The Second Coming Of Microsoft

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When Microsoft (NASDAQ: MSFT) reported Q2 earnings last month the numbers came in basically as analysts expected. The company reported $21.46 billion in revenue and $0.76 EPS for the quarter, with revenue up 3% year-on-year. This was the first quarter which included sales of Windows 8, Microsoft's new operating system, but no real information was given except that more than 60 million licenses had been sold thus far. Many people are extremely pessimistic about the prospects of Windows 8, with shrinking PC sales and general lack of interest in the new operating system. But I believe that these people are missing the bigger picture.

More Than Just Windows

To get an idea of the scale and diversity of Microsoft here's an info-graphic used by Microsoft as a recruitment tool. You can look at a zoom-able full-size version here.

<img src="/media/images/user_13886/msft-infographic_large.jpg" />

Microsoft is split into five different divisions:

  • Windows - The Windows division sells the windows operating system, currently both Windows 7 and the new Windows 8, as well as hardware products such as the Surface tablet. 65% of revenue comes from sales of the Windows operating system to OEMs (original equipment manufacturers) while the remaining revenue comes from commercial and retail sales of Windows and hardware sales. Q2 revenue was $5.88 billion, a 24% increase year-on-year.

  • Business - The Business division is composed mainly of Microsoft Office. According to the above info-graphic Microsoft office is used by over 1 billion people worldwide. The newest version of Office comes in two versions, a traditional one-time-sale version and a subscription service called Office 365. Office 365 brings Microsoft Office into the cloud much like Google Documents. Q2 revenue was $5.69 billion, a 10% decrease year-on-year. Given that the new version of office released on January 29th this decline is at least partially due to customers waiting for the new version.

  • Server & Tools - The Server & Tools division includes products such as Windows Server, Microsoft SQL Server, and Visual Studio. Growth in this division has been impressive, with 9% revenue growth year-on-year in Q2 to $5.19 billion. This makes the Server & Tools division almost as big as the Windows division.

  • Entertainment and Devices - The Entertainment and Devices division is responsible for the Xbox gaming console, Windows Phone, and Skype. The Xbox 360 is the top selling console in the United States and Windows Phone 8, the newest version of the phone operating system, launched during Q2. Total revenue was $3.77 billion in Q2, down 11% year-on-year. The decrease is not surprising given that Microsoft is expected to launch a new Xbox later this year, as the Xbox 360 is now over 7 years old.

  • Online Services - The Online Services division includes Bing, Bing Ads, MSN and advertiser tools. Most of the division's revenue is derived from the sale of advertising. Revenue grew 11% year-on-year to $869 million, with online advertising revenue growing by 15%. Bing's search market share has grown to 16.3%, up from 15.1% at the end of 2011.

Underestimating Microsoft

Windows is absolutely dominant in the PC market, with the combined market share of Windows XP, Windows 7, and Windows 8 sitting at around 91%. Think about that number for a second.

<img src="/media/images/user_13886/pc-share_large.png" />

Source

While the market for PCs, which has grown at a staggering pace over the last decade, shrunk in 2012, I don't expect it to go away anytime soon. Laptops have become extremely cheap, with many selling for less than $400. While margins for OEMs selling PCs have shrunk and will most likely shrink even more as prices continue to decline, Microsoft continues to sell an enormous quantity of Windows licenses. It doesn't matter to Microsoft if the PC retails at $300 or $1,500. They make their money regardless.

There is no real alternative to Windows. Sure, there's Apple's (NASDAQ: AAPL) Mac OS X, but you can't buy a laptop for $300 with OS X. OS X PC market share is only about 6%, and there are only so many people willing to spend over $1,000 on a laptop. Windows pretty much has a lock on all but the high-end market.

One argument levied against Microsoft is that businesses have been extremely reluctant to upgrade to Windows 8. Of course, this has always been true with any new version of Windows. Many companies still run Windows XP, which has a nearly 40% PC market share overall. This is because upgrading a large number of PCs is a giant pain. Companies may be using very specialized software which works well on XP but may cause problems on new versions. It may be that the perceived benefit of upgrading doesn't justify the cost, both in cash and in headaches.

Some kind of catalyst is needed to spur businesses to upgrade. On April 8, 2014, Microsoft will officially end support for Windows XP. This means no more patches and no more security updates. This should lead to an exodus from Windows XP to either Windows 7 or Windows 8. Apple products may very well pick up some market share, but Windows will continue to be dominant.

Tablets

The Apple iPad, while not the first tablet, created a new market. Tablet sales have grown extremely quickly as the iPad has competed with cheaper Android devices. Apple accounted for about 43% of all tablet shipments in the fourth quarter of 2012, by far the largest single vendor but falling from over 50% market share at the end of 2011. With the introduction of Windows 8, which was built for both traditional PCs as well as tablets, a new competitor enters the mix.

The question is: What are tablets for? They seem thus far to be mainly entertainment devices for playing games, surfing the internet, and watching video. Trying to do anything productive on a tablet, like typing anything of real length, is like trying to use a restroom on an airplane - the job gets done but no one's happy about it. Tablets are not a replacement for the traditional PC because they serve a different purpose. The market for PCs may contract, but it will not go away.

The fact that Windows 8 runs on both tablets and PCs is a big deal. I agree that there was unnecessary confusion created around Windows RT (the version of Windows 8 which works with ARM-based processors), but once we see inexpensive tablets running the full version of Windows 8 I expect their popularity to rise.

To some degree it doesn't matter to Microsoft what form-factor does best. Either way the company is selling Windows licenses. With Windows 8 they've simply broadened the possibilities.

The Bottom Line

I've written previously about why I think Microsoft stock is undervalued, and since that article I've bought shares myself. Many people view Microsoft as late to the party on tablets and smartphones, but just like PCs these products will eventually become commodities. And when that happens, I'd rather be the company selling the license to the OS than the company actually selling the devices. Apple will continue to see its market share erode, most likely opting to protect its margins instead. I expect that the tablet market will become much like the PC market for Apple, with a small market share but extremely profitable products. Windows, on the other hand, will be available on devices of all price-ranges. Microsoft is setting itself up for a bright, extremely profitable future with Windows 8.


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