Microsoft Needs To Deliver Some Good News On Windows 8

Microsoft (NASDAQ:MSFT) is set to announce its Q2 FY 2013 earnings on Thursday, January 24. The company had posted disappointing numbers last quarter as weak PC demand hit its Windows division. Overall, revenues declined to $16 billion during the quarter, down from $17.3 billion in Q1 FY12. Operating income also fell by approximately $2 billion to $5.3 billion in Q1 FY13.

After last quarter’s dismal earnings, the focus this quarter will be on the Windows business. The division saw its vocal head Steven Sinofsky being ousted and replaced with two new executives. Regardless of what went on with the management, the key metric that investors should be focusing on is overall Windows 8 sales and revenues. Tami Reller, the new Windows head, stated that Microsoft sold approximately 40 million Windows 8 licenses in the first month, and we will be closely watching the impact on revenues from these sales. Microsoft has bet big on the Windows 8 platform and its strength will be key for the firm going forward. See our complete analysis of Microsoft here

Windows 8 Sales Key

During Q1 FY13, Microsoft’s Windows revenues decreased drastically to $3.2 billion compared to $4.8 billion posted in Q1 FY12. This large decline in revenues was driven by the deferral of $783 million worth revenues due to Windows 8 pre-orders. These deferred revenues will be included in Microsoft’s Q2 earnings and should provide a boost.

Despite the negative numbers in Q1, we aren’t too concerned by the slowdown because we think that potential customers had deferred PC purchases due to the pending release of Windows 8. We think the decline in Widows OS sales during Q1 will be temporary and expect a slight increase in market share due to the Windows 8 release.

Windows’ market share is especially important since the company’s selling point going forward is the OS’ integration across mobile, tablet and PC interfaces. However, if Windows starts losing market share, it will not only have a downward impact on our price estimate but also hurt Microsoft’s chances to cross sell its other products.

Windows Server to Provide Growth

Microsoft’s Windows Server division has been one of its fastest growing divisions in the recent past. For example, revenue from server and tools grew 8% during Q1 FY 13 driven by SQL server growth. Overall, this division’s revenues in the coming quarters will hinge on the success of Windows Server 2012, which has been given high marks by critics for innovation. ^[1] We will be closely watching Windows Server sales as this division also has the potential to become a large cash cow like the Office and Windows divisions.

Besides being a growth driver, the server division is the key for Microsoft’s long-term prospects as it will help cross-sell other products. If a company uses the Exchange server, it has higher chances of using Windows-based PCs and will prefer that its employees have other Microsoft products such as the Windows Phone and the Surface tablet to ensure seamless compatibility. Therefore we think that if Windows Servers maintain their market share, it will drive PC and phone sales and help keep Microsoft’s overall business in good health.

Effect of Windows 8 on Bing Market Share

Although Bing has struggled to gain traction so far, Windows 8 could help provide a boost to the search engine’s market share. Bing is the default search engine on the OS, which has an effect on the choice of search engine used by customers, especially in tablet mode. Bing has done a good job with its Windows 8 app, creating a faster search experience with a new, easy-to-use tile interface, both of which improve its usability.

Even though Bing doesn’t contribute much to Microsoft’s value at present, we think its growth is key for an integrated experience on Microsoft devices. If Bing is able to gain market share from the recent momentum, it could gain a more formidable foothold in the lucrative search ads market.

We currently have a $41 price estimate for Microsoft, which is approximately 55% above the current market price.

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1. Windows Server 2012: RTM review, ZDNet [↩]