Analyzing the Impact of Microsoft's Office 365 Launch

| About: Microsoft Corporation (MSFT)
Last week, Microsoft (MSFT) announced the launch of Office 365, taking the Office suite to the Cloud. The product was launched in 40 markets worldwide, allowing users to access Microsoft Office, SharePoint Online, and Lync Products online. The product is targeted at Small and Medium Sized Business enterprises (SMBs), on a pay by subscription model. The demo at the product launch also highlighted the product’s collaborative functionality across business applications like e mail, instant messenger, conferencing and document sharing and editing that is well ahead of its competitors.
Who is it targeted at? For SMB’s, Office 365 (O365) is a viable alternativeto in house IT and competitive products like Google (GOOG) Apps. The guaranteed availability of 99.9% (approx. 9 hours of downtime / year) will be a key confidence backstop for the users. This guarantee is important for customers to commit their complete IT to a hosted service. Kiosk workers is a new market segment that the product targets. If by decoupling applications from computer, Office 360 can penetrate the 56 mn. U.S. workers without a dedicated computer, it can generate a potential revenue stream ranging from $270 mn. (lower end kiosk worker) - $1.5 bn. (higher end kiosk worker).
Pricing and Features? Three versions of the product are available 1) O365 for SMBs (less than 25 employees) with monthly pricing of $6/user 2) O365 for Enterprises with pricing ranging from $2/user to $27/user on a monthly basis 3) O365Education, that is expected to replace LiveEdu. The product promises to be a cost effective option for users. However, it’s not the direct license cost where customers are saving money. It’s actually IT overheads and administration costs where SMBs are likely to benefit. For example, for a 100 employee enterprise deploying the $27/user/month plan, the annual cost is $32,400 at full price; Microsoft Office 2010 retails at $49,900 for 100 licenses at full price (ex. Implementation and administration). Thus, from second year onwards, Microsoft is actually making more money. However SMBs are actually benefiting as they don’t have to spend too much on IT overhead and infrastructure.
Controlling Piracy? Until now, Microsoft has struggled to control piracy in emerging markets, which have a higher growth potential than traditional established markets. This piracy leads to significant loss of revenues to the company annually. Cloud-based offerings may help in reducing the piracy in the emerging markets, as users now have a more viable and cost effective option to the expensive standard license based product offerings.
Channel of Sales From a channel perspective, over 20 partners have already started selling O365, with the SMB channel expected to grow rapidly in FY12.Some of these partners include Intuit (INTU), Vodafone (VOD), Telstra, Telefonica (TEF), and NTT Communications.
Bottom-line Impact The biggest impact is expected to be the shift to a subscription based usage model from the traditional license based model, though over a long term. By controlling large amounts of business data for SMBs, there is a high ‘stickiness’ value attached to the product, ensuring recurring revenues for Microsoft. Assuming Microsoft can maintain gross margins similar to leading SaaS vendors (likely between 75-85%), O365 is likely to be comparably profitable over time.
The product also has the potential of becoming a ‘sticky’ application for mobile devices, a segment where Microsoft has not been strong till now.
View on Microsoft’s stock: Microsoft stock gained over 7% last week on rumors of early launch of Windows 8 as well as the Office 365 launch. The stock still is trading at valuations of just 9x forward earnings. I believe this provides an attractive risk reward opportunity over the next 1-2 years. Some catalysts for the stock may be beta release of Windows 8 later this year, launch of Win7 Phones with Nokia, and Office 365 gaining traction. In addition, also watch out for easing PC comps in September and long term operating targets at September analyst day.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.