Windows 7 Breathes Life Into Microsoft

After having recorded a dismal performance in the past few quarters, Microsoft (NASDAQ:MSFT) seems to have gotten back some of its lost magic with the arrival of Windows 7. Competition has been slowly gaining ground in a market in which Windows is still dominant: Whereas Windows claimed 93% of the overall OS market in September, Mac and Linux were far behind with a mere 5.12% and 0.95% market share respectively. But, a year ago, Windows had 95% of the market, Mac 3.7%, and Linux 0.86%. With Google joining the OS race, it promises to be a defining period for the industry. Will Windows 7 give Microsoft back its lost course? Or will consumers move in ever greater numbers to the Mac?

For now, it is hard to see how changes in the industry will play out: Microsoft’s performance was driven by strong Windows and Xbox sales. Windows sales grew 4% over the year. This quarter, the company sold the highest number of Windows licenses, with September being the highest single month of Windows unit sales. The numbers are just going to improve with Windows 7 overcoming Vista’s issues of compatibility and speed. However, for the quarter, the Windows segment reported a revenue decline of 39% to $2.6 million as it deferred $1.5 billion revenue of Windows 7 sales to the current quarter.

Taking a wider view, Microsoft’s recently announced Q1 revenues fell 14% over the year to $12.92 billion but beat analyst expectations of $12.4 billion. EPS of $0.40 was also significantly higher than the street’s expectations of $0.32 and fell 18% over the year. The company’s margins are being helped by its controlling expenses by 10% over the year. The company reduced its headcount by 4% and has lowered costs per person and reduced marketing and vendor spending. During the quarter, Microsoft bought back stock worth $1.4 billion.

Microsoft is increasing its revenues by improving product mix. The company announced the shutdown of lower-priced products such as Windows Home Basic in a few countries and is offering only the higher-priced product, Windows Home Premium. It is also seeing some improvement within the lower-profit-earning netbook segment, where the users are moving away from the cheaper XP to the more expensive Windows 7. Netbooks contributed 12% of Microsoft’s PC sales in the quarter compared with an 11% contribution a quarter ago.

In other segments, Business division revenues fell 11% over the year to $4.4 billion. Revenues from the Entertainment and Devices division remained flat at $1.9 billion even as its profits doubled. Server revenues also remained flat at $3.4 billion with profits growing 23% over the year.

Microsoft is expanding its product range in these segments with the recently released Windows Server 2008 R2, which boasts of improved virtualization technology. During the rest of the year, the company is preparing to launch Windows Azure, the cloud computing platform, and by next year it will launch Office 2010 and Exchange Server 2010.

IDC estimates that the PC market is estimated to have grown 2% last quarter after several consecutive quarters of decline. While this is good news for Microsoft, the company is facing stiffer competition. Rival Apple grew a significant 17% in the quarter. Even though Apple has a much smaller share with only 7% penetration, the company is expanding its reach at a much faster pace than previously. To address the Mac’s growing presence, Microsoft opened its first brick-and-mortar retail store in Scottsdale, AZ. A second store is scheduled to open in Mission Viejo, CA, on October 29. This follows the opening of the company’s web store for the United States in November 2008.

Even as Microsoft celebrated this opening, online services continued to falter. Revenues of $490 million were 6% lower than the previous year despite the increasing market share of Bing. Bing is taking market share away from Yahoo!, with which Microsoft has already signed a big search deal. The division remained unprofitable as Microsoft continued to fund its competition with Google with not much success. I have pointed out that Microsoft could acquire a vertical search portfolio, an area in which Google is weak, and also expand more into Saas with by acquiring a company such as Concur. But Microsoft has not taken steps in either direction.

The company recently announced two deals with Twitter and Facebook that will allow real-time feeds of status updates into Microsoft’s Bing searches. Facebook boasts of 40 million daily updates with an audience of more than 300 million. Since Facebook users post for a closed user group, not all their feeds will be available on Bing searches. However, most of the feeds posted by Twitter’s nearly 54 million users are available in the public domain and will be updated on Bing search results. While Twitter has also signed a similar deal Google, Facebook has tied up only with Microsoft.

Microsoft is counting on Windows 7 to help people forget about Vista. The company had to spend nearly $300 million in a brand uplift campaign to address the fallout. Microsoft has tried to address users’ concerns about Vista. Unlike Vista, Windows 7 is compatible with most drivers and hardware and doesn’t seem to have setup issues. It also boots up and shuts down quickly and is 56% faster than Vista. Its success is critical to Microsoft’s vision of “seamless connectivity between the three screens [Internet, mobile and television] and the cloud.”

Owing to Vista’s problems, many users had preferred to stay with the older XP instead of upgrading. However, that is set to change with Windows 7. Vista already lost 0.2% of the market share in September while Windows 7 claimed 0.3% during the month. Vista managed a mere 19% of the overall market since its launch in January 2007. Compare that with XP’s 72% share garnered during its eight-year stint, and you understand the debacle that was Vista.

Vista had enabled competition to seep into the market. Apple fired one of the most commented-on salvos of the Apple–Microsoft OS war with its “I’m a Mac” commercials. Now, Google joins the battle with the launch of Chrome OS. Windows 7 is looking to address the competition by adding more user-friendly features such as faster local computer search, a new task bar, and the ability to have multiple documents opened and worked upon on the side.

Further, the standard version of the Windows 7 release is not as bulky as Vista and can even be uploaded onto a netbook. But this is another area of concern, with Google working on Chrome-based netbooks to be launched by 2010. Today, Microsoft claims 96% of the netbook market through XP. Chrome could be an aggressive challenger.

It is not just the netbooks that Windows 7 addresses. Microsoft will also be competing with the long-awaited Apple tablet, which may be released this winter. Microsoft is definitely looking at getting a first mover advantage in that space now by updating the enhancement for touch screen-based tablet PCs. Several manufacturers are also expected to launch their own PC-based tablet computers using Windows 7.

There is competition in the Web browser market as well, with Google’s Chrome already commanding more than 30 million users and 3.2% of the market. Apple’s Safari has a 4.2% share. While the numbers may look paltry compared with Microsoft Explorer’s 65.7% share, analysts are expecting Chrome’s usage to reach 10% by 2011. Google is counting on the growing trend of users preferring to use software online compared with Microsoft’s products, which reside on the machine.

The stock price has reacted favorably to the results and reached a 52-week high of $28.02, taking the company’s market capitalization to $250 billion.