsoft of 8.7% as well. If Windows 8 on traditional computers doesn't appear to offer many surprises, what about the tablet market?
Microsoft Hopes To Blur The PC and Tablet Line:
According to the same Gartner study, the shift to tablets is expected to be a permanent one. “Consumers will now look at a task they have to perform” to choose what device will allow them to perform that task in the best way. Tablet sales are expected to reach 119 million units in 2012, with Apple's (NASDAQ: AAPL) taking over 60% of sales. Gartner also predicts this market to increase to as much as 180 million units in 2013. However, the firm sees iOS and Google's (NASDAQ: GOOG) Android taking at least 88% of these sales. For Windows 8 to be successful, it must take more than just a small portion of the tablet market. Microsoft hopes its Surface tablet is a step in the right direction. This product was both unexpected and a step away from Microsoft's core competency of creating software. That being said, Ballmer believes that in the future “it's going to be hard to tell what's a tablet and what's a PC.” If this is the case, I would expect Microsoft to produce more hardware if for no other reason than the company can drive Windows 8 tablets more effectively by pushing other companies like Dell, Samsung, and others to create unique tablets based on the Windows 8 system. There is one big difference between tablets and software though, and that is the margins. We will come back to that, but given Microsoft's almost 77% current gross margin it's something to think about.
Smartphones Are The Battlefield:
There might not be a more important market for Microsoft going forward than smartphones. With Android and iOS in a commanding lead of the market, Windows 8 Phone will need to be a big win. According to NPD DisplaySearch, the smartphone market is expected to reach 567 million units by year end 2012. The same company says that smartphone shipments are expected to double again to over 1 billion by 2016. This means just in 2012, smartphones would outsell PCs by 154%, and tablets by 476%. A recent study by WinterGreen Research showed that, “over one-half of all smartphones in the global market are made by Apple and Samsung.” Since Apple obviously isn't going to produce a Windows 8 phone, this means Microsoft must get strong support from Samsung. There are at least two big challenges. First, Samsung sells millions of smartphones that run Android. Since Android is open-source, why would Samsung pay to license Windows 8 Phone? Second, Samsung is rumored to be readying a release of its popular Samsung Galaxy S3 running Tizen, which is an open-source OS based on Linux. This option is backed by Samsung, Intel, and others and, while Android is free, it comes with connections to Google. I'm sure Samsung would love for Tizen to take over where Android is now. If this option meets with any popularity, this would be a major blow to not only Microsoft's ambitions, but to Google as well.
So what should investors do with all of this information? Quite simply, don't assume the Microsoft you know today will be the same company tomorrow. Steve Ballmer said in five to ten years he sees Microsoft as a “devices-and-services company.” This is a massive change that can't be understated. How would this affect the stock and the company's earnings? If Ballmer has his way, there is no way around the fact that Microsoft's gross margin would compress, possibly significantly. Microsoft currently has an almost 77% gross margin. By contrast, Apple (which basically is a devices and services company) sports a gross margin of 42.81%. Even Google, which is beginning its foray into tablets and devices, has a gross margin of 58.96%. The main point for Microsoft investors is that Windows 8 has to be impressive enough to make consumers seek out this system on smartphones.
The company already essentially owns the PC, server, and productivity (Office) marketplaces. These divisions generated $18.3 billion, $18.7 billion, and $23.99 billion in sales in the company's most recent quarter. If Windows 8 becomes a reasonable alternative to iOS and Android on tablets, there will be some cannibalization of the company's PC sales. If Windows 8 Phone becomes even the third most popular OS, this would change Microsoft's growth rate. In order for this to occur, Samsung in particular has to adopt Windows 8 in a big way. Microsoft's Entertainment and Devices division only represented 13% of sales and 1.67% of operating income in the last quarter. If the company hopes to really deliver for investors, these numbers are going to have to grow exponentially. This being said, Microsoft's stock seems dirt cheap at current prices. With shares at just 10 times 2012 estimates, and currently paying a 3% dividend, you are getting paid to wait. You won't have to wait long though. When Windows 8 comes out on October 26 I'm sure everyone will know in just a few months whether this transformation is the real deal.
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