A relative of mine asked me this morning about whether or not they should buy Microsoft stock right now, based on a tip he received from an investment guy that “Windows 8 was a big update.” What follows is an edited version of my response, but first, a disclaimer.
Disclaimer: I’m not a financial advisor, I do not provide financial, investing, or legal advice. Anyone who buys or sells an investment based on my analysis deserves what they get: poverty. Also, I used to work at the ‘soft, and left on positive terms. However, it was a while ago—I’m sure things have changed signifigantly in the years that have passed since my departure. Also, there’s no way around it: this is a really long post. Grab some popcorn.
Microsoft’s fundimentals are as strong as ever, with a nearly unparalleled balance sheet– only Apple’s is better. Loads of cash, great margins, and an attractive P/E ratio. On a pure value basis, it’s a good stock, but by no means a slam dunk.
However, the question was not about Microsoft as a company, but about Windows, which is really only one leg of the three-leged stool that is Microsoft’s revenue and profit machine. (Office and Server are the others, while Xbox is only a little better than break-even but adds cache to the brand, giving them consumer mindshare.) Their online services hemorrages cash in an almost embarassing display of largesse funded by the three aforementioned stools. Everything else is a rounding error.
The Windows Business
The Windows business is huge and deeply entrenched– indeed, was declared a monopoly by antitrust officials in the U.S. and Europe for a reason: 95+% market share in the PC operating system market with nearly insurmountable barriers to entry. It costs billions to create a fully-featured PC operating system, but more importantly, there are extremely high switching costs for customers (especially businesses) wishing to jump ship. A company wanting to switch from Windows to another OS would have to replace all their application software (which is way more costly than the OS) as well as retrain users, deploy new machines and infrastructure, etc.
Despite that, Apple has made inroads, though really only in the consumer space. They’ve gone from 1–2% market share in PC OS’s to around 10% (as high as 20% in some markets) despite the enormous advantages Microsoft has as the incumbent monopoly. However, doing so took almost 15 years: Microsoft was essentially leaking about a half a percent per year of market share to an incredibly strong competitor with unlimited funds, an excellent product, and the second most valuable brand in the world. Pretty impressive.
What I’m saying is that Windows— and the PC Operating System monopoly— has proven to be a highly stable and lucritive asset. It makes a nice, steady income regardless of what happens. To illustrate, Windows Vista was widely panned as a complete failure, and was universally disliked. Windows 7, on the other hand, was widely viewed as an enormous success and is loved by consumers and businesses alike. Despite this wide divergence, they both made essentially the same amount of money. The reason? People don’t buy Windows, they buy computers. When they buy a computer, it has the current version of Windows on it.
How good or how bad the current version of Windows is perceived to be is essentially irrelevant to how much market success and money it will generate. In the short run (2–3 year time horizon) it makes essentially no difference, though in the longer run (5–10 years) it can result in very slow erosion, and allows companies like Apple to pick up steam.
Businesses did not adopt Windows Vista– they stayed with the previous version, Windows XP. When Windows 7 came out (and was excellent) businesses finally started upgrading in huge numbers. However, Microsoft’s revenues were stable throughout this. Microsoft made essentially the same money whether you buy Windows XP, Windows Vista, or Windows 7. Microsoft’s monopoly in desktop operating systems is secure, and isn’t going anywhere. However, how valuable of a market is that in the long run? Microsoft may have an essentially constant piece of a shrinking pie.
Enter Windows 8
Technology pundits describe this decade as the beginning of a “post PC era.” There is a shift away from the traditional PC (desktop, laptop) towards tablets like the iPad and increasingly powerful smart phones. Mobile is king, and the PC is a declining empire.
Though most people are buying tablets today as secondary “companion” devices in addition to their PCs, it’s clear that this is temporary. Over the next 5–10 years you can expect to see the sales of PCs decline, offset by coresponding increases in the sales of mobile coputing devices like tablets and smart phones. More and more people will be able to meet their daily computing needs with a tablet and/or phone, and sales of PCs will dry up to a trickle. There will always be people who need the more powerful PC, but they will be the 10% case. Microsoft sees this happening, and Windows 8 is their response.
Windows 8 is a tablet operating system, not a PC operating system. It’s Microsoft betting big on establishing a beechead in the post-PC era, trying to make PCs and tablets merge rather than one replacing the other. It’s a big bet, and it’s a smart bet. However, it’s an enormously ambitious technical challenge, and the realities of schedules forced them to compromise. Windows 8 is, to a huge degree, unfinished.
If you buy a new tablet with Windows 8 on it (or a tablet with Windows RT, the version for devices with mobile processors— don’t get me started on that quagmire) you will likely be pretty happy with it. The new user interface, whch was codenamed “Metro,” is beautiful, elegant, and truly innovative. It’s honestly one of the best things Microsoft has ever done… but lurking behind it is good old fashioned Windows.
This Jekel and Hyde personality is not unlike the first Windows PCs back in the late 80s and early 90s when Windows was a thin façade on top of DOS. Likewise, Windows 8’s Metro user experience is a thin, beautiful façade on top of Windows. Inevitably, you wind up piercing this façade and having to go back to the old desktop, and experience that is jarring and confusing for new users.
If you put Windows 8 on an existing PC (or buy a new PC with an old-school desktop/laptop form factor) you will almost certainly not be happy. It’s an awful experience: the system is clearly designed for tablets with touch screens. Though it technically works with a tradional mouse and keyboard, it doesn’t work very well.
We’re in a risky transitional period for Windows. Many experienced users will dislike it ”What the hell is this Metro crap? Why isn’t there a start menu?” Novices will love the new stuff, but be thrown off by the mixed metaphor and complexity of the two environments.
Businesses will not buy Windows 8. They’ll stick with Win7 (Again, Microsoft doesn’t care– they get paid either way.) Indeed, it’s this very dynamic that enabled Microsoft to make such a bold move with Windows 8.
Cut to the chase…
Bottom line, Windows 8 is a big gamble. It’s hard to know how this will play out. The operating system itself is a real mixed bag– beautiful, elegant Metro, combined with the same old deskop minus the start menu. It doesn’t work all that well on laptops and desktops, but it allows Microsoft a foothold on tablets.
Their new strategy seems to be to double down on the money hemoraging online services business unit, go with their tablet-first Windows 8 strategy to protect the Windows franchise and keep the market from evolving away from them, and keep Server and Office basically humming along as-is for now. The new component is that they are building hardware (the first product being their Surface tablet) which is a very risky move, frought with possible anti-trust concerns, to say nothing of the potential to alienate of their partners.
Speaking of alienation, the split between Windows 8 and Windows RT is going to alienate a lot of customers because Redmond did a lousy job of explaining it. (It’s beyond the scope of this post, but suffice it to say RT is the future, but we live in the present… and these two products look and feel identical, but are incompatible.)
Is Microsoft a good speculative bet? Maybe. Is it a safe bet? Far from it. They are in the most precarious position in the post-Windows 95 history of the company.
And they pushed the most effective and brilliant (though widely hated) executive out the door without a solid bench to replace him.
I wouldn’t put my money in MS stock right now, but I wouldn’t bet against them either. Microsoft is living in “Interesting Times” in both the “chinese curse” and positive sense.
Oh… the real loser in the whole shift from PC to tablets and phones: Intel. The winner: ARM Holdings.