Opinion seems to be divided regarding the success of Windows 8 in the tech media. Adrian Covert declared it a hit in a recent CNN article, whereas Adrian Kinsley-Hughes took Windows 8 failure as a given in a recent ZDNet post. Even Microsoft's (MSFT) own pronouncements at their earnings conference call on 4/18/13 seemed equivocal and apologetic.
In his prepared remarks, CFO Peter Klein launched into the following soliloquy:
While Windows revenue has been impacted by the transition from the traditional PC to a new era of computing devices, the overall addressable markets are growing and we are excited by the opportunities ahead of us. We built Windows 8 with touch and mobility at the center of the experience, which positions us well for this new era. However, the transition is complicated, given the size of our hardware and software ecosystems. We still have an immense amount of work to do, yet we feel good about the foundation we have laid and are optimistic about the long-term success of Windows. [Italics mine]
These aren't the kinds of things you say about a big hit, but I still felt that they left open the question of Windows 8 success and whether there is even an objective way to assess it, given the information that Microsoft has provided. Matters would be simple if Microsoft had provided a number for Windows 8 licenses as they did in the January conference call, and the lack of a precise number is probably not a good sign. Microsoft isn't shy about providing numbers when they're boast-worthy. Are there other metrics for Windows 8 success that investors can use instead?
The performance of Windows Division in terms of revenue and operating income are stated separately in Microsoft's 10-Q, and these might be good metrics if we knew the relative contributions of Windows 8, but there just isn't enough information to deduce this. Microsoft head of Investor Relations Chris Suh did state:
In the Windows division, revenue was flat this quarter. Within that, OEM revenue performance was in line with the overall x86 PC market, which continues to be challenged as the PC market evolves beyond the traditional PC to touch mobile devices.
In fact, OEM revenue for Windows Division outperformed the overall PC market, suffering only a 3% decline sequentially from 2012 Q4, compared to the 12% PC shipment decline reported by Gartner Research. This decline is also much less than the decline suffered by Windows Division after the debut of Windows 7 in October 2009. Between 2009 Q4 and 2010 Q1, OEM revenue dropped by 36%, but there was a lot of pent up demand for Windows 7 after Vista, and revenue had spiked by more than 100% from the previous quarter.
OEM revenue may provide the best currently available quantitative metric for comparing Windows 8 success to Windows 7, subject to some caveats. Once Win7 was released, I think it's reasonable to assume that Vista sales disappeared, given the unpopularity of that OS, while the same may not be true for Windows 8. Assuming that OEMs have mostly been licensing Win8 since its release, then the comparison to Win7 is favorable. In 2009 Q4 (when Win7 was released) and 2010 Q1, Windows Division OEM revenue totaled $9.05 billion. In 2012 Q4 and 2013 Q1, OEM revenue totaled $7.529 billion or 83% of what it had been for Windows 7. I think this is pretty good, considering that the Windows 7 release was pre-iPad and is a thumbs up for Windows 8 success.
Other metrics aren't so favorable. The aforementioned decline in Q1 PC shipments I believe is a consequence of the disruptive nature of Windows 8. In an earlier review and assessment, I concluded that Windows 8, while a good tablet OS, really had nothing to offer the traditional PC user without a touch screen. As a consequence, my copy of Windows 8 sits on the shelf, and my three (non-touch) Windows PCs run Win 7. I'm not the only one to make such an admission. Mary Jo Foley, who has written about Microsoft for decades and who is hardly an Apple "fanboy," made a similar admission in an article on the forthcoming Windows update in Zdnet.com.
When I wrote my competitive assessment of Windows 8, I predicted that upgrade sales would dry up, and I believe this has happened. Even Microsoft's presentation material for the Q1 earnings release confirms this indirectly. In the presentation charts it's stated that non-OEM revenue is up 40%, driven by sales of Surface and commercial sales of Windows. Conspicuously absent is any mention of retail or upgrade sales of Windows 8.
Furthermore, the commercial sales are predominantly volume licensing of Windows 7 to corporate customers, whose IT departments will probably skip Win8 altogether, just as they did Vista. This will probably be a very large source of revenue for the rest of the year, since Microsoft has announced that they're ceasing support for Windows XP as of April next year. Windows XP still commands a huge user base, estimated by Netmarketshare.com to be more that 38% of all desktop operating systems in use.
Desktop usage share for Windows 8 also continues to lag, according to Netmarketshare. They estimate Windows 8's share to be just 3.17%, behind even the much reviled Vista at 5%. The adoption rate for Windows 8 is also slower than Windows 7, which had a 10% share by this time after its release. Currently, the largest usage share is still held by Win7 at 44.7%.
So even though the evidence is somewhat circumstantial, I believe the release of Windows 8 did negatively impact PC sales overall in Q1, since many of the PCs offered were still non-touch. The drop in PC shipments are a thumbs down for the question of Windows 8 success.
Prospects for the coming quarters
The mixed votes for Windows 8 success are part and parcel to its Jekyll/Hyde split personality. As a tablet OS it works well and is fully capable of driving sales of Intel (INTC) based tablets going forward. Microsoft and Intel are both optimistic about the prospects of new Haswell-based tablets with good reason, since Haswell will make Windows 8 tablets lighter and more affordable.
In the mean time, Microsoft is working on a revision to Windows 8 (8.1) that is rumored to incorporate some features that users have missed, such as the Start Menu and being able to boot into the desktop. This is probably just the start of a reunification of the tablet and desktop models that will become the next generation of Windows.
Windows 8 on non-touch enabled devices, whether desktop or laptop, currently has very little to offer Windows 7 users, and as a consequence, most PC makers are offering some form of Windows 7 option. Although Haswell processors are due to start shipping this quarter, I expect PC sales overall to continue to decline roughly 10-15% per quarter in Q2 and Q3 until Haswell accelerates Intel tablet and ultrabook sales in Q4, whereupon PC sales will turn around by 10-20%, partly as a result of the normal Holiday Season uptick.
Windows 8 OEM revenue will continue to decline by about 10% as well in Q2 and Q3 from the $3.707 billion of Q1 , with most of the decline made up in commercial licensing of Windows 7. Overall, I expect Q2 and Q3 Windows Division revenue to be flat relative to Q1 with division revenue ramping back up in Q4 by 10%.
The main dark spot in the Windows tablet story will be Windows RT, the variant of Windows 8 for ARM based devices. IDC estimated that only 900,000 Surface RT tablets were shipped in Q4 2012, and Bloomberg reported that only about a million had been sold as of 3/14/13. I expect Haswell based tablets to completely cannibalize Windows RT devices, leaving Microsoft with little alternative but to pull the plug on Windows RT by the end of the year.
With flat Windows revenue and the impending demise of RT, I expect Microsoft to trade sideways through Q2 and Q3. I doubt the stock market will punish Microsoft excessively for its misstep in Windows RT however, given that Haswell based Windows 8 tablets will finally create a credible Microsoft presence in the tablet space. For this I expect the markets to reward Microsoft richly by the end of the year, probably out of all proportion to the actual revenue gains by the company. Share price gains of 5-10% are likely, and even 20% is not unthinkable, making Microsoft a solid momentum play starting in Q4.