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Microsoft Corporation (NASDAQ: MSFT) is the world's largest software maker by revenue, and the company's $60.42 billion in 2008 was an 18% increase over 2007.^[1] 80% of Microsoft's revenues come from sales of Windows, Office, and Server & Tools (used by IT professionals to manage groups of users), but while revenue from these products is steady, it is slow-growing, at a 15% percentage change in revenue year over year. In contrast, Microsoft's Online Services and Entertainment divisions had as compared to the over 30% year over year growth in 2007, and the company has sought to emphasize these divisions in its future plans.^[2][3]

Microsoft made headlines with a bid for Yahoo! for $44.6 billion or $31 per share in early 2008. The internet advertising industry is rapidly growing, with revenues in the first nine months of 2007 up nearly 26 percent compared to the same period in 2006. Unfortunately for Microsoft, Google has dominated this business thanks to its advantage in search, where it controls 62% of the market.^[4] Online ads made up just 5% of Microsoft's 2007 revenue and the division took a loss of $576M^[5], but a combined MS-Yahoo! could help significantly as the merged company would have held 29 percent of the 2007 search market, according to Neilsen.^[6]

While Microsoft plays David to Google's Goliath in search, it also finds itself fighting off challenges from a number of upstart competitors in its traditional software business.^[7] The software as a service (SaaS) market directly challenges the PC-based software market and represented approximately 5 percent of total software industry revenue in 2005; by 2011 Gartner, Inc. projects that it will represent 25 percent of new business software.^[8] Microsoft's newest Office version will offer online versions of Word, Excel, PowerPoint presentation software that can be managed and edited on a normal desktop computer, a Web browser or a mobile phone.^[9]

Contents 1 Business Overview 1.1 History 1.2 Products and Service Offerings 1.3 Financial Analysis 1.3.1 Earnings for Fourth Quarter 2008 2 Trends and Forces 2.1 Slowing Rates of PC Growth 2.2 Software as a Service Threatens Microsoft's Long Term Business 2.3 Focus on High-growth businesses: Web Services and Entertainment 2.4 Piracy Risks 2.5 Antitrust risks 3 Competition 4 References

[edit] 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.^[10]

[edit] History

Co-founded in 1975 by Bill Gates and Paul Allen, Microsoft Corporation began to dominate the computer industry with its 1992 introduction of the Windows 3.1 operating system. In following years, the highly successful releases of Windows 95 and 98 consolidated this lead, as did warm receptions of 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 come from the pockets of private individuals, and Microsoft is a common name both at home and work.

[edit] Products and Service Offerings

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

• Client (28% of revenue and 45% of income^[12]): 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.^[13] A recent version of the Windows operating system, Windows Vista, released in fiscal year 2007, includes advances in security, digital media, user interfaces, and other areas that enhance the user and developer experience.

• Server and Tools - Products for IT Professionals (22% of revenue and 16% of income^[14]): 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).^[15]

• Business (32% of revenue and 42% of income^[16]): 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. ^[17]

• Online Services (5% of revenue and -4% of income^[18]): 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.^[19] 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^[20]): 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).^[21] 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.^[22]

Of these divisions, the highest earners by far 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 far second. The table below shows revenue breakdown by segment (in millions) and their perspective percentages of Microsoft’s total revenue for 2008.

[edit] Financial Analysis

Revenue growth was driven primarily by increased licensing of the 2007 Microsoft Office system, increased Xbox 360 platform sales, increased revenue associated with Windows Server and SQL Server, and increased licensing of Windows Vista. Foreign currency exchange rates accounted for a $1.6 billion or three percentage point increase in revenue during the year.^[24]

Operating income increased primarily reflecting increased revenue, partially offset by increased headcount-related expenses (increase of 12%), increased costs for legal settlements and legal contingencies ($1.8 billion of legal charges during the year primarily related to the European Commission fine of $1.4 billion), and increased cost of revenue (increase of 8%). At right is a graph detailing Microsoft's Revenue (in millions) and Operating Income as a percentage of total Revenue for the years 2006, 2007, and 2008:^[25]

Revenue increased in each of Microsoft's five segments:

• Client revenue increased reflecting growth in licensing of Windows Vista, with more than 180 million sold in fiscal year 2008.^[26]
• Server and Tools revenue increased from growth in volume licensing of Windows Server and SQL Server products. Also notable is a boost from foreign currency exchange rates of $464 million or four percentage points.^[27]
• OSB revenue increased as a result of increased online advertising revenue from $553 million to $2.3 billion (31%), attributable to a growth in Microsoft’s existing online advertising businesses and a $161 million additional revenue from aQuantive. However, this increase in revenue was coupled by a cost of revenue increase of $796 million or 71%, from increased data center and equipment costs, online content expenses, and aQuantive-related expenses, resulting in an overall loss of income.^[28]
• MBD revenue increased reflecting growth in licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of $724 million or four percentage points.^[29]
• EDD revenue increased $1.7 billion or 41% as a result of increased Xbox 360 console sales, video game sales led by Halo 3, Xbox Live revenue, and Xbox 360 accessory sales. Microsoft shipped 8.7 million Xbox 360 consoles during fiscal year 2008, compared with 6.6 million Xbox 360 consoles during fiscal year 2007.^[30]

[edit] Earnings for Fourth Quarter 2008

Microsoft reported earnings for its fourth quarter of FY2008 on July 17, 2008. The company earned $15.84 billion in revenue, barely missing analysts estimates for the quarter and as a result shares fell over 6%.^[31] For the fiscal year 2008, Microsoft reported revenues of $60.42 billion, an increase of 18% over 2007. The earnings results for the fourth quarter signaled to investors that the major technology companies, including Google and Yahoo!, are also susceptible to weak market conditions.

[edit] Trends and Forces

[edit] 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.^[32] A slow-down in PC purchases in most developed countries means a decrease in profit growth for Microsoft as well. However, while PC sales in developed countries are in decline, Gartner predicts that Worldwide PC sales will increase almost 11 percent in 2008 over 2007 due to strong growth in emerging markets in Asia and Latin America - and with approximately 95% of the total market share in PC operating systems, Microsoft's revenues will increase with this growth.^[33]

[edit] 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. ^[34]Although shareware, open-source, or low-cost alternative software (like Google Spreadsheet and Writely) 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. ^[35]

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.

[edit] 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. ^[36] aQuantive had an online advertising revenue of $161 million and a total revenue of $345 million in 2008.^[37]

In Entertainment, Microsoft's most successful device is the Xbox 360. 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.^[38]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.^[39] 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.^[40]

[edit] 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.^[41] 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.

[edit] 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 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.^[42]

[edit] 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.

	Gross Rev. ($M)			Market Share
	2005	2006	2007	2005	2006	2007
Microsoft (MSFT) (advertising revenues only)	1,500	1,600	2,000	8%	7%	6%
year over year growth		19%	31%
Google (GOOG)	6,000	10,500	16,400	32%	43%	51%
year over year growth		73%	56%
Yahoo! (YHOO)	4,600	5,600	6,500	25%	23%	21%
year over year growth		22%	18%

Source: Company Data^[43], ^[44], ^[45]

• 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).

[edit] References

1. ↑ Microsoft Annual Report 2008 - Item 7 - Page 22
2. ↑ Microsoft Annual Report 2008 - Item 1 - Page 6-7
3. ↑ Microsoft Annual Report 2008 - Item 1 - Page 23-27
4. ↑ Releases April 2008 U.S. Search Engine Rankings – May 22, 2008
5. ↑ - Internet Advertising Revenues in Q3 ’07 Surpass $5.2 Billion, Setting New High - November 12, 2007
6. ↑ comScore Releases April 2008 U.S. Search Engine Rankings – May 22, 2008
7. ↑ http://www.reuters.com/article/rbssTechMediaTelecomNews/idUSN2841811520081028?pageNumber=1&virtualBrandChannel=10339 UPDATE 1-Microsoft says next Office suite will go on the Web - October 28, 2008
8. ↑ SaaS market&hl=en&ct=clnk&cd=1&gl=us Gartner: SaaS Market Heats Up - August 28, 2006
9. ↑ http://www.reuters.com/article/rbssTechMediaTelecomNews/idUSN2841811520081028?pageNumber=1&virtualBrandChannel=10339 UPDATE 1-Microsoft says next Office suite will go on the Web - October 28, 2008
10. ↑ 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
11. ↑ Microsoft Annual Report 2008 - Item 7 - Page 23 - 27
12. ↑ Microsoft Annual Report 2008 - Item 7 - Page 23 - 27
13. ↑ Microsoft Annual Report 2008 - Item 1 - Page 4
14. ↑ Microsoft Annual Report 2008 - Item 7 - Page 23 - 27
15. ↑ Microsoft Annual Report 2008 - Item 1 - Page 5
16. ↑ Microsoft Annual Report 2008 - Item 7 - Page 23 - 27
17. ↑ Microsoft Annual Report 2008 - Item 1 - Page 6
18. ↑ Microsoft Annual Report 2008 - Item 7 - Page 23 - 27
19. ↑ Microsoft Annual Report 2008 - Item 1 - Page 5
20. ↑ Microsoft Annual Report 2008 - Item 7 - Page 23 - 27
21. ↑ Microsoft Annual Report 2008 - Item 1 - Page 7
22. ↑ Microsoft Annual Report 2008 - Item 7 - Page 21
23. ↑ Microsoft Annual Report 2008 - Item 6 - Page 20
24. ↑ Microsoft Annual Report 2008 - Item 7 - Page 22
25. ↑ Microsoft Annual Report 2008 - Item 7 - Page 22
26. ↑ Microsoft Annual Report 2008 - Item 7 - Page 24
27. ↑ Microsoft Annual Report 2008 - Item 7 - Page 25
28. ↑ Microsoft Annual Report 2008 - Item 7 - Page 26
29. ↑ Microsoft Annual Report 2008 - Item 7 - Page 27
30. ↑ Microsoft Annual Report 2008 - Item 7 - Page 28
31. ↑ "Google, Microsoft Slide; Earnings Show Falling Demand (Update4)", www.bloomberg.com, July 18, 2008.
32. ↑ Microsoft Annual Report 2008 - Item 1 - Page 6-7
33. ↑ 11% PC Growth For 2008: Gartner - March 25, 2008
34. ↑ SaaS market&hl=en&ct=clnk&cd=1&gl=us Gartner: SaaS Market Heats Up - August 28, 2006
35. ↑ - Interop NY 2008: What is SaaS (Software as a Service)? - October 3, 2008
36. ↑ [Microsoft Pays $6 billion for aQuantive: Massive Ad Network Consolidation Is Occuring - January 12, 2008]
37. ↑ Microsoft Annual Report 2008 - Item 7 - Page 26
38. ↑ [1]
39. ↑ sales of the wii, xbox, and playstation&hl=en&ct=clnk&cd=6&gl=us Nintendo Wii Sales Trounce Xbox 360, PlayStation 3 - April 18, 2008
40. ↑ Xbox 360 division quarterly revs surge 68 percent - April 24, 2008
41. ↑ Microsoft to describe anti-piracy campaign - Oct 20, 2008
42. ↑ Microsoft Annual Report 2008 - Item 7 - Page 22
43. ↑ Microsoft Annual Report 2008 - Item 7 - Page 26
44. ↑ Google Annual Report 2007 - Item 7 - Page 44
45. ↑ Yahoo Annual Report 2007 - Item 6 - Page 37
46. ↑ ^{46.0 46.1} ADBE, 2007 10-K, Item 8, Pg. 75
47. ↑ AAPL, 2007 10K, Item 1, page 11
48. ↑ MSFT, 2007 10-K, Item 8, Pg. 40
49. ↑ ORCL, 2007 10KSB, Item 15, Page 68
50. ↑ ORCL, 2007 10KSB, Item 7, Page 38
51. ↑ ^{51.0 51.1 51.2} SAP, 2006 20-F, Item 17, Pg F-2

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