Microsoft’s Challenging Decade Ahead

A recent Gartner report estimates worldwide PC sales to grow 12% over the year to $245 billion. Microsoft (NASDAQ:MSFT) will be pleased with those numbers, but that does not change the fact that the company is facing stiff competition from Apple. Apple is slowly gaining PC market share: for the March-ending quarter it claimed 8% of the U.S. market share compared with 7.2% a year ago. I can vouch for this, having just completed a shift from PC to an elegant MacBook Pro, which delights me every moment. The PC did the exact opposite. It frustrated me every moment.

Google too is encroaching on Microsoft’s territory through its open source Office Apps and browser Chrome. Both are forcing Microsoft to look beyond and grow its addressable market by launching a series of new products and services.

For Q3, however, Microsoft’s revenues grew 6% over the year to $14.5 billion. EPS of $0.45 was significantly higher than previous year’s $0.33. The market was expecting revenues of $14.39 billion with EPS of $0.42.

The growth in revenues was driven by sales of Windows 7, which remains the company’s fastest-selling OS release. The Windows and Windows Live segment generated 30% of the Q3 revenue and reported 30% growth over the year. While the number of Windows 7 licenses sold to the consumer segment grew 35%, the enterprise markets were weaker with growth of only 15% over the year. Nearly 90% of netbooks use Windows and nearly half of them operate on Windows 7.

The Microsoft Business Division contributed 29% of revenue and reported growth of 6% over the year. The segment has seen good growth from the sale of Azure, Microsoft’s cloud-based platform. Microsoft began charging users to access Azure earlier this year. Azure offers computing services that run applications, storage services that store data, and helps to manage and monitor applications that use the cloud platform. Azure already boasts of a healthy and growing customer base and has added names such as Starbucks and McDonald’s to its list.

Microsoft released Office 2010 to the manufacturing sector this quarter. The new suite is expected to be in market release by June. It remains to be seen how the new Office will compete with Google’s open source applications. Microsoft is expected to offer an online component for its Word, Excel, and PowerPoint software to address the Google competition, but I doubt that will be enough. I have started using Apple’s Keynote presentation software, and it is infinitely better than PowerPoint.

The Server & Tools segment contributed a quarter of the company’s revenue, and sales grew 3% over the year. The Online Services business generated 4% of revenue and dropped 22% over the year. Bing continued to do well and reported an 11.7% share in the U.S. query market, compared with an 8.3% share when it launched last May.

The Entertainment & Devices segment is another area in which Microsoft is launching new products. For the quarter, segment revenues grew 6% over the year. However, Gaming revenues fell 4%, driven by a 12% reduction over the year in Xbox 360 console sales. Microsoft is already working on Project Natal to challenge the competition posed by Nintendo’s Wii to the Xbox. Microsoft’s product will offer a “controller-free” experience through a natural user interface using gestures, voice commands, and images.

In the Non-Gaming segment, revenues grew 14% over the year, driven by growth in the mobile segment. Microsoft is counting on Windows Phone 7 and the Kin phone to help drive growth, but it will be an uphill task. Windows Phone 7, which was reviewed publicly earlier this year to rave reports, is expected to be available by the end of the year. By that time, Apple will already have released its next iPhone, which could outshine the Microsoft OS.

Analysts also don’t expect the Kin Platform to deliver any market-shattering performance. Kin is not positioned to challenge the more expensive iPhone market, but Microsoft does hope to address users who are more interested in social networking and messaging features. Unfortunately, with Google’s Android already in the market, most manufacturers already offer feature phones at prices lower than the iPhone. Unless Kin comes with an exceptionally low price, I don’t see how it will really compete.

The stock is trading at $30.96, taking the market capitalization to $272 billion. Last week it touched a new 52-week high of $31.53. Apple and Google are growing their market capitalization as well. Apple was trading at $270.83 with a market capitalization of $246 billion and Google’s stock price of $544.50 has taken its capitalization to $173 billion.

For this decade, my bet is squarely on Apple and Google, since Microsoft is wrestling with a punishing market that has come to resent its long reign while producing below-average software, especially on the OS and usability fronts.