microsoft: mission impossible

Microsoft: Mission impossible

Published by Edison Investment Research

Three missions to achieve long-term growth.

Legacy businesses look under control…

...but the ecosystem needs a lot of work to make users love it.

Marketing and mobile turnaround needed to succeed in Missions 2 and 3.

Shares are attractive even if Missions 2 and 3 fail...

...with a valuation of $61.0 per share, it is safe to live in hope.

Dr Richard Windsor CFA +44 203 239 9904 [email protected]

Jeremy Silewicz +44 203 077 5704 [email protected]

June 2015

Microsoft | 2 June 2015 2

Mission impossible

Microsoft’s position is difficult but not impossible. Nadella’s mission, which we feel he has decided to accept, is threefold: 1) control legacy; 2) bring the ecosystem to life; and 3) merge Digital Work and Digital Life. Microsoft must reverse its share declines in mobile, make its ecosystems delightful and fix its marketing in order to succeed. Fortunately, we feel the shares of Microsoft are attractive even if it blows Missions 2 and 3.

Opening act – Nadella has already achieved what many thought was impossible, in flipping the culture of Microsoft on its head. From boardroom to water cooler, the company is aligned in realising that things have to be very different going forward.

Mission 1 – control legacy. Edison calculates that Microsoft has snuffed out the PC revenue time bomb by moving to business subscriptions. There is a long pay-back period but there will be more profit generated in the long run. Edison thinks that Microsoft has succeeded in this mission, moving the focus onto Missions 2 and 3.

Mission 2 – ecosystem. Microsoft’s position in Digital Work is very strong and it has a good portfolio of Digital Life services. However, the services need to be properly integrated in order to offer the seamless user experience that will win the hearts and minds of users. Microsoft must also reverse its market share losses in mobile as this is having a seriously negative impact upon its credibility in mobile. Progress so far in FY15 has been disappointing.

Mission 3 – Digital Life and Digital Work. Merging Digital Life and Digital Work seamlessly in a way that is both easy and fun to use is something that we feel only Microsoft has a real hope of achieving. This will create differentiation, allowing the company to monetise and improve profit growth. To succeed here requires Mission 2 to work, service integration at least as good as Google’s, and a turnaround in marketing.

Marketing – Edison thinks that Microsoft’s marketing is not nearly as effective as it should be. In the ecosystem, Microsoft is the challenger and hence it must explain to users why they should live their Digital Lives and Work with Microsoft. Simply telling users that it exists may have worked 20 years ago. It no longer does today.

Safe to live in hope – the good news is that Microsoft’s valuation is undemanding even if it fails to execute on Missions 2 and 3. Edison has used a combination of comparative valuation and DCF to arrive at a valuation of $61.0 per share based on success of Mission1 only.

This makes Microsoft attractive on just the basis of the success of Mission 1, where it is already showing excellent progress.

Microsoft


Contents Mission Impossible ............................................................................................................................................. 2 Introduction ......................................................................................................................................................... 4 Mission 1: Deal with legacy ................................................................................................................................ 5

PC Market ................................................................................................................................................... 6 Microsoft ..................................................................................................................................................... 7 PC product cycle ......................................................................................................................................... 9 Surface ....................................................................................................................................................... 9 Office and Office 365 ................................................................................................................................ 11 Microsoft ‘at risk’ revenues........................................................................................................................ 13

Mission 2: Ecosystem ....................................................................................................................................... 14 Culture ...................................................................................................................................................... 15 Digital Life ................................................................................................................................................. 16 Digital Work .............................................................................................................................................. 20 Microsoft ................................................................................................................................................... 22 Freemium .................................................................................................................................................. 22 Google ...................................................................................................................................................... 23 Apple ...................................................................................................................................................... 24 IBM ...................................................................................................................................................... 25 Windows 10 .............................................................................................................................................. 26 Eagles and turkeys ................................................................................................................................... 27 Marketing .................................................................................................................................................. 28 Mission 2 assessment............................................................................................................................... 29

Mission 3: Digital Life and Digital Work ............................................................................................................. 30 Law 6 – Data Integration ........................................................................................................................... 31

Conclusion ........................................................................................................................................................ 32 Financials ......................................................................................................................................................... 33 Valuation ........................................................................................................................................................... 34

Comparative analysis................................................................................................................................ 34 DCF valuation ........................................................................................................................................... 35


Introduction

Although Microsoft talks a big game when it comes to cloud and mobile, it is still first and foremost a perpetual licence software company. Its main assets are the Windows operating system, Windows Exchange Server and Office 365 which will make up 60% of revenues and 86% of gross profit this fiscal year (FY15 ending June) (Exhibit 1). A major element of these revenues and profits are dependent on the PC market where long-term growth looks exceedingly unlikely and the rest is dependent on enterprise spending on IT infrastructure.

Exhibit 1: Microsoft Revenues and gross profit, 2015e

Source: Microsoft, Edison Investment Research

More than ever, companies are under pressure to be more cost efficient and to make their employees more productive. This is what underpins the high level of interest in both mobile and cloud computing. Allowing employees to access enterprise data from a mobile device has long been known to improve productivity and the trend is to increase access beyond just email, calendar and contacts. Furthermore, while using cloud-based IT infrastructure does not necessarily reduce costs, it does increase flexibility and reduces time to implement change. Both have a big impact on making the most from IT investments.

When one considers this efficiency drive alongside the trend of some PC users replacing their PCs with smartphones and tablets, it is not difficult to conclude that the bulk of Microsoft’s profit generating businesses are under threat of long-term decline. However, Edison thinks that much of the server and infrastructure business does not face this threat in a meaningful way as it so deeply ingrained inside many enterprises that it would be more trouble than it is worth to switch over to something else. This is especially the case as Microsoft has moved to protect this revenue stream by offering migration to the cloud for those that want it. Even leaving this to one side still leaves Microsoft profitability substantially exposed as Edison calculates that 35% of revenues and 51% of gross profit are at risk of long-term decline (Exhibit 2).


Exhibit 2: Microsoft revenue and profit at risk of decline


This is where the problems begin as these are the most profitable areas within the company and consequently, more than capable of changing moderate profit growth into long-term decline if badly managed.

In order to change the prospect of long-term revenue and profit decline into growth, Edison thinks that Microsoft must successfully execute on three missions:

Mission 1 – Deal with legacy: Microsoft must convert as much of Office perpetual licence sales into Office 365 subscriptions as it can. Edison thinks that there is very little that can be done with Windows OS revenues but there is the opportunity to earn ecosystem revenues instead (Missions 2 and 3).

Mission 2 – Ecosystem: Microsoft must create a thriving ecosystem of Digital Life and Digital Work services. Success will mean that users make a positive choice to live their Digital Lives and Work with Microsoft which the company can then monetise by any one of: selling devices; selling advertising based on usage; or charging a subscription for the services (Exhibit 12).

Mission 3 – Digital Life and Digital Work: Microsoft must combine its consumer ecosystem (Mission 2) with its strength in the enterprise (Digital Work) to create a single experience where users can live their Digital Work and personal Digital Life in one place. This is important because it is the one thing that Microsoft can do much better than anyone else giving it huge differentiation and pricing power, if successful.

Success in these missions is likely to result in steady profit growth over the medium term, albeit at significantly lower gross margins.

The following in depth look at the Microsoft ecosystem and its core businesses makes an assessment of how well it can execute on these three missions. Edison’s outlook for revenue and profit growth comes as a direct result of its assessment of execution on the three missions.

Mission 1: Deal with legacy

Microsoft has been an incredibly successful company for the last 20 years. Together with Intel, it has shared almost all of the profits from the PC market leaving the long suffering PC makers as little more than commodities. With a 90% share in PC operating systems and a 90% share in processors, Microsoft and Intel have been able to dominate the market. However the PC market is no longer an engine of growth and in some segments it is being eroded by smartphones and tablets. Here, neither Intel nor Microsoft have a meaningful position and their revenues have languished as users have switched spending from PCs to mobile devices.


This trend has been largely responsible for the very weak performance of the PC market over the last five years.

Microsoft is very exposed to the PC market. Every PC that ships offers an opportunity to sell an OS and to sell a copy of Office. Together these represent at least a $200 per unit opportunity from which Microsoft will earn 93% gross margins. Between consumers and corporations, the PC still generates 35% of Microsoft’s revenues and 51% of its gross profits (Exhibit 2) meaning that for the medium term it will be an important driver of performance no matter how well the missions are executed.

PC Market PCs are sold to two end markets, consumers and corporates. Historically, these two segments have each made up half the market but the consumer has been significantly weaker for the last five years. Edison separates the consumer market into two pieces; content consumers and content creators (Exhibit 4).

Content consumers are those who only use a PC for browsing the web, watching videos, chatting and sending emails. Until 2010 the best and the most cost-effective way of doing this was to use a PC despite the fact that this represented a substantial underutilisation of the capabilities of the device. The advent of the smartphone and the tablet brought a cheaper and more convenient way of carrying out these activities and so content consumers no longer had a reason to buy or use a PC.

Content creators are those who use a PC to create documents, data, video, images and so on. These users need a keyboard and a mouse and very often require the kind of processing power and a larger display which is not available on a smartphone or a tablet. Edison thinks that these users will always have need of a PC and so purchasing by this segment will be stable (Exhibit 3).

Exhibit 3: Dynamics of the PC market. 2012a-2020e, units (m), %

Source: Microsoft, Gartner, Edison Investment Research

Microsoft, Intel and the PC makers have been able to sell users a device that was far more capable than required as there was nothing else available. This issue has now come home to roost and without a major product cycle, Edison thinks that the PC market will remain stagnant. Content consumers will continue to desert PCs and their decline will be somewhat offset by very slight growth from content creators and corporates (Exhibit 3).


Exhibit 4: PC user numbers by end market. 2012a-2020e, users (m), %


Edison forecasts indicate that this trend will continue until 2017e by which time essentially all content consumers will have migrated to smartphone or tablet leaving just corporates and content creators as buyers of PCs. Edison thinks that smartphones and tablets are not a threat to these segments as these users require more power, a keyboard and a mouse for the uses for which they put a PC. Even with the content consumers gone, growth will be almost non-existent meaning that Microsoft, Intel and the PC makers will still need to look elsewhere to find any growth.

Microsoft Against that backdrop and without a product cycle, Microsoft can hope for its exposure to the PC market to be a cash cow in the best instance. Exhibit 5 shows that sales of Office Commercial, Office for consumers, Windows for corporates and Windows for consumers are all directly linked to the PC market. These four businesses still make up 51% of gross profit (2015e) and if PCs stopped selling tomorrow, revenues would grind to a halt. These businesses are driven by selling copies of Windows or Office to be installed directly on a user’s PC.

For the consumer (21% of 2015e gross profit), these sales are very often bundled with the device at the point of sale and are included in the headline price of the device. While this keeps this part of Microsoft a hostage to the PC market, it has the added benefit of being an expense that the consumer is used to and is very likely to continue paying. This essentially means that Windows for consumer revenues are likely to remain underpinned by the PC market. After 2017e, almost all of the content creators will have replaced their PCs meaning that the drag on the market should have come to an end. Even then, without a product cycle, the outlook for revenues remains flat, with steady gross profit (Exhibit 9).


Exhibit 5: Microsoft revenues derived from PCs, 2014a-2018e


It is in Office revenues where Microsoft will see the real decline in revenues. It is important to remember that this is deliberate and that these revenues are copies of Office installed on a PC and do not include revenues from Office 365 which is a subscription-based service. This business is accounted for elsewhere within Microsoft and as it is a subscription business, it is not linked to the twists and turns of the PC market. As long as Office 365 can generate as much profit as perpetual Office licences, Microsoft will have mitigated this issue.

Edison thinks that there is very little that Microsoft can do to control its Windows OS revenues but the good news is that while they are not likely to grow, Edison thinks that they will be more sustainable than many may fear. With the PC market erosion by smartphones and tablets now starting to taper off, the long-term outlook for the PC market is reasonably stable. Microsoft can expect to see Windows OS revenues as a profitable, stable cash cow (Exhibit 6).

Exhibit 6: Windows revenues vs PC market, 2014a-2018e

Source: Company Data, Edison Investment Research

Office is another matter entirely. There are viable and free competitors for this business which threaten to take market share. Microsoft has risen to this challenge by moving its Office proposition from a one-time purchase to a subscription and at the same time greatly increasing the functionality of the software and services on


offer. This offering is called Office 365 and in the long term, Edison calculates that Microsoft will be better off by having Office in the form of Office 365 as a subscription rather than as a one-time sale (Exhibit 10). However, there will be some revenue and gross margin softness in the short to medium term.

PC product cycle Edison’s forecasts for both the PC market (Exhibit 3) and the revenues that Microsoft derives from it (Exhibit 5) assume that there is no innovation whatsoever in this market ever again. However, Edison sees significant opportunity for a product cycle to kick-start the PC market into life once again, albeit for a short time.

The laptop form factor has been in the market for 30 years and currently makes up more than half of all PCs that are shipped today. This form factor exists because when it was invented the keyboard had to be physically attached to the screen. This was because the components and the battery were so large that there was only enough space for them by putting them underneath the keyboard. Furthermore there was no reliable wireless technology to connect keyboard, mouse and screen together. The folding of the keyboard onto the screen also made a convenient way to carry the device and in the absence of better ideas, this form factor became the mainstream.

Times have changed and with them has arrived, in Edison’s opinion, a greatly superior form factor to use for portable computing, the tablet PC. The laptop has solved historical space problems and is easy to carry around but Edison believes that it offers the user a poor user experience when compared to a desktop in the following ways:

Mouse – a laptop uses a trackpad or mini-joystick to control the cursor. These both offer much less control and the combination of moving the cursor and right or left clicking is cumbersome at best. The user can always attach a separate mouse to the laptop but because there is already one there, almost nobody does it. Consequently content creation on a laptop is much more difficult and tiresome than it is on a desktop.

Keyboard – almost all laptops offer a cramped keyboard in order to be able to fit it under the screen. This offers a more difficult and error prone typing experience than a device that has been exclusively designed to be a keyboard.

Screen position and ergonomics – the laptop is one of the least ergonomic devices that is on the market today. The position of the screen means that the user is constantly bending their neck forward to look at the screen. The cramped keyboard and mouse mean straining of arms and shoulders to reach the keyboard and uncomfortable wrist bending to use the trackpad. Every practitioner of spinal health recommends the screen at eye-level and the use of a separate keyboard and mouse. Essentially what the medical profession is saying is “don’t use a laptop, use a desktop instead”.

Until recently, in order to be able to use a PC while not in the office meant having to make these compromises to the user experience as well as suffering the discomfort and health risks of poor laptop ergonomics.

Surface The idea of having an entire PC in a tablet form factor is not new but it is only recently that a tablet has come to market than can properly function as a fully specified PC. Windows RT for ARM was underpowered and made so many compromises to the user experience that it was unsuitable as a laptop replacement. It has taken Microsoft three attempts to get it right but the Surface Pro 3 and the Surface 3 are the first tablet PCs that are fully capable of offering full PC performance.

This is highly significant, as for the first time in 30 years the user no longer has to make any real compromises on the computing user experience when they are not at a desk. The Surface Pro 3 can function as a tablet (apart from a shortage of apps) but when a Bluetooth keyboard and mouse are connected, a full desktop experience (albeit with a smaller screen) is achieved. With the keyboard no longer needing to be physically attached to the screen the screen can be placed at eye level and the keyboard is in the right place as on a


desktop. This is why Edison believes that the Surface Pro 3 represents a substantial step forward when it comes to portable computing and why it believes that the laptop form factor is now obsolete.

Unfortunately, to cram the power of a laptop into a tablet has taken a substantial amount of R&D. Edison believes that Microsoft has spent upwards of $100m developing the Surface 3 and Pro product line. Furthermore, it is an expensive product with the cheapest version (Surface 3) starting at $499 without a keyboard or a mouse.

This is where the problems begin. PC makers have such low margins at 2-4% best case that it is not possible for them to spend large sums developing single product lines. Their commoditisation is so acute that most of them have almost stopped R&D entirely and depend on the Taiwanese ODMs for their product development. They too do not invest heavily in product development. Hence, the products that are being produced are ugly and clunky and are unlikely to generate purchasing interest. Consequently, only those with reasonable gross margins are likely to be able to develop these types of products unless Microsoft gives the design away in order to stimulate the market.

Despite these issues, Edison believes that if Microsoft and Intel can create enough excitement around the tablet PC format, users are likely to begin replacing their laptops with these devices. This will require a significant shift in marketing strategy, with companies actively educating users as to why this form factor is so much better. To date they have utterly failed to address the opportunity (see marketing section).

Exhibit 7: PC unit shipments by form factor 2014a-2018e, units(m)

Source: Edison Investment Research, Gartner, IDC

Laptops have been around for 30 years and most users are so used to them that they cannot conceive of using anything else. This is where Edison thinks the problem lies. Triggering of a strong replacement cycle of laptops for tablet PCs is the only thing that is likely to stimulate some renewed growth from the PC market. In order to do this Intel and Microsoft need to be masterful in the execution of their marketing strategy. Unfortunately, this has proved to be very far from the case as neither has yet understood that just telling a user that the product exists is no longer enough to sell it. They need to educate the user as to the significant benefits of adopting the format (see marketing section). Until they do so, Edison thinks that the tablet PC market will remain niche and will only make up a small part of the overall market.

Edison’s current estimates (which assume no real product cycle) see tablet PCs growing to 43m units in 2018e but this is mostly at the expense of laptop sales meaning that there is no real meaningful impact on the overall market. If users begin appreciating what is on offer, then Edison sees significant upside, albeit only for two to three years. This would clearly have a positive impact on Microsoft as with more units (tablet PCs) shipping, its legacy licensing business would see a temporary return to growth.


Office and Office 365 Edison believes that Office and Exchange Server are the most valuable assets that Microsoft has. Historically, Office has been sold as software installed on a PC for which the customer pays a one-off fee. This has been a very successful business and Edison estimates currently generates around 30% of all gross profit for the company. The problem is that one-off sales of licences are tied to the shipments of PCs which have been suffering as content consumers desert the platform and move to smartphones and tablets.

Exhibit 8: Forecast Microsoft Office revenues from perpetual licence and 365


Furthermore, the days of devices not being connected to the Internet are now well and truly over, meaning that there is much more that a user can do with Office when it is offered as a service in the cloud. This is what has become known as Office 365. This is a suite of software programs with Word, Excel, PowerPoint, Access, OneNote and Publisher at the centre but with much more functionality built around them. With document storage in the cloud, collaboration becomes much more straightforward. To this, Microsoft has added Skype for Business (Lync) as a communication platform as well as many other features that offer solutions for most of the activities that knowledge workers do in an office environment (see Digital Work section).

Office 365 was launched for general availability in June 2011 but has really only begun to gain traction in the last 12 months. It is a subscription service that is available at a variety of price points from Office 365 Consumer at $9.99 per user per month to Office 365 Enterprise at more than $20 per user per month. With the same level of performance but much greater functionality, the subscription is a much better option for content creator than a perpetual software licence. This is why perpetual Office revenues from both corporates and consumers have gone into, what Edison believes, is terminal decline (Exhibit 5).


Exhibit 9: Total Office revenues and gross profit

Source: Company data, Edison Investment Research

In the long term, Edison believes that Microsoft will be able to generate more profit from Office via 365 than it can via the Office perpetual licence offering (see below) but in the short term, both revenues and profits will decline as the transition takes hold. Currently gross margins for Office 365 are less than half those of the Office perpetual licence version (93%) meaning that Office 365 has to generate more than $2 in revenues for every $1 decline from perpetual licence just to keep overall gross profit flat. However, gross margins of Office 365 are rising rapidly and Edison thinks that they can reach about 60% in the medium term. This will cushion the impact of users migrating from one to the other but we forecast that it will still be 2017e before Office revenues start growing again.

The most important question is whether the implicit investment being made in Office 365 is worth it? Edison believes that Office 365 could end up being the most important asset within Microsoft both strategically, in terms of forming part of the ecosystem (Mission 2), and financially in terms of its ongoing ability to generate profit for the company.

The biggest generator of revenue and profit is Office for corporates where a large part of the contracts are written on an annual, subscription basis despite the licence being for perpetual software. This gives revenues greater sustainability when it comes to migrating business over to Office 365. However, the most important factor is whether Microsoft will generate more profit from a user who buys copies of the different versions of Office every time a PC is bought or from a user who is a subscriber to Office 365.


Exhibit 10: Economics of Office 365 vs perpetual licence office

Source: Company data, Edison Investment Research

In order to asses which works out better for the shareholder, the focus has to be on gross profit. This is because while Office 365 is growing very quickly, it is very unlikely to ever reach anything like the gross margins that are generated by selling perpetual licences. Edison has estimated that the gross margin of an Office 365 consumer is 35% while Office 365 for business is 55% and has compared the profit generation of a perpetual licence over the lifetime of a PC to an Office 365 subscription (Exhibit 10). Revenue and gross margins generated after the time of sale are discounted at Microsoft’s weighted average cost of capital so they can be fairly compared to revenues and gross margins generated up front.

Exhibit 10 shows that takes three years and 11 months (consumer) and three years and eight months (business) for Office 365 to generate an equivalent level of gross profit compared to the sale of a single perpetual licence for Office software. If one assumes that every time that a PC is replaced, a new copy of Office is purchased (which is by no means the case), PCs need to be replaced more frequently than four years for Microsoft to be worse off with Office 365. The current replacement rate of PCs is anywhere from five to seven years, meaning that in the long run, Office 365 is a better proposition for the shareholder than a one-off perpetual licence sale.

Consequently, the short-term weakness that is being experienced in Office is not being caused by a decline in the appeal of Office or of the PC market. Instead, Edison is comfortable that the declines over the next two years represent a transition period while Office 365 obtains enough scale to improve on its initially much lower gross margins. Finally, the Office asset is also being used as a core part of Microsoft’s strategy to build an ecosystem for both the consumer and the professional. This is where Office for iOS, Office for Android as well as offering certain functions for free all come into play. As this is part of Mission 2: Ecosystem, this is discussed later in the report.

Microsoft ‘at risk’ revenues Edison concludes that the core drivers of Microsoft’s historical success (Windows and Office) are not going to underpin the company’s future but they are not going to undermine it either. Importantly, both of these business lines are very profitable, and while profitability will fall due to the mix shift towards Office 365, the


absolute level of profit will be higher in the long-term as subscribers end up paying more than those that just buy a perpetual licence.

Exhibit 11: Microsoft revenues and gross profit from legacy

Source: Edison Investment Research, Microsoft

A stable PC market and the rejuvenation of Office paints a steady picture when it comes to revenues and gross profits (Exhibit 11). Furthermore, Edison thinks that there is significant scope for Office to gain share over its rivals which could lead to greater revenues in the long term should Mission 2: Ecosystem also be a success. Consequently, Edison is not concerned that Microsoft’s legacy revenues are about to go into free fall which gives the company a good base from which to build its real future (Missions 2 and 3).

Mission 2: Ecosystem

The days of growth in the PC market are now clearly over making it extremely difficult for Microsoft to see any growth from its legacy PC business. Furthermore, Server and Infrastructure are showing signs of slowing down, meaning that Microsoft must turn to other avenues if it is to see any return to long-term growth. It is here that the ecosystem comes into play (see Mobile Ecosystems – Devil in the details, 18 March 2015, for a detailed description of ecosystems and how they work).

The ecosystem is really the only opportunity for Microsoft to return to any sort of growth and here it has an opportunity to create an offering that none of its competitors can match. Microsoft is very strong in the enterprise but at the same time every single person who uses Microsoft products in the course of their work (Digital Work) is also a consumer. Microsoft also has a strong portfolio of assets for the consumer (Digital Life) which have the potential to be very appealing to users. If it can then go one step further and marry the two together in a single, easy and fun to use experience (Mission 3), then it will have an offering that none of its competitors can match.

http://www.edisoninvestmentresearch.com/serve_pdf.php?d=sectorreports&f=MobileEcosystems_Devilinthedetails_180315.pdf


Exhibit 12: Three models of ecosystem monetisation

Source: Edison Investment Research

If Microsoft can make its ecosystem appealing to users, they will choose to spend their Digital Lives with Microsoft, giving it scope to begin earning revenues from it. There are three ways that the ecosystem can be monetised (Exhibit 12):

Monetisation through hardware. This involves keeping the ecosystem exclusive to the devices from a single manufacturer and earning a return on the ecosystem through premium device pricing. If the ecosystem is desirable, then users will be willing to pay for access to it. This is exactly what drives Apple’s margins and what almost every other device maker is trying to emulate.

Monetisation through advertising. This involves giving the ecosystem away for free and then monetising by targeting its users for marketing campaigns sold to advertisers. This is a very effective method for the mid- and low-tiers but it requires excellent infrastructure to be effective. This method requires a good score on Laws of Robotics 3, 4 and 6 (page 18) in order to achieve effective monetisation.

Monetisation through subscription. This involves monetisation by selling access to the ecosystem for a fixed fee per month or per year. It is the least developed of all of the business models, but Edison can see this becoming more popular should users become fed up with being constantly bombarded with advertising. This model can also sell itself on its security and privacy as there is no need to track user behaviour or to share it with any third parties. Edison thinks that Microsoft could follow this route by expanding its Xbox Live offering to cover more Digital Life services or through offering Windows 10 and the services around it on a subscription basis like Office 365.

To reach the monetisation stage, Microsoft must develop its ecosystem to the point where users demand it and are prepared to pay up in order to get access to it. Microsoft is very far from this point and this section looks at what needs to be done and how Microsoft might get there.

Culture The first step in making this strategy successful is to have the right culture. Under Steve Ballmer, Microsoft had a culture that drove its legacy businesses, but the world has moved on. The PC is no longer the only computing platform being used for everyday tasks and outside of the PC, Microsoft’s presence is very weak. As a result, using Windows as a lever to force users into using Microsoft’s services no longer has any power at all and so a different approach is needed.


This is why Edison thinks that Satya Nadella’s approach to reshaping the culture of Microsoft is instrumental in any success that the company achieves in the ecosystem. Edison has been particularly impressed with the complete turnaround that has been effected in the culture of the company in the space of one short year.

The ivory towers where separate businesses did not talk to each other and even competed against each other in some cases have been knocked down and the “Windows Windows Windows” mantra has been consigned to the annals of history. Instead of an individual relationship with the CEO, the group heads all have relationships with one another with the goal of getting to the journey’s end together. This collegiate and collaborative approach has already been successfully filtered down through the ranks leaving Edison comfortable that the old culture and view of the world has been almost completely replaced.

This culture change is essential as in the ecosystem, Microsoft is very far from market leadership. For the first time in 20 years it is a challenger and that means that it must go out and win the hearts and minds of the users and persuade them to sign up. It has to be better than the rest as it has very little power anymore to force anybody to do anything. This change is already being reflected everywhere in the company’s strategy with Office 365 being offered for free on some platforms as well as free OS upgrades to Windows 10 and free copies of Windows on certain hardware types and screen sizes.

The fact that Microsoft has realised its predicament and successfully changed its culture, gives it a much better chance of returning to growth than if it had remained fixated in its old ways. Now it is just a question of execution.

Digital Life Edison’s analysis of Digital Life is already very well defined (see Mobile Ecosystems – Devil in the details, 18 March 2015, which includes details about the ‘Seven Laws of Robotics’, see below). The Digital Life Pie (Exhibit 13) remains central to Edison’s analysis of the digital ecosystem. It is a measure of how much time users spend engaged with digital services on their devices outside of voice and text (and e-commerce). Analysing each ecosystem on this basis gives a very good idea about how well developed an ecosystem’s strategy is and how much more work or investment is needed to assemble the right assets to have a complete offering for the user’s Digital Life. It also gives a good assessment of how big the monetisation opportunity is.

Exhibit 13: Microsoft’s position in Digital Life

Source: Edison Investment Research, Nielsen, Google, Pewinternet.org, CommScore, NetMarketShare

A key observation from this analysis is that the whole is much greater than the sum of the parts. This is for two reasons:



Firstly: the more of the pie that is addressed, the more the ecosystem will know about the user. Therefore targeting will be more accurate, more relevant and hence carry much higher ASPs.

Secondly: the greater the portion of Digital Life that the ecosystem addresses, the more time the user will spend within that ecosystem. Hence, there will be a greater opportunity to target the user. Combining these two reasons makes it clear that both ASPs and volumes will increase as coverage improves, giving a much greater uplift in overall revenues. This is particularly important for those ecosystems which aim to monetise users via advertising (Exhibit 12) but also understanding the user is very important to provide the best user experience.

According to our methodology, Microsoft has good coverage (71%) of Digital Life but how good is it at offering these services in a way that will appeal to users? Edison uses what it refers to as the ‘Seven Laws of Robotics’ to make this assessment. These are seven tests by which Edison believes the quality of the consumer ecosystem can be judged. The seven laws are:

1. Easy and fun: an Ecosystem must provide easy and fun access to Digital Life;

2. Set Up: an Ecosystem must be simple and easy to set up and use;

3. Traffic Capture: an ecosystem must capture traffic on its own servers;

4. App. Equivalency: an ecosystem must offer access to a good range of third party apps;

5. Data Sharing: an Ecosystem must allow Digital Life services to share data;

6. Data Integration: an Ecosystem’s user data must be integrated; and

7. Software Consistency: an ecosystem must have consistent device software.

Exhibit 14: Microsoft vs the seven law of robotics


Against the seven laws, Microsoft scores a healthy 68%, which is considerably better than most of the other ecosystems outside of Google and Apple but despite this; the ecosystem is substantially underperforming its potential (see below).

Users spend almost all of their Digital Lives either on smartphones or tablets. This will change as other devices like TVs, cars and wearables get better at offering Digital Life services but for the moment the experience is driven predominantly by these two. Of the two, the smartphone is by far the most important and


is the device where users spend 75% of their mobile time. Consequently it is essential that every ecosystem is strong in delivering its services to mobile. Edison measures the size of the ecosystem as the total number of users that the ecosystem has using its services on a smartphone or a tablet. In Edison’s opinion simply using Office on iOS is not enough. The user must engage with Microsoft as its primary source of Digital Life services. In this example, Microsoft is simply a third party app developer.

This is where Microsoft substantially underperforms its potential. When Nokia switched to Microsoft away from Symbian in 2011, some headway was made in 2012 and 2013 but it never really gained any real traction with the user. Since the acquisition of Nokia Devices and Services by Microsoft, things have only become worse with the latest set of earnings (fiscal Q315) showing a further market share loss in mobile devices.

Exhibit 15: Microsoft’s ecosystem on mobile, 2014a-2018e

Source: Counterpoint, Edison Investment Research

Edison believes that to be viable, an ecosystem needs to have at least 100m users on mobile and to be successful an ecosystem needs 300m users or more. It comes as no surprise that Apple and Google, who are currently earning almost all of the profits from digital ecosystems, are both comfortably over 300m users in size. By comparison Microsoft ecosystem is tiny at 71m users and its weak position in mobile devices is having a substantial and deleterious effect on the outlook for Microsoft to develop a thriving ecosystem for the consumer.

There are two main problems which need to be addressed:

Firstly – The Blue Squares of Death. Edison believes that Microsoft is still failing to market its ecosystem properly. Microsoft designs its campaigns around the view that if it tells users that the ecosystem exists that they will adopt it in droves. What it is missing is the explanation why. It is not nearly enough to tell users that it exists; it needs to explain why it is great and why users should live their Digital Lives with Microsoft.


Exhibit 16: The Blues Squares of Death


In almost every case, what is put into a user’s hand at retail is a virtually blank device. There is very little or no data sitting behind any of the Digital Life services offered on the device (hence Blue Squares of Death). This makes it impossible for the user to know how easy and fun it would be to live their Digital Life with Microsoft. If this is carefully explained to the user and they are shown how the ecosystem could make their life better, easier and more fun, then there is a much better chance that they will walk out of the store with a device.

In many ways, Edison thinks that 30 years of dominance in the PC industry has done the damage as Microsoft has not been in the position of the challenger for over 20 years. A challenger has to adopt a completely different philosophy and explain to users why its wares are worthy of their attention. Microsoft’s marketing department seems to think that it already has users’ attention when actually they are fixated on Apple and Android. Unfortunately, there is still no sign of change at this part of Microsoft despite the huge changes that have already been made elsewhere. Edison hopes that this will begin in 2015 but does not expect a material change in its position in the ecosystem until it does. A change in the acceptance of the Windows smartphone is the most likely sign that everything is about to come right.

Secondly – the availability of apps. To date, the single biggest reason for a Microsoft device to be returned to the store has been the lack of decent apps when compared to iOS or Android (Law 4). Edison does this by comparing the top apps in the Apple App Store what the Windows Phone Store has to offer, (this analysis is described in Mobile Ecosystems – Devil in the details, 18 March 2015, page 9 where Law 4 is explained in detail). Against this comparison, Microsoft continues to struggle but has seen some improvement over the last six months. Currently, in its store Microsoft can offer the same app, a clone or something similar for 70% of all the apps in the top 10 free, grossing and paid charts in the Apple App store. However, when Edison looks at the quality of these apps, the Microsoft Store gets a score of just 58% (Exhibit 17). This is a further hindrance to the appeal of the Microsoft ecosystem, but it is making steady progress. Edison thinks that Microsoft needs to see a score of at least 74% before this ceases to be a problem.



Exhibit 17: Microsoft Store vs competing app stores

Source: Edison Investment Research, Apple, Amazon, Yandex, Google, Microsoft, App Annie

At its Build 2015 conference, Microsoft announced that it had taken a step forward in making it easier for developers to write apps for Windows. Previously, a developer had to do a laborious port of his app to Windows where it would really only run on the phone. With only a small installed base of devices and a bad reputation, this has made little sense. Microsoft’s new strategy is to make available two new add-ons for Visual Studio. These allow the developer to take the Objective-C or Swift code that his iOS app is written in and recompile it for Windows 10. The same will be available for C++ and Java that Android apps are written in. Once recompiled the developer needs only to debug and tweak the application and then publish it to the store. In Windows 10, the code base is the same between all devices meaning that the addressable market for a single app will be much greater than it is today. However, Microsoft will still need to persuade the developer to make its app available for Windows which is where the risk of this strategy lies. Microsoft’s falling market share in mobile devices is killing its credibility and many developers simply cannot be bothered to develop for Windows no matter how easy it is.

Should the next few quarters start to see improvement in how the story is told to potential users and there is good progression on the app store coverage, then the size of the Microsoft ecosystem on mobile should start to move in the right direction. However, this is why market share is so important. Losing market share in smartphones severely damages the ecosystem’s credibility in the eyes of users and app developers and makes the task ahead even harder. This is why Edison believes that it is essential for Microsoft to reverse this trend sooner rather than later or face the increasing probability of a complete collapse of its mobile ambitions. In a company with a mobile-first, cloud-first strategy this would be little short of disaster.

Digital Work Fortunately, when it comes to the enterprise, it is a completely different story. Here, Microsoft is very strong with hundreds of millions of users, offerings for almost every professional activity and a very strong infrastructure offering supporting it all. When it comes to the transformation of Microsoft, the server and infrastructure element is not where the real change needs to come from. Server and infrastructure needs to be migrated to support the new services but its model and function are unlikely to change very much. The real difference will be made in the software and services with which the users interact directly which will define their user experience.


Exhibit 18: Digital Work pies for fixed and mobile, 2015e

Source: McKinsey, Radicati, Workfront, Microsoft, Webtorials, Edison Investment Research

Consequently, Edison has estimated how office workers spend their time during a working day, referring to this analysis as Digital Work. This analysis is analogous to the Digital Life analysis which measures how much of the user’s Digital Life an ecosystem addresses with its offering of services. In this case it is a measure of how well an ecosystem offers services or applications that allow a user to carry out their professional duties. This analysis applies only to knowledge workers in an office environment. Outside of this environment the duties of workers are so varied that any analysis of Digital Work becomes meaningless for determining how well an ecosystem has addressed the Digital Work opportunity. Edison thinks that the quality of the data gathered is meaningfully less than that gathered for the Digital Life analysis. Data sources for Digital Life were in general agreement but for Digital Work there is contradictory data forcing Edison to make more estimates than it normally would. Consequently, Edison views the Digital Work pie as a work in progress and anticipates meaningful revisions going forward.

Just as games dominate Digital Life, e-mail is the dominant activity in the day of any knowledge worker. E-mail is so ingrained in the mind of every worker that even though there are many alternatives available such as chat systems and collaboration tools, most communication still goes over electronic mail. It is the easiest and most reliable form of professional communication and Edison thinks that it will be a long time before it is replaced with collaboration or instant messaging tools. Users also spend more than half an hour of every working day wasting time engaging in personal activities. Since the advent of the smartphone the majority of personal activity now takes place on that device but this segment also includes PC browsing of the internet for personal reasons. Any ecosystem that has an offering for both Digital Life and Digital Work has a great opportunity to cement its relationship with the user by offering both sets of services in an easy and fun to use way on a single device. Edison believes that only Microsoft is really well positioned to do this and has the opportunity to significantly differentiate itself if it can make it work well (Mission 3).

Edison has employed the same method for assessing Digital Work as it has for Digital Life by mapping the ecosystems’ services onto the Digital Life pie to see how well the opportunity has been covered.

Edison sees the potential to marry Digital Work and Digital Life into a single seamless offering as a real opportunity for Microsoft to differentiate its proposition to the user. Consequently, Edison has run the initial Digital Work analysis for the other ecosystem players that are showing some inclination to offer something similar within their ecosystems. Currently, only Apple and Google have even the beginnings of being able to


effect this strategy and so this analysis is limited to four players, (IBM has also been included as it has long been a competitor for many Digital Work services). Edison thinks that BlackBerry does not have the resources to mount a challenge in this space and consequently it has been removed from the analysis. Other players like MobileIron, Air Watch and Good are platforms and their focus is on enabling an enterprise to securely and reliably mobilise its functionality. In that regard they compete with Microsoft’s backend and server products but they are not competing for the mind share of the user.

Microsoft On our analysis, Microsoft’s position is by far the strongest in the industry. Not only does it have the leading offering for many of these activities, but it also has the back end to ensure that the user experience is as good as possible. In the enterprise, reliability and security are also crucial factors and here Microsoft also fares well. Most of its new services such as OneNote and OneDrive are based on technology that has been around for many years. While this may make its software sound out of date, it actually means that the software will be very stable and offer a reliable service. This is why in Edison’s opinion, Microsoft’s online storage service, OneDrive knocks the socks off iCloud or Google drive and why it is a much better choice for any entity requiring an enterprise grade service.

Exhibit 19: Microsoft in Digital Work

Source: McKinsey, Radicati, Workfront, Microsoft, Webtorials, Edison Investment Research

Freemium The move away from the PC triggered by smartphone and tablets for content consumers has forced Microsoft to rethink much of its strategy. Smartphones and tablets together ship over 5x more units than the PC industry and in this new market Microsoft has consistently failed to get any real traction. This was largely due to the company’s insistence that its services and its software had to run on Windows. With the exit of Steve Ballmer and the entrance of Satya Nadella, this idea has been completely upended and the focus now is to get as any people as possible using Microsoft services and software no matter what platform they are on.

This makes complete sense for two reasons. Firstly, the users that it is targeting on smartphones and tablets have already left the PC platform and therefore their contribution to Microsoft’s bottom line is already zero. Therefore, any contribution that they might make in the future is all upside. Secondly, it is clear that the operating system is no longer a factor in the user’s decision on Digital Life or Digital Work in one ecosystem or


another. This means that there is no benefit to Microsoft in insisting that its operating system be used to access its services on devices outside of PCs as it will only hamper the uptake of its services.

Consequently, Edison thinks that by making its services available on other platforms, it is not meaningfully damaging its Windows licensing business which has virtually no business outside of the PC. However, Microsoft is not stopping there but is also moving towards a freemium model for some of its most valuable assets and Office in particular. On iOS and Android, Office 365 is free but the functionality is limited to just the most basic of editing tasks. These sorts of the devices are very limited in their capability to offer an in depth office experience and a full Office solution is not really appropriate on these devices. This creates a good hook to bring users back to Microsoft when they reach a point that they need greater functionality. This goes hand in hand with the decision to make Office 365 free for students who are enrolled at qualifying schools and universities. This will cost Microsoft some money in the short run but these two strategies have the potential to cut competitors off at the knees.

Offerings like Google Docs, iWork, Apache OpenOffice and LibreOffice are inferior to Office, but they have the added bonus of being free. This has allowed them to gain traction within some companies that have some desktops running Mac OSX, Linux or within organisations that use Google as a Digital Work supplier. Now that the basic functions of Office are free, Edison thinks that most users will be dissuaded from using other solutions as the main incentive to use them has now been removed. Compatibility is a very important issue when it comes to these sorts of documents and despite the claims of their owners, the compatibility of Google Docs, iWork, Apache OpenOffice and LibreOffice is very far from where the user would have a seamless experience. Consequently, Edison thinks that most knowledge workers will prefer Office given a choice and from here it expects that new users will almost always choose Office. Edison anticipates that there will be some switching to Office 365, given the attractive pricing scheme but this will take a while and the competing solutions are likely to be around for a long time to come.

This freemium model, and with education, substantially broadens the funnel for converting users to becoming fully paid up subscribers of Office 365. This tactic is also being used with Windows in order to increase its appeal and make it competitive at lower screen sizes. Edison thinks that Microsoft will increasingly use this tactic across all of its services and believes that it has little to lose in adopting this strategy for the long-term benefit.

Google Google has had an Office competitor for some time. Google Docs originated from a program called Writely which Google acquired in 2006. Google Sheets originated from a program called XL2Web which Google acquired in 2005. Since that time, Google has stitched together an offering for the enterprise mostly through acquisition and integration which is not dissimilar to Office 365.

The combination of Gmail, Google Docs, Chrome and Google Talk puts Google in a good position when it comes to having a reasonably complete offering for the enterprise but its offering lacks maturity. On an analysis of Digital Work, Google scores 82% but many of its assets like Google Talk or Gmail do not have anything like the kind of functionality offered by Outlook or Skype for Business (Lync). However, Google’s excellent position as it relates to its Digital Life ecosystem, makes it something that many users are willing consider as it is an entity that they know and they like in their personal lives. The service is priced in two tiers one starting at $5 per user per month and the other is similar to Office 365 at $10 per user per month. The difference between the two is the level of storage and management of certain policies that would be required by an IT administrator.


Exhibit 20: Google in Digital Work

Source: McKinsey, Radicati, Workfront, Google, Webtorials, Edison Investment Research

A lower tariff is attractive for very small, cost conscious businesses but the higher tariff does not compete well against the entry level Office 365. Furthermore, given Office is now supported on most mobile platforms, Edison thinks that this is no longer an attractive proposition for a small- or medium-sized company. Microsoft’s move to make Office 365 much more competitive are reasonably recent and so the impact on Google’s offering has yet to be seen.

In mobile, Google also has a competitor to Microsoft’s Enterprise Mobility Suite that it refers to as Android for Work. These suites are very like the offerings from AirWatch, MobileIron, BlackBerry Enterprise Server, Good and so on which help a company manage its data, applications and policies on mobile devices that are running outside of the firewall. Although Android for Work is expressly aimed at securing Android devices so they can be used inside the enterprise, it does also have the ability to manage iOS devices giving it much wider appeal. However, compared to Microsoft’s Enterprise Mobile Suite, Edison thinks that it is both less capable in terms of the policies that it can manage and less mature in terms of its reliability. Microsoft also has the added advantage of allowing the IT administrator to control all the enterprise’s devices from a single console. PCs, laptops, tablets and mobile devices can all be controlled with a common set of policies making the IT administrator’s task much easier. Furthermore, Edison thinks that Microsoft often bundles this functionality in for free with its Exchange Server product making it much harder for third parties to make a case for deploying their software where Exchange Server already exists. Edison thinks that this will be a factor in keeping the competitiveness of Microsoft’s server and infrastructure offering strong which will help underpin its steady growth.

Apple Of all the potential competitors for Microsoft when it comes to Digital Work, Apple has the weakest portfolio but is one that senior management in enterprises are most often requesting. This is a great example of how important it can be to be strong with the consumer when attempting to get a foothold in the enterprise. The senior executives who make the key decisions are also consumers and in many enterprises, they live their Digital Lives on iOS. This is how Edison believes that the iPad has done very well in the market for enterprise


tablets as CIOs and CTOs are likely to own and use iPads in their personal lives. It would also explain why there is a lot of development of enterprise apps for the Apple Watch despite not a single really beneficial use case being shown.

Exhibit 21: Apple in Digital Work

Source: McKinsey, Radicati, Workfront, Apple, Webtorials, Edison Investment Research

Apple has 55% of the Digital Work pie covered and no position in server software to augment its offering. This comes as no real surprise as Apple’s aim is to sell desirable hardware at a premium price to users and enterprises. For the enterprise, it relies on partners and third parties to write the apps that make its devices useful in an enterprise setting. This is where Apple’s partnership with IBM (see below) comes in. IBM is very strong in enterprise server software and has a reasonable position in terms of its ability to create customised apps that leverage its infrastructure services onto mobile devices. In this way, Apple has an offering that is attractive to many enterprises, but in terms of a strategy around winning the user with a range of Digital Work services, to date, this does not appear to be Apple’s strategic thrust.

Consequently, Edison does not see Apple as a serious threat for Microsoft in Digital Work. Apple has the same problem here as it does in Digital Life (see Mobile Ecosystems – Devil in the details, 18 March 2015, page 20). Without its own suite of services it will become commoditised as the other platforms get better at offering services in an easy and fun to use way. If the usability and hardware is just the same and Apple has no real services of its own, its ability to differentiate and hence put premium prices on its products will be diminished. This is still quite a long time from becoming a reality and in the meantime its close relationship with IBM for customised apps is filling some of the gap.

IBM IBM is very strong in server side software and appears to have a strong challenge in Digital Work, but Edison thinks that its strength is limited to company specific applications. Nominally, it has good coverage of the Digital Work pie (Exhibit 22) at 65%, but Edison does not see much future for many of these products. 10 years ago, IBM was a major player in the enterprise communication space with Lotus Notes which acted as a front end for IBM’s Domino email solution. This was complimented by Lotus Symphony which offered office applications but this was discontinued in 2012 in favour of Apache OpenOffice.



Exhibit 22: IBM in Digital Work

Source: McKinsey, Radicati, Workfront, IBM, Webtorials, Edison Investment Research

IBM’s position with Lotus Notes, Symphony and now Apache OpenOffice is considerably weaker now than it was 10 years ago. Edison estimates that Lotus Notes’ market share is now just 15%, down from 50% in 1998. Edison’s research indicates that the usability of these solutions is inferior to almost any other offering and the replacement of Symphony with Apache OpenOffice is a further indication of IBM’s cursory commitment to this segment of the enterprise. Furthermore, Edison suspects that the weakening position of Lotus Notes will also have a deleterious impact on the appeal of IBM Connections and Sametime.

Where IBM is very strong is in server side software and in specific applications for devices to access and process the data managed by IBM’s software. Many corporations use IBM inside their IT infrastructure giving IBM a very good opportunity for user facing applications that access its infrastructure. This tends to be company specific applications which do not seem to take up a lot of the knowledge worker’s time but Edison thinks are of high value to the organisation. This is where the partnership with Apple comes into play as IBM is providing the enterprise functionality and Apple is providing the attractive devices and some of the Digital Life services that users love.

Edison thinks that Google and IBM currently offer the greatest threat to Microsoft in Digital Work but neither of these two are really giving Microsoft a run for its money. Consequently Edison is comfortable with regards to the following:

Office 365 should continue to grow subscribers from new users, competing solutions and switches from perpetual Office licences. Edison does not see significant pricing pressure beyond Microsoft’s own desire to gain market share.

Server and Infrastructure should continue its steady growth supported by the increasing appeal of Office 365 and Microsoft’s improving offering when it comes to the Digital Work pie (Exhibit 18).

Windows 10 In many ways the headlines regarding Windows 10 are irrelevant. The upgrades and changes in Windows 10 fix the shortcomings of Windows 8 and keep the operating system current, but that is about it. What really matters for Windows 10 is that using this software on its devices will make it much easier for Microsoft to fulfil its ambitions to become an ecosystem company. This is because Windows 10 will


make it easier for Microsoft to address some of the shortcomings in its ecosystem as well as having a much wider range of devices for developers to target, all with the same code base.

Eagles and turkeys It is Microsoft’s turn for a hot product. For the last 14 years, Microsoft’s major operating system releases have reliably alternated between eagles and turkeys. Windows XP was a breakthrough product to be replaced with the awful, half-finished Windows Vista which was then replaced by the superb Windows 7 followed by the disastrous Windows 8. Windows 7 is what Windows Vista should have been and it looks very much as if Windows 10’s successes will be based on fixing all the shortcomings of Windows 8. Edison thinks that this pattern is due to the nature of software development. As the deadline for a major new release draws near, Microsoft always seems to run out of time and starts dropping features and cutting corners in order to get the software out on time. It then spends the next two years adding back what was dropped and fixing the shortcuts until it releases a superb operating system. Windows 10 is showing signs of following this path exactly and fixing all the problems of Windows 8.

Exhibit 23: Microsoft migration to Windows 10


Windows 10 is not a breakthrough product. Windows 10 is really what Windows 8 should have been just as Windows 7 was what Windows Vista should have been. Where Windows 10 really makes a difference is that for the first time, every device that runs Windows will have a common core (Exhibit 23). Windows Phone, Xbox and the PC to date, run code that is similar, but there is no real ability to run an app across all of these devices without making significant revisions to the code. This has limited the appeal of Windows to developers as they have had to target specific devices rather than targeting an entire ecosystem of devices. This also means that there will no longer be three app stores (Xbox live, Phone and PC) but one, making it much easier for users to understand what they are buying and creating a much larger addressable market for developers. That is the theory, but how it works in practice remains to be seen. Either way, Windows 10 represents a big step forward for Microsoft’s ecosystem ambitions in three ways:

Firstly: Seven Laws – Edison judges the quality of an ecosystem by its performance against The Seven Laws of Robotics (Exhibit 14) and thinks that Windows 10 greatly improves Microsoft’s performance on Law 7 – Software Consistency and should also help it to improve its performance against Law 4 – App Equivalency.

Secondly: cross device – the smartphone and the tablet are currently the most important devices when it comes to the ecosystem but this is changing fast. Televisions, consoles, augmented reality, wearables and white goods are all becoming more intelligent and with that comes the opportunity for them to be more useful to the user by enabling certain aspects of the user’s Digital Life. This will start with the consumer but Edison


suspects that over time, Digital Work will also begin to be incorporated into devices outside of PC, tablet and smartphone. As this becomes more relevant, the importance of software consistency (Law 7) becomes more relevant. An ecosystem with both Digital Life and Digital Work services needs to offer a consistent experience across all of the devices upon which the services are offered. This will enable a user to identify with the ecosystem so that he will choose one device over another based on the ecosystem that he wants on it. This is critical because it is this choice that governs the ability of an ecosystem to make money in any of the three ways that Edison has identified (Exhibit 12). By using a common core, it will be much easier for Microsoft to offer a common user experience as well as consistent services across all of these device types. If this experience is easy to use, fun and useful, then users will begin to choose devices that run Microsoft Digital Life and Digital Work services over those that do not. This will give Microsoft the ability to monetise, either through device pricing (if running Windows) or though subscription for its services (if not). This is what is needed to open up new avenues of revenue growth.

Exhibit 24: Ecosystem across devices


Thirdly: the marriage of Digital Life and Digital Work (Mission 3) – bringing the two use cases for Microsoft’s ecosystem together in a seamless, easy and fun to use way is an important part of Microsoft’s long-term strategy. This has been covered in more detail below, but having a single code base underpinning all the Digital Life and Digital Work services will make it much easier to offer them in an integrated and consistent fashion. Consistency is a critical element when trying to get a user to identify with an ecosystem which is why Windows 10 is so important to Microsoft’s long-term ambitions and why Microsoft now scores well against Law 7 – Software Consistency (Exhibit 14).

Marketing Sales and marketing is Microsoft’s single biggest expense item (Exhibit 25). It is high in both US$ terms and relative to the total revenue generated by the company. Despite the vast expense, Edison thinks that investors are seeing a poor return on the money that is being invested. Low market share in mobile, low volumes in Surface Pro 3 as well as a failure to be taken seriously by many developers are but a few of the symptoms of poor marketing.


Exhibit 25: Microsoft sales and marketing issues 2014a-2018e, $m


Microsoft is no longer a marker leader. In the personal and professional ecosystems where it is trying to forge itself into a new company, it is a challenger. Microsoft has identified its new world as mobile first, cloud first but it leads the market in neither of them. Consequently, it can no longer market its wares, its brand and its proposition as if it was. Edison thinks that just as the culture of Microsoft has been turned on its head, the marketing strategy must too, be entirely rethought. The default position of any user when it comes to a device that is not a PC, is Apple or Google and Microsoft must carve out a good position on non-PC devices if it is to realise any of its long-term ambitions. Consequently, simply telling users that Windows 10 or Surface or Windows Phone exist is not nearly enough. In the PC market, all Microsoft has to do is tell everyone that a new version of its software exists and things begin to happen. Outside of the PC, when Microsoft does this, very little happens. Microsoft must explain why these products will delight users and until it begins to do this, users are unlikely to take much notice.

Furthermore, Microsoft must also make the most of the products that it has developed to create new use cases that do not currently exist. The best example of this is Surface. Edison believes that this form factor opens up a whole new use case for portable computing and renders the laptop obsolete. However, Microsoft continues to market this product as a laptop which Edison believes is the worst use case for this product. Edison thinks that a Surface Pro 3 or Surface 3 with the type cover attached is an awful computing experience and greatly inferior to a MacBook Air or similar Ultrabook. Despite this, Microsoft has continued to market this product in its worst possible configuration which Edison believes is a reason why there is only niche interest in this product and why volumes have pretty small to date (Exhibit 7). Microsoft’s engineers have worked wonders with this product which enable it to usher in a new era in computing. However, marketing has spent 30 years selling laptops and seems to be incapable of doing anything else.

Microsoft must change its marketing to explain to users why it should buy its products, not simply say that they exist. It must also take a step into the unknown and encourage new use cases with its new form factor and product categories. Until this happens Edison thinks that Microsoft will underperform its ecosystem ambitions and continue to squander both large amounts of cash as well as the opportunity to return to steady growth.

Mission 2 assessment In terms of vision and assets, we suggest that Microsoft is far advanced in making a success of Mission 2. Against Digital Life (Exhibit 13), The Seven Laws of Robotics (Exhibit 14) and Digital Work (Exhibit 19), Microsoft scores well. A lot of work is needed to improve the quality of its ecosystem when it comes to Law 4 – App Availability and Law 6 – Data Integration but overall, it has the right assets and the right strategy to


succeed in creating an ecosystem for Digital Life and Digital Work. Furthermore, it is aware of its shortcomings on Laws 4 and 6 and is actively working to rectify these issues.

However, there are two areas that Edison believes are substantially undermining the ability of Microsoft to succeed in creating a good ecosystem: marketing and mobile market share.

Exhibit 26: Microsoft’s progress on Mission 2


Marketing is an area that Edison thinks needs a complete overhaul. In a nutshell, Microsoft still markets itself as it did during the glory days when all it had to say was Microsoft and users would come running. Those days are over and in the world of digital ecosystems, Microsoft is a challenger. This requires a completely different approach which is discussed above.

Mobile is also a big problem. Microsoft holds itself out to the market as competing in a ‘mobile-first, cloud-first world’ with a strategy to match. Unfortunately, when it comes to mobile, Microsoft continues to flounder. Financially, at this point, this is a tiny blip on the profit and loss account but in terms of strategy and credibility, Microsoft must turn this around. Losing market share in smartphones severely damages the ecosystem’s credibility in the eyes of users and app developers and makes the task ahead much harder. If share is seen to be going the wrong way (as it is at the moment), developers will not be bothered to develop for the ecosystem no matter how easy it is and users will be less inclined to even consider using it. This is why Edison believes that it is essential for Microsoft to reverse this trend sooner rather than later or face the increasing probability of a complete collapse of its mobile ambitions. Edison believes that the decision in terms of which ecosystem to live in, is most affected by the ecosystem delivery on a smartphone because this is where users spend most of their time. If Microsoft is perceived to have no hope in mobile, winning over users in both Digital Life and Digital Work will be much more difficult which is why this issue has to be fixed regardless of the financial implications. In a company with a ‘mobile-first, cloud-first’ strategy, failure in mobile could seriously dent long-term growth.

Mission 3: Digital Life and Digital Work

Microsoft’s third mission is to build on Mission 2, by integrating the Digital Life and Digital Work experiences into a single seamless experience. This is a crucial final step because if it can be achieved, Microsoft will have created an experience that none of its competitors can match. Almost all of its competitors in the enterprise have no position with the consumer, meaning that competition with respect to achieving mission 3 coming


from the enterprise is unlikely. This is why the Digital Work analysis is mainly focused around those players that could pose a threat to Microsoft with offerings in both Digital Life and Digital Work.

If Mission3 can be achieved, then very much like the Digital Life pie (see Mobile Ecosystems – Devil in the details, 18 March 2015, page 3) where the whole is much greater than the sum of the parts, the same will be true of an ecosystem that encompasses both Digital Work and Digital Life. All knowledge workers are also consumers meaning that there is an opportunity for Microsoft to enhance acceptance of its Digital Life experience by bringing users in via their interaction with Microsoft as part of their working lives. This would result in higher user growth in the consumer part of the ecosystem and greater stickiness resulting from Digital Work. Edison believes that revenues and profit growth will be meaningfully higher through any one of the three monetisation mechanisms that it has described (page 15).

Edison thinks that the biggest barrier to putting the two experiences together in a seamless, easy and fun to use way is the fact that Microsoft’s services, as they relate to user data, are currently very badly integrated.

Law 6 – Data Integration Law 6 refers to an ecosystem’s ability to understand usage as a user profile rather than a series of separate activities. This means that the ecosystem needs to have all of the information collected from its Digital Life services in a single database. Microsoft will need to know every user as a user of all of its services rather than just one service.

Exhibit 27: The requirement for integration in Mission 3

Source: Edison Investment Research, Nielsen, Google, Pewinternet.org, CommScore, NetMarketShare

Currently, each user has a profile within each of the services but none of the services know anything about each other. Bing knows nothing about a user’s contact list within Skype for business and Xbox Live knows nothing about what the user has been watching with Media Player or what games reviews the user has been checking out with Internet Explorer. This puts huge limitations on Microsoft’s ability to understand its users and to offer them a better service. It also makes it impossible to integrate Digital Life and Digital Work in a way that the user would like to use. This is a major challenge even in the simplest of implementations. Microsoft still has difficulty in understanding the differences between Digital Work on Office 365 and Digital Life on Windows Phone and Surface. Running Digital Life and Digital Work on the same set of devices constantly causes confusion and frustration on the part of the user because Microsoft’s systems are still




incapable of really telling the two apart. Edison thinks that a big reason for this is the myriad of user databases hiding behind the single sign-on which we suggest perform as if they have been cobbled together with sticking tape and chewing gum. The result is an erratic and inconsistent user experience that test the user’s commitment to the Microsoft ecosystem.

The good news is that Edison believes that Microsoft is fully aware of this problem and is working to collapse all of the databases into one, but it is taking a long time. It is not a technically demanding task but involves a lot of messy software plumbing. Microsoft is far ahead of many of its competitors when it comes to recognising this problem and acting on it but it is still far behind its chief rival Google when it comes to execution on this issue. Edison believes that a complete resolution of this problem is required before Microsoft can hope to succeed in Mission 3.

Conclusion

When assessing Microsoft’s overall progress, the good news is that there is no immediate danger of a collapse in revenues. This is because Edison is comfortable that Microsoft has taken the necessary steps to either stabilise legacy revenues and gross profits or to switch them into another business line which will ensure continuity (page 13).

Exhibit 28: Microsoft’s progress against its three missions


This gives Microsoft breathing space to execute its long-term vision but this is where the problems begin. The development of its Digital Work offering is mature and best in class but its Digital Life offering still needs a lot of work. The assets are all there (Exhibit 13) but they need to be integrated to offer a seamless, easy to use and fun experience. Furthermore, Microsoft must also regain the confidence of the user and of the developer community in the viability of its mobile offering as well as ensure that all the leading apps are available on its platform. This must all be done before Microsoft can hope to have a chance at succeeding in Mission 3.

These are difficult but not impossible missions and Edison thinks that the rewards for success will be substantial over the long term. Hope of steady long-term growth is something that most commentators and investors have long since abandoned, meaning that there is significant upside if Microsoft manages to pull it off.


Microsoft has three hurdles to get over to succeed in its missions: 1) it needs to stop losing share in mobile; 2) It needs to improve the delivery of its Digital Life services to users (Law 6) as well as make sure there is thriving third party app development (Law 4); and 3) It must completely change the focus of its marketing.

Financials

Based on the analysis of Microsoft’s progress against the three missions, Edison has assumed that Microsoft is successful in stabilising and returning to low growth in its legacy businesses. However, It has assumed no real revenue or profit growth coming from success in developing its ecosystem to delight users (Mission 2) or from putting Digital Life and Digital Work together (Mission 3) in a seamless and easy to use way.

Successful execution on the three missions is likely to see the ecosystem begin to generate meaningful revenues for the company. Furthermore, with Digital Life and Digital Work working together in a seamless way it will have a competitive edge and a barrier to entry leading to attractive margin development. This could be realised through any of the three monetisation mechanisms that Edison has identified as being available to an ecosystem owner (Exhibit 12). Margins are never going to be the 93% enjoyed by the legacy businesses but long-term stable growth is something that the market has assumed has long deserted the company.

Exhibit 29: Microsoft revenue, gross margin and OPEX, 2014a-2018e


Without any real contribution from the ecosystem, we forecast that Microsoft is capable of some EPS growth, 7.7% (CAGR) over the next three years, generating nearly $93bn in cash from operations. (21% of this growth comes from the share buy-back program that Edison thinks is 60% efficient in buying back shares which are then cancelled). Edison thinks that there is meaningful upside to these numbers from delivering on Missions 2 and 3 but these are unlikely to be delivered in a meaningful way inside the explicit forecast period 2015-2018e. Fortunately, success on Mission 1 gives Microsoft time to deliver on Missions 2 and 3 as moderate growth should be possible. Edison also sees the possibility of a PC product cycle but this too, has not been included in the estimates for Microsoft.


Exhibit 30: Microsoft EBIT, EBIT margin and EPS, 2014a-2018e


Edison’s estimates assume that Microsoft is able to transform its legacy businesses to stave of declines, but assumes very little success from the ecosystem and no turnaround in the PC market. On this basis, the shares are still attractive (see below) giving plenty of upside if the vision can be executed and realised.

Valuation

Edison has valued Microsoft using both a comparative method against its peers in the market as well as a DCF valuation. In contrast to many earlier-stage companies, DCF is a good measure to use for Microsoft as its cash flows are not growing fast, they are very large and fairly predictable. Furthermore, its significant market capitalisation and high liquidity means that the typical assumptions that tend to skew this analysis are much more reliable in this case. The two measures point to a valuation of $61.0 per share, some 30% above current levels. There is plenty left on the table for investors despite the recent rally.

Comparative analysis The most controversial aspect of this analysis is the choice of the peer group. 10 years ago, one would have chosen Intel and the PC makers, but Microsoft is a much more complicated company than that. It has cloud revenues, internet revenues, hardware revenues, gaming revenues and it intends to generate revenues from its ecosystem over time. Consequently, it is appropriate to include companies with similar revenue streams to get a realistic idea of how Microsoft’s revenue and profit streams should be valued by the market.


Exhibit 31: Comparative valuation of Microsoft

Source: Edison Investment Research, Microsoft, Bloomberg. Note: Priced at 11 May 2015.

This analysis arrives at a valuation of $56.5 per share (Exhibit 31) which is lower than the DCF based valuation. Edison has much greater confidence than normal in the DCF based valuation given the greater reliability of the assumptions that need to be made. This is discussed below.

DCF valuation DCF is a valuation method that is fraught with problems. Although it is fundamentally the only reliable valuation method, the assumptions that have to be made in terms of long-term growth can skew the valuation so much that it renders the end figure useless. This is typically a problem with high-growth businesses or those that do not have stable cash flow. In the case of Microsoft, it has very stable cash flow and Edison has used a long-term growth assumption of just 1%. This is below a long-term economic growth rate and Edison thinks that this is achievable even if there is never any contribution to revenues and profits from the ecosystem.


Exhibit 32: DCF based valuation of Microsoft

Source: Edison Investment Research, Microsoft, Bloomberg

The DCF-based analysis (Exhibit 32) takes its market data from Bloomberg and calculates a Weighted Average Cost of Capital (WACC) which is then used to discount future cash flows to work out what they are worth today. Using reasonably conservative assumptions DCF values Microsoft shares at $65.4 per share, which differs from the comparative valuation by less than 20%.

Putting the two methods together gives a valuation of $61.0 per share, some 30% above current levels without having to deliver on Missions 2 or 3. Should Microsoft see some success with these, then there is scope for increases in growth and valuation in the long-term.

The key catalysts required to reveal this value include:

halting market share loss in mobile;

improving the delivery of its Digital Life services to users (Law 6) as well as making sure that there is thriving third party app development (Law 4); and

changing the focus of its marketing completely.


Exhibit 33: Microsoft profit and loss account, 2014a-2018e Microsoft consolidated US$ m (June fiscal year)

2014 2015e 2016e 2017e 2018e

Devices and Consumer Licensing

19,528 14,977 13,740 12,963 12,261

Computing and Gaming Hardware

9,093 9,856 13,946 20,300 21,280

Phone Hardware 1,982 7,679 6,401 9,435 11,644 Devices and Consumer Other 7,014 8,766 10,453 12,799 15,094 Commercial Licensing 42,085 41,091 39,859 39,772 39,207 Commercial Other 7,546 10,995 15,773 21,635 27,864 Corporate and Other (415) 215 (165) (193) (210) Total revenues 86,833 93,577 100,006 116,710 127,141 COGS (27,078) (32,888) (35,698) (44,018) (47,633) Gross income 59,755 60,690 64,308 72,692 79,508 Gross margin 68.8% 64.9% 64.3% 62.3% 62.5% Research and development (11,381) (11,987) (13,734) (16,028) (17,460) % sales 13.1% 12.8% 13.7% 13.7% 13.7% Sales and marketing (15,811) (15,951) (17,152) (19,989) (21,763) % sales 18.2% 17.0% 17.2% 17.1% 17.1% General and admin (4,677) (4,449) (5,021) (5,860) (6,384) % sales 5.4% 4.8% 5.0% 5.0% 5.0% Other OPEX (127) (1,673) EBITDA 27,759 26,631 28,401 30,815 33,901 Depreciation and amortisation (4,960) (5,664) (5,721) (5,778) (5,836) EBIT 27,759 26,631 28,401 30,815 33,901 Net interest income 286 (15) (181) (154) (126) Equity participations Other non-operating income (225) 15 Pre-tax profit 27,820 26,631 28,220 30,661 33,774 Tax charge (5,746) (6,372) (6,634) (7,208) (7,940) Tax rate 20.7% 23.9% 23.5% 23.5% 23.5% Net income before minorities 22,074 20,259 21,586 23,453 25,835 Minority interests Net income 22,074 20,259 21,586 23,453 25,835 Extraordinary items (127) (1,383) Adj-net income 22,201 21,642 21,586 23,453 25,835 EPS US$ 2.63 2.45 2.66 2.94 3.27 Adj -EPS US$ 2.64 2.62 2.66 2.94 3.27 DPS 1.12 1.24 1.35 1.49 1.66 % paid out 42.6% 50.6% 50.6% 50.6% 50.6% Source: Edison Investment Research, Microsoft


Exhibit 34: Microsoft balance sheet, 2014a-2018e Microsoft consolidated US$m (June fiscal year)

2014 2015e 2016e 2017e 2018e

Cash 8,669 7,412 10,253 13,614 17,340 Marketable securities 77,040 88,024 88,024 88,024 88,024 Gross cash position 85,709 95,436 98,277 101,638 105,364 Trade debtors 19,544 12,638 15,101 17,202 18,436 Days 76 52 52 52 52 Inventories 2,660 2,511 3,000 3,418 3,663 Days 10 10 10 10 10 Other current assets 6,333 8,201 9,799 11,162 11,963 Current assets Plants property and equipment 13,011 14,375 14,178 14,090 14,115 Associates and JVs 14,597 11,697 12,962 14,038 15,065 Financial assets 6,981 7,081 8,461 9,638 10,330 Other assets 3,422 3,254 3,889 4,429 4,747 Intangible fixed assets 20,127 21,728 21,728 21,728 21,728 Fixed assets 58,138 58,135 61,218 63,924 65,984 Total assets 172,384 176,921 187,395 197,343 205,410 Trade creditors 7,432 6,804 8,130 9,260 9,925 Days 29 28 28 28 28 Short term borrowings 2,000 1,725 1,725 1,725 1,725 Current portion of long term debt 2,499 2,499 2,499 2,499 Other current liabilities 13,043 23,234 18,108 11,745 4,541 Current liabilities 45,625 34,261 30,462 25,229 18,690 Long term borrowings 20,645 27,644 27,644 27,644 27,644 Other long term liabilities 16,330 22,556 26,173 29,775 31,626 Long term liabilities 36,975 50,200 53,817 57,419 59,270 Total liabilities 82,600 84,461 84,278 82,648 77,960 Shareholder’s equity 89,784 92,460 103,117 114,695 127,450 Equity in issue 68,366 68,475 68,475 68,475 68,475 Retained earnings 17,710 20,514 31,171 42,749 55,504 Minority interests 3,708 3,471 3,471 3,471 3,471 Total liabilities and shareholder’s equity

172,384 176,921 187,395 197,343 205,410

Total Interest bearing debt 22,645 31,868 31,868 31,868 31,868 Net debt or (cash)* (63,064) (63,568) (66,409) (69,770) (73,496) Source: Edison Investment Research, Microsoft. Note: *Includes marketable securities.


Exhibit 35: Microsoft cash flow statement, 2014a-2018e Microsoft consolidated US$m (June fiscal year)

2014 2015e 2016e 2017e 2018e

Net profit before minority interests 22,074 20,259 21,586 23,453 25,835 Depreciation and amortisation 4,960 5,664 5,721 5,778 5,836 Working capital (176) 6,427 (1,626) (1,387) (815) Change in other operating assets 2,511 (4,608) 3,614 3,082 1,811 Cash flow from operations 32,231 28,505 29,294 30,926 32,666 Capex (5,485) (5,363) (5,524) (5,690) (5,860) Acquisitions (5,937) (2,797) Disposals Movement in short term financial instruments

(12,596) (14,293)

Other investing activities 5,185 3,319 Cash flow from investing (18,833) (19,134) (5,524) (5,690) (5,860) Borrow short term 9,474 18,477 Pay back short term (1,012) (6,575) Borrow long term 2,088 (1,500) Pay back long term (3,000) Share buy back (7,316) (12,664) (10,000) (10,000) (10,000) Payment of dividend (8,879) (9,929) (10,929) (11,875) (13,080) Other 251 1,639 Cash from financing (8,394) (10,552) (20,929) (21,875) (23,080) Net cash flow 5,004 (1,181) 2,841 3,361 3,726 Effect of FX (139) (76) Net increase in cash and cash equivalents

4,865 (1,257) 2,841 3,361 3,726


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