Microsoft (MSFT)

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Microsoft Corporation (NASDAQ: MSFT) is the world's largest software maker by revenue, with $58.43 billion of revenue in FY2009.^[1] Its software products run the gamut from operating systems for servers, personal computers, mobile phones, and other devices to software development tools, video games, and hardware such as the Xbox 360 and Zune.

Despite the successes of Apple’s client operating system and client and server systems under Linux and other unix-like operating systems, Windows not only continues to dominate its rivals in operating systems but is also growing market share. With the release of Windows 7 in December 2009, Windows finished the year with roughly a 92% market share, as well as an 80% market share among enterprise customers and a 63% market share in web browsing (through Internet Explorer^[2][3][4].

Company 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.

Business and Financial Metrics

Microsoft reported a record revenue of roughly $19 billion for 2Q10, a 14% increase from 2Q09^[6]. Top-line growth was driven by the well-hyped release of its new operating system, Windows 7, which was launched globally October 2009 and sold more than 60 million copies in 2Q10, making it the fastest selling operating system in history^[6]. It was also boosted by a 15-17% YoY increase in unit PC sales, as well as the sale of 5.2 million XBOX 360 consoles ^[6]. Its Online Services Division witnessed a 5% YoY decline, hurt by a 2% decline in online advertising revenue and the negative impact international rate declines took on its display revenue. However, the real story in 2Q10 was MSFT's ability to simultaneously cut costs, which resulted in a net income of $6.66 billion for the quarter, a 60% increase over 2Q09. This disciplined cost-cutting dates back to FY2009, when MSFT reduced general and administrative expenses by 28% to offset the weakness in the global PC and server market that was plaguing its revenue growth ^[7]. The company also managed to generate $5.0 billion in operating cash flow, $4.8 billion of which it returned to investors.

Products and Service Offerings

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

• Client (28% of revenue and 45% of net income in FY2009: 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.^[9] In an effort to strengthen its grip on the PC market, Microsoft launched Windows 7 on October 22, 2009 replacing its disappointing Vista, which had been released three years earlier. Visa frustrated many home users and turned off business customers due to its sluggishness, intrusiveness, and incompatibility with many gadgets. Windows 7 is faster, less cluttered, and has new touch-screen features, while keeping Vista’s security and stability^[10]. In June 2010, Microsoft announced that Windows 7 was the fastest selling operating system in history, having sold more than 150 million licenses since its debut, a rate of approximately "7 copies per second^[11]."

• Server and Tools - Products for IT Professionals (22% of revenue and 16% of net income in FY2009): 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).^[12]

• Business (32% of revenue and 42% of net income in FY2009): 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. ^[13]

• Online Services (5% of revenue and -4% of net income in FY2009): 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.^[14] 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 net income in FY2009): 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^[15]. In June 2010, Microsoft released a slimmer version of the console known as the Xbox 360 Slim, in an effort to lower its production costs and compete with the smaller consoles of rivals such as Sony, who had great success with the launch of its re-designed Play Station 3^[16]. The company also said that starting November 2010, Xbox 360 releases will come equipped with Kinect, a body movement-sensitive add-on peripheral^[17][18].

In May 2010, Microsoft released two phones under the Microsoft brand in an attempt to target teenagers and facilitate social networking access. In contrast to focusing on building its phone around third party applications, it strives for simplicity by merely integrating popular social features, such as Facebook, Twitter, RSS feeds, etc^[19]. These phones, manufactured by Sharp Corp. and distributed through wireless carrier Verizon Wireless, were not compatible with applications written for the previous operating systems, in an effort to maximize functionality and user friendliness^[20]. Less than two months in the market, Microsoft ended production of the Kin smartphones in June 2010, announcing that it would instead merge its Kin team with the WIndows Phone 7 team^[19]. Analysts blame the already saturated smartphone market and several other competing releases for the Kin's lack of success (it is rumored based on insider information that only 503 Kins were sold^[21][22].

Trends and Forces

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. ^[23] Although shareware, open-source, or low-cost alternative software (like Google (GOOG) Apps, 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. ^[24]

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.

Piracy Risks

Roughly 41% of all software installed on personal computers is obtained illegally, costing the software industry over $53 billion according to a 2009 report by Business Software Alliance^[25]. 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.

Microsoft's Clout Across Multiple Markets Poses Perennial Antitrust Risk

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.^[26]

Economies of Scale in Cross-Platform Applications

Microsoft, like other companies with proprietary operating systems, is able to unify its app development across its video game and mobile technology segments. These cross-platform games can run on the XBox, Windows, and Windows Phone 7, with the code being 90% compatible across each of the platforms. One is able to save the game on one platform and resume it on another^[27]. This eases developers' access to consumers and does not force them to pick one platform over another. It also incentivizes them to build relationships with Microsoft over those of competitors' not offering similar cross-platform functionality.

Competition

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

• Apple and Oracle: in the world of operating systems, Oracle is a far greater threat to Microsoft than Apple. Despite consumer migration towards Apple desktops and netbooks, especially in the younger generations, Apple is lacking Microsoft's Windows in most corporate environments. (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 is Microsoft's primary competitors in Internet Services outperforming Microsoft by a wide margin. In an effort to stiffen competition in this field, Microsoft signed a ten-year partnership with Yahoo! in February 2010 to use the Bing search engine on Yahoo's site while Yahoo focuses its internal personnel on a more aggressive sales effort ^[28]. 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. This leaves Microsoft with 10% of the search advertising business to Google's 90%^[29]. Google also competes with Microsoft through its cloud-computing based software offerings.

• Sony and Nintendo: Microsoft's two primary competitors in the Entertainment & Devices sector are the Nintendo Wii and the Sony Play Station 3. Following the announcement of the cutting-edge Kinect peripheral device to the Xbox 360, Sony plans to release Move, its own body movement-sensitive add-on to the Play Station 3, while Nintendo plans to release a new version of its DS handheld device that does not make use of 3-D goggles^[30].

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

In the non-commercial sector, there are significant forces at work which have slowly but importantly been reshaping the character and depth of product offerings which provide viable alternatives to Microsoft products with powerful, free operating systems software, language translators, editors, and utility programs numbering in the thousands, particularly attractive to sophisticated users. These applications are in use by millions of users around the world. See The Free Software Foundation (fsf.org), Debian GNU/Linux (debian.org),and other Linux variants, Vim/Gvim (vim.org), Perl (perl.org), mailers and browsers such as Mozilla (mozilla.org), Opera (opera.com), among many, many others. What their overall impact is on Microsoft is difficult to guage, but their influence on the user community is not inconsequential and will only grow over time.

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} "Microsoft Reports Record Second-Quarter Results," Microsoft Investor Relations, 01/18/10
7. ↑ Microsoft Reports Fourth-Quarter Results. Microsoft (2009-07-23). Retrieved on 07-24-2009.
8. ↑ "Microsoft," Morningstar Investment Research
9. ↑ Microsoft Annual Report 2008 - Item 1 - Page 4
10. ↑ Windows 7 Keeps the Good, Tries to Fix Flaws (October 21, 2009).
11. ↑ "Microsoft Sells Seven Win 7 Copies Per Second," InformationWeek, 06/24/2010
12. ↑ Microsoft Annual Report 2008 - Item 1 - Page 5
13. ↑ Microsoft Annual Report 2008 - Item 1 - Page 6
14. ↑ Microsoft Annual Report 2008 - Item 1 - Page 5
15. ↑ Microsoft Annual Report 2008 - Item 1 - Page 7
16. ↑ "Microsoft to launch smaller Xbox 360 game console," VentureBeat, 06/14/2010
17. ↑ "E3: Microsoft Shows off Gesture Control Technology for Xbox 360," Los Angeles Times, 06/01/2010
18. ↑ "Microsoft to sell Kinect motion-sensing system for $149," VentureBeat, 07/20/2010
19. ↑ ^{19.0 19.1} "Verizon misses the point of the Kin, prices it out of its market," MobileCrunch, 05/05/2010
20. ↑ MSFT 2008 10-K pg. 6,7
21. ↑ "Microsoftie: We didn’t like the Kin, either," MobileBeat, 7/7/2010
22. ↑ "Microsoft Kills New Kin Phone After Only Two Months," 24/7 Wall St., 06/30/2010
23. ↑ Gartner: SaaS Market Heats Up. eBiz.com (2006-08-28). Retrieved on 06-28-2009.
24. ↑ What is SaaS(Software as a Service). Interop NY. Retrieved on 06-28-2009.
25. ↑ "Software Piracy on the Internet: A Threat to your Security," Business Software Alliance, October 2009
26. ↑ MSFT 2008 10-K pg. 22  
27. ↑ "Microsoft Demos Cross-Platform Game on Xbox, Windows, and Windows Phone 7," VentureBeat, 03/06/2010
28. ↑ [1]
29. ↑ "Microsoft-Yahoo Search Deal Approved," BBC News
30. ↑ "New Xbox Consoles Can’t Move Microsoft’s Stock," Trefis 09/22/2010