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Investment Overview for Microsoft (NASDAQ:MSFT)
Below are key drivers of Microsoft's value that present opportunities for upside or downside to the current Trefis price estimate for Microsoft:
Windows Operating System
- Microsoft's Market Share of PCs: We currently forecast Microsoft's market share of PCs to decrease slightly to approximately 73% by the end of the Trefis forecast period. We believe that the new version of Windows - Windows 8 - will see at least as many license sales as Windows 7. There could be a downside of more than 5% to the Trefis price estimate if our forecasts fail to materialize, and Windows market share declines to 53% by the end of our forecast period. Other factors that could contribute to a decline would be the popularity of competing OS's such as Apple's Mac OS X, Google's Chrome OS, and Linux.
- Global Notebook & Netbook market: We conservatively forecast global notebook and netbook market to increase from around 221 million in 2012 to 290 million by the end of the Trefis forecast period, an average growth rate of around 4%. This growth is much less than the average growth of 24% achieved in the past few years. We believe the primary reason for this slow growth will be the advent of tablets, which could cannibalize sales of low cost notebooks and netbooks. However, there could be an upside of more than 10% to the Trefis price estimate if the notebooks & netbooks market grows to 550 million by the end of our forecast period.
- Windows OS Operating Margin: We currently forecast Windows OS operating margin to decline from about 59% in 2012 to nearly 54% by the end of the Trefis forecast period. Although the growth in netbook sales has increased Windows license sales, it has lowered the average license pricing, as netbook OS licenses are typically much cheaper than notebook or desktop licenses. This has caused margin declines in the past. However, the increasing popularity of premium ultrabooks could boost the average Windows license pricing, and thus its margins. There could be an upside of 5% to Trefis price estimate if it is able to maintain its margins at around 64% in future.
- Microsoft Share of Productivity Software market: We currently forecast Microsoft's market share of Productivity software to decline from about 94% in 2012 to 92% by the end of the Trefis forecast period. We believe that increasing competition from cloud computing players like Google could cause market share declines. However, Microsoft has released Office 365, a web-based version of its Office productivity suite to better compete with Google. There could be an upside of more than 1% to the Trefis price estimate if Microsoft is able to maintain its market share throughout. However, if Google is able to capture large market share at the expense of Microsoft, there could be a downside of 2% to the Trefis price if Microsoft's market share declines to 85% by the end of Trefis forecast period.
- Microsoft Office Operating Margin: We currently forecast Microsoft Office operating margin to decline from about 66% in 2012 to nearly 60% by the end of the Trefis forecast period. The margin decline is primarily due to the introduction of lower priced Office 365, as well as the increased cost of operating it. There could be a downside of approximately 10% to the Trefis price estimate if its margins decline to around 40% by the end of Trefis forecast period.
Microsoft makes money primarily through the sale of business productivity and operating system software. Microsoft's business productivity software suite, known as MS Office, is used for word processing, spreadsheet preparation, presentations and email. MS Office is sold primarily to businesses worldwide. Microsoft's operating system software, known as Windows, is sold primarily to PC manufacturers (such as Dell, HP, Acer), which sell Windows-based PCs to consumers and businesses.
In May 2011, Microsoft agreed to acquire Skype Global for $8.5 billion in cash. This acquisition is the largest ever done by Microsoft. Skype is an internet phone company that enables phone calls to be made through internet for free or for a nominal charge. We believe Microsoft can use Skype to strengthen its enterprise, search and mobile businesses.
Microsoft could make use of Skype by integrating its voice, video and sharing capabilities with Microsoft Office, as a way for businesses to improve collaboration. We think that Microsoft could leverage the large Skype user base to promote its search advertising business, Bing.
Microsoft will also benefit from the integration of Skype into its own mobile operating system - Windows Phone 8.
We believe Microsoft Office and Windows Operating System are the most valuable segments of Microsoft for the following reasons:
MS Office Has High Market Share
Microsoft Office has higher market share in the productivity market compared to the market share Windows OS has in the PC market. Even if users use Mac OS X over the Windows OS for their personal computing needs, Microsoft's Office Suite is still one of the best available productivity suites on the platform. Even as more competition enters the productivity software industry, we still think that Office is substantially better than competing products.
Windows Pricing To Decrease
Due to the large number of operating systems in the industry, along with the advent of tablets computers, we think that Windows pricing for PC makers will decline from $55 to $48 per license over our forecast period. While Microsoft Office also faces stiff competition, we think that the overall growth in the global productivity software market will keep the MS Office revenues stable despite falling prices.
Threat of Google Docs to Eat Into Office Margins
Microsoft Office operating margins were around 66% in 2012. Microsoft released Office 365, a cloud-based software, to compete with Google Apps. 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.
Microsoft faces headwinds in tablet market
Microsoft launched the next version of Windows - Windows 8 - in 2012 which works on notebooks as well as tablets. The company's new release, the Surface tablet has been hit with negative reviews. Since the competitive tablet industry has already established products such as the Apple's iPad and Google's Android tablets, Windows 8 faces strong headwinds as it tries to increase market penetration.
Nokia partnership could benefit Microsoft
Microsoft announced a strategic partnership with Nokia in 2011 in which Nokia will adopt Windows Phone 8 as the main operating system for its smartphones. In this arrangement, Microsoft is paying approximately $250 million per quarter to Nokia to carry its Windows OS.
The deal also stipulates that Microsoft's Bing search will power Nokia’s smartphones and Nokia’s app store will be integrated with Microsoft marketplace. Nokia has a large presence in emerging markets, which is also attractive to Microsoft.
Through the Nokia partnership, Microsoft not only stands to gain licensing revenues for its operating system, but also search advertising market share.
Windows Pricing / Market Share Threat from Emergence of Netbooks, Cheaper Laptops and Tablets
Netbooks and cheaper laptops took shape as a phenomenon in 2008 and have started to account for a increasingly larger proportion of the PC market since their launch. Netbooks are targeted towards price-conscious consumers and are used to primarily run web-centric applications like email and the Internet, where the OS requirements are light. This has lead PC OEMs to be more willing to look at lower- priced, reasonably capable alternatives to Windows, such as Linux. If cheaper laptops continue to be a bigger part of the PC mix, that trend will dilute either Microsoft's market share or its pricing and margins.
Microsoft will also target tablets with Windows 8. The license price for Windows 8 for tablets will likely be lower than the average Windows license pricing. This could lead to a further decline in Microsoft's Windows license pricing.
Growing Threat from Google Apps
We expect that Microsoft's Office suite will continue to experience challenges from hosted solutions like Google Apps, as well as open source alternatives, such as Star Office.
Increased Marketing of Microsoft's New Bing Search Engine
In June 2009, Microsoft unveiled its newly-positioned search engine called Bing. Microsoft is believed to have spent hundreds of millions of dollars on marketing and promoting Bing, which is primarily why its Online Services division continues to be in the red.
Piracy Remains an Issue
Piracy is an important issue for Microsoft as software piracy in emerging markets is particularly problematic. The problem is grave in China, as some of its biggest organizations (and some segments within government itself) use a large proportion of pirated software. For example, Microsoft estimates that 84% of the Office software and 97% of Windows server software used at China Railway Construction Inc. is pirated.
If the Chinese government fails to crackdown on these piracy issues, Microsoft will be left out of a lucrative Chinese market.
How Does Trefis Modelling Work?
How do we get the historical numbers for this chart?
Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.
Who came up with the Trefis forecast for future years?
The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.
How does my dragging the trendline on the chart impact the stock price?
- We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
- We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.
See more on: DCF Methodology
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