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In 2014, Microsoft (NASDAQ:MSFT) faces three main challenges in its Devices and Consumer segment:

1) Growing its Windows mobile device platforms into profitable businesses.

2) Transitioning the remaining XP users into Microsoft platforms.

3) Creating a popular successor to Windows 8.

Success in these areas virtually guarantees continued robust growth in the newly created Devices and Consumer segment, while failure in any of the above areas could result in an unprecedented decline in the number of consumer Windows users.

Altered Perceptions

As I've pointed out in recent articles on Apple (NASDAQ:AAPL), ARM (NASDAQ:ARMH), and Intel (NASDAQ:INTC), I've been struck by how much perceptions have changed in the past year for all these companies as well as for Microsoft. A year ago, Microsoft seemed on the verge of supremacy in mobile devices. Microsoft had just launched Windows 8 and Phone in time for the holiday season. The natural order of things, in which Microsoft (or Intel, or both) were dominant, had been inexplicably upset by Apple's iOS and Google's (NASDAQ:GOOG) Android devices. Many expected that this order would soon be restored.

Fast forward to the present, and it's apparent that Microsoft's mobile expectations haven't panned out, based on Microsoft's earnings, the results of its chief Windows Phone partner Nokia (NYSE:NOK), and the research of IDC and Gartner.

Windows Phone: For the full year of 2013, IDC and Gartner report that Windows Phone achieved a 3.2-3.3% worldwide market share. Windows Phone market share actually declined sequentially in the calendar 4th quarter from 3.6% (9.5 million units) in Q3 to 3.0% (8.8 million units) in what is typically the biggest quarter for smartphone sales. Nokia sold 93% of the Windows Phones in Q4, and its Mobile Devices division (which includes smartphones and feature phones), posted a loss for the quarter, as it had all year.

Windows Tablets: After the second quarter of 2013, IDC stopped providing a breakdown of tablet market share by operating system, but as of Q2, Windows tablet market share stood at just 2%. If Surface is any indicator, there's no reason to expect that market share improved markedly in the following quarters. Buried in Microsoft's 10Q is an admission that Microsoft lost $39 million on Surface sales revenue of $893 million. It's been estimated that Microsoft sold a total number of 1.275 million Surface devices (including the Surface Pro), which is a reasonable back of the envelope estimate. A year ago, IDC estimated that 0.9 million Surface RT tablets were sold in the last two months of 2012 Q4.

Windows 8: By the 4th quarter Windows OEM consumer-oriented licensing was down by 20% y/y. It could be argued that this was a natural decline compared to the launch of Win 8 last year, but Windows 8 hasn't won much usage share in the Windows ecosystem. As of January, netmarketshare.com shows Windows 8.x having a 10.6% usage share. If we accept the estimate of Benedict Evans (of Enders Analysis) of about 1.7 billion Windows users worldwide, then there are about 180 million copies of Win8 in use.

Windows XP: In contrast to Win8.x, Windows XP still has a 29% usage share according to Netmarketshare, or about 493 million users, by the same math I used above. Since Microsoft has announced the discontinuance of support, the remaining XP users represent a large target market for OS upgrades and new machines. To a large extent, the XP upgrade cycle in business has driven revenue growth in OEM professional licensing and in commercial volume licensing (booked in the Commercial Segment half of the new Microsoft).

Despite setbacks in mobile and its flagship Windows OS, Devices and Consumer segment posted a 13% y/y increase in revenue to $11.9 billion, about half of Microsoft's total quarterly revenue of $24.5 billion. However, operating income for D&C declined by 25.6%. This was despite strong holiday sales of Xbox One (3.9 million) and a 12% y/y increase in Windows OEM professional licensing revenue.

Meeting the Challenges?

Mobile Device Profitability: Although Microsoft admitted in its 10Q that it had lost money on Surface devices, the profit picture for Windows Phone is less clear. The question of profitability becomes all the more pressing now that Microsoft has agreed to buy Nokia's mobile device business, which definitely lost money all last year. The purchase of Nokia is starting to seem less and less like a good idea in light of the Google experience.

In the past, I've argued that becoming a vertically integrated device maker would allow Microsoft to retain profit that would otherwise go to a manufacturing partner or contractor. Whether this added profit will be enough to achieve profitability when Nokia's mobile business is integrated into Microsoft remains to be seen. Google's manufacturing partners have a built in cost advantage in getting their Android operating systems for free.

My call: Microsoft will prove to be no more adept at turning around a money losing hardware company than Google was.

Transitioning Windows XP Users: That there were still so many XP users in January came as a surprise to many who expected the number to dwindle rapidly as the April deadline approaches. Most of the business XP users have made the transition, so that leaves mostly individual consumers and a few businesses dependent on WinXP software they can't easily replace. Either way, the transition is becoming a tough sell for Microsoft. Most of the people still using XP are doing so precisely because they're not interested in having the latest technology. They have very modest computing needs already being met by a familiar and reliable platform.

To deal with the remaining XP diehards, what MS needs and doesn't have is an extensive infrastructure of stores like Apple's, filled with friendly Microsoft "geniuses" ready to help XP users transition to shiny new Surface tablets. Short of that, Microsoft might offer discounts for upgrades out of XP.

My call: Unlike Apple, Microsoft lacks the experience and infrastructure to cater to non-technical users. Microsoft will probably flub this one with roughly 25% of XP users defecting away from Microsoft in 2014. Most will likely go to Android or Chrome.

Successor to Windows 8: There's already talk of what Windows 9 will consist of, and it's almost certain to be better than Win8, not that I'm one of those to revile Windows 8. I'm writing this article on a Windows 8.1 machine. I think Microsoft has a pretty good idea of what they need to do: provide a truly integrated and consistent UI rather than the split personality Metro/Desktop of Win8.

My call: Windows 9 will be much better than Win8.x, but, arriving in 2015, it will be too little too late to prevent the XP defections or bring profitability to Microsoft's mobile businesses.

The Perfect Storm

The stakes are great in these areas because the consumer side of the business is still very important at roughly half of Microsoft's total revenue. Microsoft is facing a perfect storm in which it fails in all three areas. This will lead to an overall decline in the installed base of consumer Windows devices of all types as existing Windows users defect to other platforms, especially mobile ones. Such a decline might not be immediately apparent, as there's a lot of uncertainty about the number of current Windows users.

The first hints will be declines in Windows OEM professional licensing (booked on the D&C side) as well as declines in commercial volume Windows licensing (booked on the Commercial side). This could start as early as next quarter as the business upgrade cycle winds down.

When and if the decline in the Windows user base does become apparent (probably by the end of the year), it will send shock waves throughout the industry, and end the perception of Microsoft as a leader in personal computing.

Source: Microsoft's Perfect Storm