2 Microsoft Concerns That Could Deflate Our Enthusiasm

Microsoft (NASDAQ:MSFT) dominates the markets in which it competes, in particular the operating systems where Windows has 75% PC market share and the business productivity market where Office has 95% share by our estimates. Microsoft competes with Apple (NASDAQ:AAPL) and open source players like Red Hat (NYSE:RHT) and Novell (NASDAQ:NOVL) that support Linux distributions in operating systems and Google’s (NASDAQ:GOOG) Apps suite of products, Adobe (NASDAQ:ADBE), IBM (NYSE:IBM) and Oracle (NASDAQ:ORCL) in business productivity. ^[1]

Our current $31.66 Trefis price estimate for Microsoft stock is about 16% higher than the current market price.

Here we explore the downward scenarios of operating margins for Microsoft’s OS and Office businesses, which would justify the current market price and put a wet towel on our view that additional upside exists. At the heart of this issue is the dual impacts of pricing pressures and greater competition which could challenge market share.

10% Downside – Microsoft OS Struggles to Tap Mobile Boom

Microsoft OS’ operating margins have declined from around 79% in 2007 to around 66% in 2010, and we expect it to continue to decline to around 59% by the end of Trefis forecast period. The margins have declined as average OS license pricing has suffered given the company’s expansion into emerging markets and due to lower priced netbooks for which Microsoft sells a cheaper OS license. We expect these trends to continue in the future in addition to the growth in other mobile devices like smartphones and tablets which could weigh on margins in the future.

If Microsoft’s push into new mobile devices doesn’t gain the traction envisioned, this could hurt profitability as the company has invested in these markets. We mentioned some of these issues in a recent note titled Microsoft’s Tablet Headwind Could Hurt Its Stock. According to IDC, the tablet market is expected to grow quickly with unit sales increasing from 17 million in 2010 to 71 million in 2012 and presents a large opportunity. ^[2]

There could be a downside of 10% to our estimate for Microsoft stock if Microsoft OS’ margins decline to around 44% by the end of Trefis forecast period.

See our full analysis and $31.66 price estimate for Microsoft

7% Downside – Microsoft Office Margins Decline Beyond Expectations

Microsoft Office operating margins have declined from around 67% in 2007 to around 61% in 2010, and these could continue to decline to around 54% by the end of Trefis forecast period. Last year, Microsoft released Office web apps, a cloud-based software, to compete with Google Apps, and we discussed some of the challenges in for this product in a note titled Microsoft’s Stock Could Lose $2 if Office Margins Decline to Google App Levels.

Under the cloud-computing model, Microsoft would store Office programs on its own servers and deliver them to customers online. Although this is more cost effective for its customers, cloud-based Office software will cost Microsoft more when compared to supplying software that is installed on the computers and servers of customers. If Microsoft willingly ends up cannibalizing some of its own business productivity products, it could be due to fears that competition and mobile apps are a serious threat to its business long-term and would pressure margins anyway.

In this scenario, its margins could suffer even more that our current forecast. There could be an additional downside of 7% to our estimate for Microsoft stock if Microsoft office margins declines at a faster reach to reach around 44% by the end of Trefis forecast period.

While these two scenarios are more pessimistic than our current forecast, they could help explain some of the discrepancies between the market price and our price estimate, and it could highlight some potential sources of downside risk should circumstances deteriorate further than the ones outlined here.

1. Microsoft operating segments report for 2010 [↩]
2. IDC tablet market report, January 2011 [↩]