3 Downside Scenarios for Microsoft’s Windows OS

+0.39%
Upside
417
Market
419
Trefis
MSFT: Microsoft logo
MSFT
Microsoft

Microsoft (NASDAQ:MSFT) has been the dominant player in the PC operating system market with little competition from Apple’s (NASDAQ:AAPL) Mac OS and Open Source software companies like Red Hat and Novell that support Linux distributions. Google’s (NASDAQ:GOOG) Chrome OS, which is expected to launch in early 2011, will also be based on Linux.

We estimate that Microsoft’s Windows operating System constitutes around 41% of the $31.56 Trefis price estimate for Microsoft’s stock, which is about 18% above the current market price.

Last week we examined a bullish scenario – the upside to Microsoft should the PC market be able to sustain its recent growth trends. (See Microsoft 30% Upside if PC Growth Maintains Current Trend.) We currently estimate a growth rate of roughly 10% for global notebook and netbook units sold going forward, implied by our price estimate that currently stands about 18% ahead of market value. Should market growth instead continue at the 24% annual pace established between 2006 and 2009, there could be an additional 30% upside to our estimate.

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Here we consider a bearish case, the potential downside for Microsoft’s PC operating system given increased competition and the threat of piracy. We examine 3 factors — market share, pricing, and profit margins.

(-5%) – Market Share Loss

Microsoft has so far been able to maintain a high share of around 75% in the PC operating system market. Windows 7, which was launched in October 2009 was a success and received better reviews than Windows Vista.

Going forward, Microsoft faces rising competition from large players like Apple, with its Mac OS, and Google, expected to launch its Chrome OS in early 2011.

Microsoft also loses a significant amount of business through piracy. Although the company has started to improve its anti-piracy efforts, particularly in emerging markets like China and India, [1] the benefits to these efforts could be gradual. There could be a downside of more than 5% to the $31.56 Trefis price estimate for Microsoft stock if the company’s anti-piracy effort does not materialize and rising competition cause market share to decline to 60% by the end of Trefis forecast period.

(-7%) – Windows Pricing Pressure

We believe that increased penetration of emerging markets and demand for slimmed-down versions of Windows for netbooks will drive a shift from premium versions to lower-priced editions in the years ahead. We forecast that the average price for Windows for PCs will decline from around $61 today to around $53 by the end of our forecast period. However, increased competition could pressure prices further and add downside to market share estimates beyond our forecasts. If average prices for Microsoft OS declines to about $40 by 2017, our price estimate could see 7% downside.

(-5%) – Windows OS Operating Margin

We currently project that Windows OS operating margin, the amount of revenues that flow through to company profit after operating costs are removed, will remain roughly in line with estimated 2010 levels of 64% going forward. However, increased competition and pricing pressure could hinder margins in the years ahead, as the current overflow of revenues beyond operating costs declines. A gradual 10% decline in operating margins during our forecast period beyond our current forecasts would imply 5% downside to our estimates.

Should these three scenarios materialize, our price estimate would decline to roughly $27 (vs. current $31.56), just ahead of current market value. The contribution of Windows Operating System to Microsoft’s stock value would also decline to about 19%, vs. the current estimate of 41%.

You can see the complete $31.56 Trefis Price estimate for Microsoft stock here.

Notes:
  1. According to a New York Times report []