Jefferies & Co. said investors are uncertain about Microsoft Corp.'s (MSFT) future in consumer technology and that they have chosen to discount all parts of the business until it becomes clearer what Microsoft’s competitive position in the key areas of tablets, smartphones and online search will be.
We recently hosted Microsoft for some investor meeting. Uncertain over Microsoft's future in consumer tech, investors seem to be discounting all parts of the business. While not ignorant about potential market share losses, we are more sanguine given its history of come-from-behind victories and early success in cloud, gaming and phones, said Katherine Egbert, an analyst at Jefferies.
Egbert said she is more sanguine about Microsoft’s future opportunities in consumer tech, having studied their history of come from behind victories and observing in a world in which dollars matter and value trumps image. Their early successes in cloud, gaming and smartphones reinforce her belief that investors are overly discounting Microsoft’s potential.
Egbert said it seems likely that Windows 8-based tablets, based on low-power ARM chips, become generally available in first half of calendar 2012. Recall that Microsoft announced Windows support for ARM-based chips from Nvidia (NVDA), Texas Instruments (TXN) and Qualcomm (QCOM) at the Consumer Electronics Show last month in Las Vegas.
Microsoft’s work to port the next version of Windows to ARM has been under way for more than 1.5 years, pre-dating last year’s Apple Inc.'s (AAPL) iPad debut. Microsoft also let it be known at CES that it plans to release the next version of Windows 24-36-months after the October 2009 introduction of Windows 7, i.e. sometime between October 2011 and October 2012. Egbert thinks the middle of this timeframe is probably most likely.
The next milestone for Windows 8 is likely to be the release of a beta version of the product. A typical beta cycle lasts 2-3 months, and is typically followed by a series of release candidates. The last release candidate typically turns into the Windows version that gets released to manufacturing (RTM). RTM to general availability (GA) of new hardware running new Windows is typically six weeks. The entire cycle from the first beta to GA is typically 6-8 months, Jefferies said in a note to clients.
While there are Windows 7 tablets currently available that offer touch-based input, they are inferior to the iPad since they don’t offer instant on, long battery life, nor the same breadth of applications. The introduction of front and back cameras, USB input, the ability to run Flash applications, and HDMI input are areas where the current line of tablets can be improved, although these features are likely to be incorporated into non-Windows tablets before Windows 8 debuts.
Egbert said although no specifics were offered that Microsoft intends to enable features in Windows 8 that can’t be matched by the iPad and other tablets. Egbert is unsure what these features might be, but long battery life even when paired with peripherals, stylus-based input, voice recognition, and a natural user interface ala Kinect are technologies that seem ready to go.
Egbert estimates that one-third of the development time for any new version of Windows is spent on writing the new code, while two-thirds is spent on testing the code and on support for peripherals.
The commentary and demonstration of Windows 8 at CES showed how far along the development process is, Egbert believes Microsoft is now firmly in the testing/logistics phase. Again, Egbert expects the next version of Windows to debut on a variety of devices in first half of calendar 2012. Egbert's estimates call for 10 percent to 12 percent PC growth per year for each of the next three years.
The near-term goal for Windows Phone 7 seems to be stabilization of recent market share losses for Windows, which over the past 5 years have fallen to range of 2.5 percent to 5 percent from more than 20 percent (source: Nielsen).
The 2 million Windows Phone 7 units that have been sold since the debut in October are a modest success, and have come in-line with previous internal expectations. While Egbert doesn't expect to see Windows phones regain 20 percent share quickly, there are several catalysts that seem to make share loss stabilization a reasonable short-term goal.
Egbert said Microsoft's management did not confirm or deny the recent chatter about Nokia Corp. (NOK) supporting Windows phones, although many investors seemed supportive of such a relationship.
Egbert expects Nokia as a channel for Windows phones makes a lot of sense for both parties, given Nokia’s steep market share losses to Android and Apple and what has been described to her (not by Microsoft) as the Finnish giant’s historic blindness to the value of mobile software and applications.
However, it seems unlikely to Egbert that Nokia would sign an exclusive agreement to resell only Windows, so it remains to be seen what type of deal, if any, materializes between the two giants. There have been press reports (Sunday Times) of Nokia’s plans to manufacture tablets under its own brand. A tie-in between Window-powered smartphones and tablets could give Microsoft a leg up over other competitors.
Online Search -- Bing
The overall goal in search is continue to gain market share from Google Inc. (GOOG). Bing is now up to about 12 percent organic share, and nearly 30 percent when the traffic from Yahoo! (YHOO) is added. Microsoft now serves the algorithmic search for Yahoo!’s American and Canadian properties, which represent the majority of Yahoo!’s traffic. Mexico, Brazil and other countries should roll in early this year.
Our checks indicate that Microsoft has cleaned up much of the spurious traffic Yahoo! allowed to flow through its engine. It is now challenged with convincing those advertisers who let their Yahoo! ad budget run down to renew their contracts with Microsoft, said Egbert.
Fortunately, most advertisers see value in having choice in determining the monetization of their online ads. Egbert said her checks also indicate that online ad rates have converged. On the flip side, the Online division is likely to continue to lose $100 million for the foreseeable future, as Microsoft has guaranteed Yahoo! about $200 million per quarter in payments for traffic alone. Extra money is spent on sales and engineering for the two platforms.
But more than this, Egbert sees Microsoft as being attracted to the high growth, high margins and high barriers to entry offered by online search, and she doesn't expect them to back down from committing several more years’ worth of profits from other areas of the business in pursuit of online search share.
Microsoft’s cloud efforts center on infrastructure and applications. Overall, the cloud solutions result in about 25 percent decline in costs for the customer and a steep ramp in revenue and profits for Microsoft vs the on-premises equivalent. Cloud-based delivery also dramatically cuts down on piracy, which is particularly prevalent at the low end of the SMB market and in emerging nations.
Microsoft's cloud offerings include: Office 365 : Office in the Cloud; SharePoint online; Lync unified communications via VOIP; Dynamics CRM Online; and Azure.
Egbert said a few investors asked about the recent departure of Robert Muglia, a Microsoft employee who most recently ran the Business Division.
Muglia’s upcoming departure is the latest in a string of executive exits over the past year at Microsoft that also includes Steven Elop, now the CEO of Nokia; Ray Ozzie, former Chief Software Architect; Chris Liddell, former CFO, now at GM; Robbie Bach, former president of Entertainment and Devices; and Brad Brooks who was most recently responsible for marketing Windows 7.
Egbert believes the turnover represents a mix of voluntary and involuntary exits. Large multi-national companies such as Microsoft often are seen by recruiters as a rich pool for management talent, so some turnover should be expected ala General Electric (GE).
Egbert doesn't think the most recent exits are indicative of the health of the various business units either: Entertainment and Devices Division for instance, has reported record growth and profits since Robbie Bach’s departure last summer.
Lastly, it’s important to note that Steven Elop left on good terms to go head Nokia. A good ongoing relationship with the cell phone giant could help Microsoft as it seeks to build a bigger mobile footprint, Jefferies said.
Through the first six months of fiscal 2011, Microsoft returned $12 billion in cash to shareholders, about $9 billion in share repurchases and about $2.5 billion in dividends. Egbert doesn't believe it’s a coincidence that they raised $2.25 billion in new debt last week after the repurchases and dividends were paid for.
Microsoft has long held a large majority of their balance sheet cash outside the US. Last week’s actions indicate that 25 percent is probably the threshold for the domestic cash that is freely available to be used for shareholder value. (24 percent = $12 billion spent out of $50 billion cash on the balance sheet.)
We expect management to continue to aggressively repurchase shares, particularly given the recent valuation, and to maintain a dividend that puts them in-line with the yield on the S&P index, said Egbert.