The worries about Microsoft's fiscal second quarter and fiscal 2009 are starting to pile up. While Microsoft is viewed as one of those recession resistant companies--no company is recession proof--the headwinds to the software giant's quarter are becoming clear.
On Thursday, Morgan Stanley analyst Adam Holt lowered his second quarter and fiscal 2009 estimates. When Microsoft reported its first quarter results it provided conservative guidance, but acknowledged that the tech spending outlook was fluid. In a CNET News interview Bob Muglia, Microsoft's server and tools chief, reiterated the company's conservative view.
Holt reckons that the PC market has unraveled since Microsoft CFO Chris Liddell delivered the company's outlook.
Holt isn't alone. Bernstein analyst Jeffrey Lindsay in a report zooms out and figures that netbooks provide a significant wild-card to Microsoft's business model on the consumer side of the equation. On the enterprise side, the biggest threat to Microsoft is software as a service. Add it up and Microsoft has some significant uncertainties ahead. Lindsay, however, thinks that the cloud computing as Microsoft killer argument is overrated. There will be a hybrid SaaS-software approach.
And as if PC demand, SaaS and other worries weren't enough Microsoft is facing tight IT budgets. Benchmark Brent Williams argues that corporate customers are likely to push back on enterprise licenses once they come up for renewal.
Add it up and Microsoft's estimates are falling fast on Wall Street. Williams shaved 6 cents a share of Microsoft's fiscal 2009 estimate to $1.99 a share. He cut his 2009 fiscal revenue estimate by $850 million to $64.6 billion.
Holt upped the ante. Holt expects fiscal 2009 earnings of $1.84 a share on revenue of $62.2 billion, down from his prior target of earnings of $2.02 a share on revenue of $64.4 billion. Wall Street is currently expecting Microsoft earnings of $1.99 a share fully reported on revenue of $64.7 billion. Holt said in a research note:
Microsoft hasn’t negatively preannounced since Dec ’00. However, business conditions have deteriorated since MSFT guided in Oct. and we believe the company could come up short of its FQ2 targets.
With that gloom and doom in mind let's examine the top concerns swirling around Microsoft.
The PC marketIf Intel and AMD see their quarters unraveling what are the chances that Microsoft won't be affected? Microsoft's business still depends on the PC market to be healthy. Holt writes: 2009 will likely see a material deceleration in PC growth and longer term it will be harder for revenue to outgrow PC units. IDC is already projecting anemic PC demand of 3.8 percent in 2009.
NetbooksThe good news is that the PC market does have one growth engine--netbooks. For Microsoft, that's also the bad news. To wit: Netbooks are often powered by Linux operating systems. Microsoft is using XP in netbooks with good success. The rub: Margins on XP and netbooks are lower than full-blown Vista laptops and desktops.
Microsoft acknowledges that it doesn't know how netbooks will impact its business, but that didn't stop Lindsay from making some educated guesses. Lindsay looks at Microsoft's operating system revenue as a whole--including Windows Mobile.
We believe that by 2012 approximately $850 million in revenues (or approximately 1% of Microsoft's expected 2012 revenues) will move to other operating systems and stacks – such as Linux, the iPhone and Android. While the shift to netbooks and mobile devices is significant, we estimate that the impact on Microsoft's operating system franchise will be of the order of $850 million (see Exhibit 20). While up to 30% of netbooks, we think, will choose Linux to keep costs down and another 20% will go for XP rather than Vista, the impact upon the installed base and the enterprise space we think will be limited. Typically, using XP over Vista represents a saving of $30 to a manufacturer who can also get away with less processing power. In the case of Linux, which is having something of resurgence thanks to netbooks, the savings can be greater (on the order of $55 per netbook) but gives a much less satisfactory user experience.
Here are Lindsay's figures (click to enlarge):
Office and business applicationsThe IT spending outlook for 2009 is anemic at best and ugly at worst. While Forrester is predicting weak IT spending in 2009 Citigroup is seeing Armageddon ahead with budgets falling as much as 10 percent to 20 percent. Citigroup analyst Ashwin Shirvaikar, who covers the services sector, notes:
Many buyers – especially in the financial services vertical – seem to be considering IT budgets that are lower year/year by as much as 10%-20%. This kind of a decrease is sharply lower than our CIO survey from September, which indicated that IT spend would be down sequentially, but still up ~1% year/year. To put this in perspective, we have had overall IT spending at flattish only once before – in 2002 – while all other years the IT budget has grown. Clearly the credit crisis and global economic slowdown – especially with sharply negative news-flow that coincided with the budget season – is a contributing factor. There are many ways to achieve this lower budget target, but reduced pricing is normally the one that gets the most attention.
You can expect Microsoft to win some business in a down market based on pricing, but it's likely that the software giant will get hit with some shrapnel.
The other wild-card: SaaS. If this downturn does push corporate buyers to SaaS, an applications model that appeals to bean counters, Microsoft's core could be threatened. Lindsay estimates that $3.6 billion (5 percent of Microsoft's projected 2012 revenue) will go to rivals pitching enterprise resource management applications enabled by SaaS.
Customer pushbackIn my view, one of the biggest things to watch in 2009 will be customer-vendor negotiations. Customers, who have been milked in the name of vendor revenue growth, are going to push back. Microsoft won't be any different, but is unlikely to see the degree of animosity that SAP is facing over maintenance price hikes.
We don’t believe the business from corporate customers on Enterprise Agreement term licenses will be able to throttle back the scope of those agreements or to demand price concessions on renewals at this point, which currently supports the revenue stream from the PC and Office franchises. If IT budgets are under pressure for longer than we think (we currently expect some modest recovery in software spend growth late in 2009, with full recovery trailing behind a global economic upturn by 2-3 quarters), it is possible that MSFT may face new price pressure on EA renewals than in the past, especially if Windows 7 is late or has quality issues.
Is there an online strategy?Analysts have two takes on Microsoft's online business. On one hand the online business is a throwaway--an unprofitable unit that's sort of a sideshow. Others worry that the online business will be a distraction from the real gravy train--Windows and Office.
My hunch: If Microsoft's other businesses slip the online business will face increasing scrutiny. After all, if Microsoft really thinks advertising will mix with its software strategy someday it better get going.