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Microsoft Corporation (NASDAQ: MSFT) is the world's largest software maker by revenue, with $58.43 billion of revenue in 2009.^[1] Its software products run the gamut from operating systems for servers, personal computers, and other devices to software developing tools and video games. In addition, the company sells the Xbox 360 and Zune hardware.

Despite the successes of Apple’s operating system (on the client) and Linux (on the server), Windows continues to dominate its rivals in operating systems but is also growing in both client and server markets. With the release of Windows 7 in December 2009, Windows finished the year with a 92.2 % share. ^[2] Its Microsoft Office is also still the most prevalent suite among enterprise customers, with about 80 % market share. ^[3] On the browser side, Internet Explorer’s market share is 62.69%. ^[4]

Business Overview

In 2008, Standard & Poor's, the ratings agency, upgraded the stock to AAA, the highest possible rating. Microsoft was the first company to receive the rating in a decade. Only 5 other corporations in the United States held such a rating at that time.^[5]

History

Co-founded in 1975 by Bill Gates and Paul Allen, Microsoft Corporation has built a dominant position the computer industry. Its 1992 introduction of the Windows 3.1 operating system created a successful recurring revenue source for the company, as in subsequent years, the highly successful releases of Windows 95 and 98 consolidated its industry lead, as did well-received updated Microsoft Office software. Today, multi-national Microsoft remains at the head of the industry, its desktop operating system market share exceeding 90% and its global annual revenue of more than $44 billion. While the bulk of Microsoft’s profits derive from corporate contracts, a significant minority of its profits is derived from consumers, and Microsoft is a common name both at home and work.

Products and Service Offerings

Microsoft’s products and service offerings fall into five divisions or business sectors:

Microsoft Annual Report 2008^{[6][7][8][9][10]}

• Client (28% of revenue and 45% of income^{[6][7][8][9][10]}): The client segment, accounting for approximately 28% of total revenue, includes sales and marketing expenses for the Windows operating system. 80% of this revenue is from the sale of products with pre-install versions of Windows operating systems.^[11] In an effort to strengthen its grip on the PC market, Microsoft launched Windows 7 on October 22, 2009 replacing its disappointing Vista. The release comes three year after the launch of Vista, which frustrated many home users and turned off business customers due to its sluggishness, intrusiveness, and incompatibility with many gadgets. By summer 2009, two-thirds of corporate computers were still running Windows XP. The success of Windows, which accounts for more than half of Microsoft’s profits, is crucial to revive the company’s image and its share in the PC market. Windows 7 is faster, less cluttered, and has new touch-screen features, while keeping Vista’s security and stability; it is an improvement from Vista. ^[12]

• Server and Tools - Products for IT Professionals (22% of revenue and 16% of income^{[6][7][8][9][10]}): The Server and Tools segment, which accounts for approximately 22% of Microsoft’s revenue, develops and markets software server products, services, and solutions such as Windows Server 2008 and Visual Studio 2008. Approximately 45% of Server and Tools revenue comes from multi-year licensing agreements, 25% through fully packaged product and transactional volume licensing programs, and 10% from licenses sold to original equipment manufacturers (OEMs).^[13]

• Business (32% of revenue and 42% of income^{[6][7][8][9][10]}): Microsoft Business Division (“MBD”), accounting for approximately 32% of Microsoft’s revenue, includes the Microsoft Office system (about 90% of MBD revenue) and Microsoft Dynamics business solutions. Approximately 80% of MBD revenue is generated from sales to businesses, the rest being derived from sales to consumers. ^[14]

• Online Services (5% of revenue and -4% of income^{[6][7][8][9][10]}): The Online Services Business (“OSB”), approximately 5% of Microsoft’s revenue, consists of an on-line advertising platform with offerings for both publishers and advertisers, personal communications services such as email and instant messaging, online information offerings such as Live Search, and the MSN portals and channels around the world.^[15] In 2008, this included new releases of Windows Live Search, the Windows Live suite of applications and services, and their MSN Video Service. Revenue comes primarily from online advertising.

• Entertainment and Devices (13% of revenue and 1% of income^{[6][7][8][9][10]}): Approximately 13% of total revenue, Entertainment and Devices is the most high-profile aspect of Microsoft’s expansion, E&D includes the highly successful Xbox and Xbox 360 video game consoles, a large collection of Microsoft-licensed video and computer game titles (including Halo and the Age of Empires series), Windows Mobile and Automotive (operating systems for mobile and car navigation devices), and the Zune mp3 player (designed to compete with Apple's iPod).^[16] This segment is particularly seasonal and consumer driven, generating 40% of its revenue in Microsoft's second quarter, as a result of end of the year holiday shopping.^[17]

Of these divisions, the greatest revenue generators are Client, Business, and Server and Tools. However, the strongest rates of growth are in are Entertainment and Devices, with Server and Tools placing a distant second. The table below shows revenue breakdown by segment (in millions) and their perspective percentages of Microsoft’s total revenue for 2008.

Microsoft Annual Report 2008^[18]

Financial Analysis

The economic downturn has affected the revenue growth of the company. On July 23rd 2009, the company announced its annual revenues were down by 3% from $ 60.4 billion in FY08 to 58.4 billion for FY09. Revenue reduction was driven primarily by weakness in the global PC and server market and recession.^[19]

Operating income decreased by 9% primarily reflecting decreased revenue, partially offset by reduction in general and administrative expenses (decrease of 28%). This was primarily due to the reduced cause of legal settlements and legal contingencies ($283 million for FY09 compared to $1.8 billion of legal charges for FY08 primarily related to the European Commission fine of $1.4 billion).^[19]

Revenue increased in each of Microsoft's five segments:^[19]

• Client revenue decreased reflecting reduction in revenue with increase in cost of sales and marketing. The 10% reduction in the OEM premium mix (Original Equipment Manufacturers pre-install versions of Windows OS on machines they sell. They provide licensing revenue to MSFT for these systems (accounts for 80% of revenue of this segment). If unit sales falls so does revenue that is generated by MSFT, and thus the global recession and weak PC market has hurt this segment significantly) was cited as the reason behind the loss in revenue by 13% from $16.8 billion in 2008 to $ 14.7 billion in FY09.

• Server and Tools revenue increased from growth in both product and services revenue. Server and server application revenue (including CAL) and developer tools revenue increased $809 million or 8%, primarily driven by growth in SQL Server, Enterprise CAL Suites, and System Center revenue. This growth reflects recognition of deferred revenue and continued adoption of the Windows Server Platform and applications. Server and Tools operating income increased primarily due to growth in product revenue, partially offset by increased research and development expenses and cost of revenue.

• OSB revenue decreased as a result of decreased online advertising revenue by $73 million to $2.3 billion, attributable to a reduction display advertising which was partially offset by increase in search advertising.

• MBD revenue were flat reflecting decreased consumer revenue which was offset by increased business revenieu. Consumer revenue decreased $525 million or 14%, primarily as a result of PC market weakness, a shift to lower-priced products, and pricing promotions on the 2007 Microsoft Office system. Business revenue increased $490 million or 3%, primarily reflecting growth in volume licensing agreement revenue.

• EDD revenue decreased across most lines of business. Revenue from non-gaming business decreased $292 million or 12%, primarily reflecting decreased Zune and PC hardware product revenue. Xbox 360 platform and PC game revenue decreased $161 million or 3%, primarily as a result of decreased revenue per Xbox 360 console due to price reductions during the past 12 months, partially offset by increased Xbox 360 console sales and increased Xbox Live revenue. MSFT shipped 11.2 million Xbox 360 consoles during fiscal year 2009, compared with 8.7 million Xbox 360 consoles during fiscal year 2008.

Trends and Forces

Slowing Rates of PC Growth

80% of Microsoft's revenue comes from software sales, primarily MS Office and MS Windows - both of which are packaged with a PC.^[20] A slow-down in PC purchases in most developed countries means a decrease in profit growth for Microsoft as well. In addition to the maturation of the markets, the global recession has decreased PC sales by 6% globally in 2008. However, Gartner predicts that Worldwide PC sales will increase 10.3% percent in 2010 due to the recovering markets.^[21] Microsoft's revenues will increase with this growth.

Software as a Service Threatens Microsoft's Long Term Business

The growth of SaaS means there is more competition for traditional Microsoft products like Microsoft Office. Browser-based software represented approximately 5 percent of business software revenue in 2005 and, by 2011, 25 percent of new business software will be delivered as SaaS, according to Gartner, Inc. ^[22] Although shareware, open-source, or low-cost alternative software (like Google (GOOG) Spreadsheet, and Open Office by Sun Microsystems ) are still several years away from the security and functionality most businesses need, analysts agree that software will continue to move towards these browser-based models in the long term. Microsoft is taking steps to benefit from this trend itself, starting with the release of a new version of its Microsoft Exchange Server that is available on demand. Furthermore, the next Office suite will be available as On Demand on the internet. ^[23]

Another trend, the shift from client-server to Service-Oriented Architecture (SOA), marks the further and parallel movement of the server industry in the direction of On Demand. Here, the companies that may stand to benefit the most are those with solid bases in the small-to-medium business market, such as Oracle (ORCL). Linux software distributor Red Hat may also benefit significantly, since the resulting restructuring of the software industry could mean a revival of interest in open-source alternatives. Microsoft may have a lot of ground to make up in this area.

Focus on High-growth businesses: Web Services and Entertainment

Starting in 2005, Microsoft rebranded its Hotmail, MSN, and LiveJournal offerings under the name of Windows Live. Products in the Windows Live pipeline include a new graphics-heavy "digital human" search interface and "adCenter", Microsoft's first totally self-developed advertising platform. AdCenter uses both the maximum amount an advertiser is willing to pay per click (PPC) on their ad and the advertisement's click through rate (CTR) to determine how frequently an advertisement is shown. To compete with Google’s acquisition of DoubleClick, and expand its online advertising market, Microsoft agreed to purchase aQuantive, for roughly $6 billion, in May 2007. ^[24] aQuantive had an online advertising revenue of $161 million and a total revenue of $345 million in 2008.^[9]

In Entertainment, Microsoft's most successful device is the Xbox 360. Microsoft's Xbox 360 models were the most popular videogame consoles for online gaming (25% of the gaming market), being used by half of the more than 20,000 consumer panel members NPD surveyed for the report.^[25]Introduced in late 2005, Xbox360 is leading the next-generation of video game consoles in terms of units sold. By launching the Xbox 360 nearly 12 months before Sony's PlayStation3 and the Nintendo Wii arrived, Microsoft hoped to seed the market, aiming to have 10 million Xbox 360 units sold by December 2006.^[26]The strategy seemed to pay off; December saw more than twice as many Xbox 360 sales as PlayStation sales. However, despite the 360's year-long head start, the Wii has managed to catch up in sales, and as of April 2007 is approaching 7 million units in cumulative net sales worldwide (Xbox 360: 10 million). Likewise, in March 2008, Nintendo sold 721,000 Wii, according to NPD, more than Microsoft, who sold 262,000 Xbox 360 units, and Sony who sold 257,000 PlayStation 3 systems, combined.^[27] In April 2008, Microsoft reported third quarter earnings and the results for the entertainment division, which includes all Xbox products. The results were a 68% increase in profits from the same period a year earlier.^[28]

Piracy Risks

The software industry lost $48 billion in potential sales in 2007 because of the distribution of pirated software, according to the Business Software Alliance, a trade association.^[29] Microsoft loses a staggering US$18 billion every year from pirated Windows operating systems alone. With a total piracy rate of about 30% and the number even higher in some countries, Microsoft suffers massive losses from the distribution of pirated Windows. For instance, in China, 90% of all Windows operating systems are pirated. Worst of all for Microsoft, the countries with the highest rates of piracy are exactly those with the fastest-growing number of PC purchases. Thus the opportunity cost of piracy to Microsoft is huge: the software giant finds itself unable to tap into these burgeoning PC markets just when it needs them the most. In fact, fast-growing PC markets Latin America and Asia/Pacific account for about 1/3 of total PC shipments, but only 1/10 of total PC software spending.

Antitrust risks

Microsoft has a history of running afoul of anti-trust laws. In July of 2006, the company was fined US$356 million by the European Union in response to a 2004 antitrust ruling. In 2008, Microsoft incurred $1.8 billion of legal charges, primarily related to the European Commission fine of $1.4 billion (€899 million) as compared with $511 million of legal charges during the prior year. Given its monopolistic prominence, Microsoft is always under a slew of lawsuits, and this can affect the company's profitability, business strategy, and public image. Potential legal problems can have a variety of impacts, from negative publicity to fines to possible forced reorganization of the company.^[30]

Competition

Microsoft's involvement in many different aspects of technology and computing result in competitive pressure from a number of different sources:

• Apple (AAPL) and Oracle (ORCL): in the world of operating systems, Oracle is a far greater threat to Microsoft than Apple. Despite consumer migration towards Apple desktops and iBooks, especially in the younger generations, Apple has a wide gap to make up in most corporate environments compared to Microsoft's Windows. (And as for private consumers, Microsoft has enjoyed a kind of synergy with Apple since the release of Windows and Office for Apple.) However, Oracle is a different story and stands poised to challenge Microsoft, both obliquely through its support of Lintel (Linux OS plus Intel processor chips), and directly in replacing Microsoft's developer base with its own improved Linux-based developer platform).
• Google (GOOG) and Yahoo! (YHOO) are Microsoft's primary competitors in Internet Services, both outperforming Microsoft by a wide margin. In 2008, Google held 70% market share in searches, Yahoo! held 20%, and Microsoft only 6%. Google is a particular threat because it is also expanding into browser-based applications, with programs like Google Spreadsheet and Writely beginning to challenge Microsoft's traditional desktop-based Office suite. While Google's software offerings do not yet pose any real threat to Microsoft Office (for instance, Spreadsheet's security capabilities are many steps behind Microsoft Excel's), new versions may begin to close the gap. Google's actions have made the rise of browser-based applications an increasing threat for Microsoft which it could not prudently ignore. On July 28, 2009, the Wall Street Journal reported that Microsoft and Yahoo are close to a deal involving Yahoo's agreement to use Microsoft's 'Bing' search engine on its own site. The deal offers some marginal advantages in discussions with advertisers, but does nothing to erase Google huge competitive advantage in the search market. A 10-year agreement was announced broadly in the financial press on July 29, subject to regulatory review. The agreement envisages a division of labor between the two companies, with Yahoo utilizing the Bing search engine while focusing it's internal personnel on a more aggressive sales effort. Under the terms of the revenue-sharing agreement, Yahoo will receive 78% of the search revenue generated from Microsoft's sites during the first 5 years of the agreement and 88% of search revenue generated from Yahoo's sites, although press reports on these details seem to vary. As the New York Times characterized the transaction, "the bumpy, marathon mating dance between Microsoft and Yahoo finally concluded." The two companies hope to achieve better efficiencies of scale by a division of labor, with Microsoft focusing on search engine development and Yahoo! focusing on advertising sales. With a greater critical mass of viewers, prospective advertisers may be more amenable to utilizing their search resources.Microsoft teamed up with Yahoo in the internet search market in order to better compete with Google who holds roughly 65% share of the market. Canadian and Australian antitrust regulators see no problem with the partnership and have approved the deal, and if U.S. regulators approve it as well, Microsoft and Yahoo will together hold about 30% of the market. The partnership will help Yahoo cut costs, while enabling Microsoft to become a powerful force in Internet search. ^[31]

• Sony (SNE) and Nintendo (NTDOY): Microsoft's two primary competitors in the Entertainment sector both have much more history in the industry than the Xbox-touting newcomer does. However, Nintendo's gaming system has no pretensions to the "media center" status that the Xbox and PS3 try for with their integrated HDTV and Blu-Ray technologies. This puts the price of the Wii much lower, but it also removes Nintendo from participation in the bigger race: dominance in the media center, and tech advantage in manufacturing next-generation-graphics player consoles. As for Sony, PS3's prominence and potential recovery remains a very real threat for the Xbox 360. However, Sony's botched launching process significantly reduced introductory momentum and excitement surrounding the PS3, and the prohibitively expensive system may suffer even more if Microsoft delivers on anticipated Xbox price cuts.

Other competitors include SAP (servers), Red Hat (Linux software), Symantec (Internet Security) and Cisco (internet telephony).

The Internet Companies Google • Yahoo • EBay • Adobe • Amazon • Microsoft • Baidu • Playboy • Symantec • RealNetworks • VeriSign • Quest • GSI

References

1. ↑ MSFT 2009 10-K pg. 19  
2. ↑ Windows Market Share (January 3, 2010).
3. ↑ Microsoft Office in no danger from competitors (January 4, 2009).
4. ↑ Browser Statistics.
5. ↑ Standard & Poor's upgrades microsoft to AAA&hl=en&ct=clnk&cd=3&gl=us Microsoft Scores AAA Rating From S&P (MSFT) – September 22, 2008
6. ↑ ^{6.0 6.1 6.2 6.3 6.4 6.5}
7. ↑ ^{7.0 7.1 7.2 7.3 7.4 7.5}
8. ↑ ^{8.0 8.1 8.2 8.3 8.4 8.5}
9. ↑ ^{9.0 9.1 9.2 9.3 9.4 9.5 9.6 9.7} MSFT 2008 10-K pg. 26  
10. ↑ ^{10.0 10.1 10.2 10.3 10.4 10.5}
11. ↑ Microsoft Annual Report 2008 - Item 1 - Page 4
12. ↑ Windows 7 Keeps the Good, Tries to Fix Flaws (October 21, 2009).
13. ↑ Microsoft Annual Report 2008 - Item 1 - Page 5
14. ↑ Microsoft Annual Report 2008 - Item 1 - Page 6
15. ↑ Microsoft Annual Report 2008 - Item 1 - Page 5
16. ↑ Microsoft Annual Report 2008 - Item 1 - Page 7
17. ↑ Microsoft Annual Report 2008 - Item 7 - Page 21
18. ↑ MSFT 2008 10-K pg. 20  
19. ↑ ^{19.0 19.1 19.2} Microsoft Reports Fourth-Quarter Results. Microsoft (2009-07-23). Retrieved on 07-24-2009.
20. ↑ MSFT 2008 10-K pg. 6,7  
21. ↑ PC Shipments Showing Signs of Recovery, Gartner Says. PC World (2009-05-25). Retrieved on 06-28-2009.
22. ↑ Gartner: SaaS Market Heats Up. eBiz.com (2006-08-28). Retrieved on 06-28-2009.
23. ↑ What is SaaS(Software as a Service). Interop NY. Retrieved on 06-28-2009.
24. ↑ Microsoft Pays $6 billion for aQuantive: Massive Ad Network Consolidation Is Occuring (2008-01-12). Retrieved on 06-28-2009.
25. ↑ US online videogame play on the rise: NPD Group (AFP) (2009-03-10). Retrieved on 06-28-2009.
26. ↑ XBox 360 News (2006-12-06). Retrieved on 06-28-2009.
27. ↑ Nintendo Wii Sales Trounce Xbox 360, PlayStation 3. Infoweek (2008-04-13). Retrieved on 06-28-2009.
28. ↑ Xbox 360 division quarterly revs surge 68 percent. Gamespot.com (2008-04-24). Retrieved on 06-28-2009.
29. ↑ Microsoft to describe anti-piracy campaign (2008-10-20). Retrieved on 06-28-2009.
30. ↑ MSFT 2008 10-K pg. 22  
31. ↑ Microsoft, Yahoo search pact cleared in Canada, Australia (November 24, 2009).
32. ↑
33. ↑ YHOO 2008 10-K pg. 28