Declining Notebook Sales And A Shift Away From Console Gaming Will Hurt Earnings Growth Potential

Stagnating Growth in Microsoft Office Revenue

Microsoft’s Office suite has been a staple in workplaces and home offices for years, but competition from free cloud-based alternatives like Google Docs and other vendors like Apple, Cisco Systems, Meta, IBM, Okta, Proofpoint, Slack, Symantec, Zoom, and numerous web-based and mobile application competitors are jeopardising this key revenue stream.

The issue for Microsoft here is simple; what matters most to customers is convenience, cost and simplicity, and with Office providing a similar product at an elevated price for consumers means that plenty of users which switch to alternatives like Google 

Moreover, there was a significant price hike in Microsoft 365 and Office 365 business prices by as much as 20 percent in March 2022. While this didn’t impact segment performance, a similar price hike in tougher economic conditions like we see now could be a huge catalyst for Home and Commercial Office 365 users switching towards these free or cheaper alternatives.

Competitors like Google have been luring small to medium-sized businesses with cost-effective pricing models, and the shift towards freemium models by some competitors provides organizations with the flexibility to explore alternative productivity tools at a lower initial investment. Moreover, the rapid adoption of AI and machine learning by competitors to enhance real-time collaboration and automate routine tasks is escalating the competitive pressure on Microsoft. 

While Microsoft might have something of a moat in terms of AI integration with Co-Pilot using OpenAI’s GPT-4 model, Google is nipping at their heels with DuetAI’s integration into the Google Suite, so unless there are significant advancements to Office’s AI offerings, I could see the Business and Office Productivity segment begin to lag in this area.

Changing PC Consumption Leading To A Decline in Windows OEM Licensing Revenue

2023 has been a tough year for computer hardware manufacturers and Microsoft hasn't been able to escape the heat. The last few earnings releases from Microsoft have detailed a noticeable decline in ‘OEM Licensing revenue’. 

Have you ever noticed how your new laptop already comes pre-installed with Windows? This is because that copy of Windows has already had its license paid for by the laptop manufacturers. This is where the OEM Licensing revenue comes from. 

The last 3 successive quarters have each seen a 20% drop in OEM revenue, largely due to a sour PC sales market. However, it could be the beginning of a more worrying trend for Microsoft.

The latest reports from StatCounter say that Mac’s market share has actually continued to rise, all while Windows OEMs face continued difficulties in the market. Major OEMs like Lenovo, HQ, Dell and Acer all had recorded year-over-year drops in shipments, according to IDC data. Whereas, Apple saw year-over-year growth of 10.3%, being the only PC maker out of the top five globally to achieve the positive results.

Now, this is not to say that demand for Apple products have massively impacted Windows OEM revenue. In fact, inventory levels could also take some of the blame as Notebook OEMs’ elevated channel inventory levels point to a possible over-estimation of demand for Windows PCs and this miscalculation has led to a glut in inventory, thereby reducing the need for new licenses.

But this trend could ultimately be the first signs of the beginning of a radical change in OEM computer consumption. We may have already reached a point where most computer hardware exceeds the demands of most commercial or personal use cases, resulting in less need to upgrade. Furthermore, as mobile technology continues to advance, we may reach a point where personal computers are almost redundant for basic needs like web browsing and emails.

It may not be a case of ‘Microsoft’s OEM revenues will improve when the PC market sees a recovery', We may already begin to see the inflection point where consumers Notebooks are no longer the most viable device to meet consumers needs for mobile internet browsing.

Surge In Mobile Gaming Could See Xbox Consoles sales to Taper Off

The gaming landscape over the last 2 decades has been epitomized by a console war between Playstation vs Xbox. However, the gaming landscape has changed drastically with the rise of mobile and PC gaming, which I see as providing a significant threat to Microsoft’s console business.

The headwinds faced by Microsoft’s gaming ecosystem have been evident in the recent decline in console hardware sales. The company’s latest Q4 2023 results showed an 11% decline in console sales, despite an overall rise in Xbox gaming revenue. This is not an isolated trend either, if we jump back to the two quarters before this, we can see a startling 30% decline in hardware sales for Q3 2023 and a 13% decline in Xbox hardware sales in Q2 2023 compared to the same quarters of the previous year.

While something can be said for a difficult macroeconomic environment hurting sales, the conversation would be quite short considering that Sony’s Playstation 5 is having some of the best quarters in sales since the console’s release. 

Ultimately, I see the issue for Microsoft’s Xbox being that the gaming landscape has changed in a number of ways - particularly with respect to console gaming - that I envision will materially impact the long-term performance of Microsoft’s console segment.

1. The Mobile Takeover: Mobile gaming has seen an unprecedented rise in popularity. What was once a way to kill time on the toilet has become the largest gaming segment by revenue. Some people may forgo buying a console in favor of sticking to a smartphone that they can use in other aspects of their life. 
2. Crossplay and PC Gaming Resurgence: The advent of crossplay in modern gaming has potentially diminished one of the traditional sales drivers for consoles. Gamers are now able to interact and play with friends regardless of the gaming platform. I now no longer have to buy an Xbox console to play with my friends who own an Xbox. This, coupled with the general shift towards PC gaming due to its dual utility for both gaming and productivity, poses a challenge for Microsoft's console sales.
3. Erosion of Console Exclusive Titles: One key hardware sales driver was the exclusive gaming franchises that came along with it. Previously, fans of series like Halo, Forza or Gears of War would have to own an Xbox in order to play the latest titles. However, these titles, along with several Playstation exclusives like God of War and Spyro are now all available on PC, meaning players get to enjoy the aforementioned utility of a PC, with all the content benefits that usually were limited to consoles.
4. Cost Factor: The increasing costs of consoles might be driving potential buyers towards the more versatile and often cost-effective PC gaming setups. The initial investment in a gaming PC can be justified by its multi-purpose use, a feature consoles traditionally lack.
5. Performance and Upgradability: PCs offer a level of performance and upgradability that consoles struggle to match. Gamers looking for the best graphical and performance experience may be inclined towards PC gaming.

Now, the astute reader would point out that the above factors should also be impacting PS5 sales just as much as Xbox, but I’d argue with Xbox consoles being integrated so closely with PC gaming (see gamepass being available for PC now), the line is blurred for consumers in the Xbox ecosystem. Playstation on the other hand is a very well-defined console-only experience, which may explain why couch gamers are gravitating towards it. Playstation has become the brand synonymous with console gaming, which I think will further exacerbate the pain Microsoft will feel over the next few years relating to Xbox hardware sales.

Productivity and Business Processes

I envision a scenario wherein Microsoft 365 Consumer subscriber and Commercial seat growth begin to stagnate due to the aforementioned churn of personal and small business customers for alternatives that are cheaper and easier to collaborate on small teams with, like Google Suite.

While on the flip side of the coin, I do think LinkedIn and Dynamics 365 will continue to provide some uplift to the segment.

On the balance of this, I believe the performance of Microsoft's Productivity and Business Processes segment could closely mirror that of the Office Software industry, falling slightly short due to my forecast of Microsoft’s commercial stagnation. The result of this would be the segment's current revenues of $69.3 Billion growing at 3.85% per annum - lower than the 4.35% pa growth rate for Office Software - to reach $83.7 Billion in 2028.

Intelligent Cloud

I haven't touched on Microsoft’s Intelligent Cloud segment in this narrative, but I understand it’s been a very lucrative revenue stream for the business. Microsoft’s Azure forms part of the big 3 cloud providers, alongside Amazon’s AWS and Alphabet’s Google Cloud. Naturally a close-knit competition has arisen which I see continuing for the foreseeable future with Google Cloud gaining back some ground on Amazon and Microsoft’s lead.

According to Grand View Research, the Cloud Computing industry is set to grow at 14.1% annually to 2030. However, with Google recovering some lost ground, I will run with the assumption that Microsoft’s Intelligent Cloud segment’s growth will trend closer to 10.5% pa. to 2028, thereby seeing segment revenues grow from $87.9 Billion to $144.8 Billion.

This is a segment of the business that I will watch closely, as I believe continued strength here could drastically alter my narrative.

More Personal Computing

I assume over the next 5 years, Xbox console sales will continue to taper off, particularly if low-end PC gaming becomes more competitive and the crossplay between consoles and systems continues to reduce the advantage of the network effect. I’ll also assume that no new Xbox console generation is due for release in this time, which seems to align with recent leaks.

Once you account for the contribution of Activision-Blizzard ($8.7 Billion on a LTM basis) to the segment, More Personal Computing revenues total $63.4 Billion for 2023.

I do expect this to be the weakest segment for the business, attributable to the difficulties for Xbox hardware discussed above and a decline in Windows OEM licensing revenue prolonged difficulties with Windows notebook demand due to changing consumer preferences.

I forecast segment revenue to grow at 2% pa. to 2028, which would see the More Personal Computing segment generate $70 Billion. This figure accounts for growth in the content and services through Xbox gamepass and the value of the IP acquired in the Zenimax and Activision-Blizzard acquisitions.

Share Buybacks To Continue

I assume share buybacks will continue at a similar net buyback yield of 0.8% pa. This will mean that, ignoring any diluting events due to future stock based compensation vesting, Microsoft's Shares outstanding will fall from 7.43 Billion to 7.13 Billion.

Diversification Into New Ventures Could Mitigate Downside Risks

Microsoft's diversification into other areas like Cloud Services and LinkedIn could mitigate some of the risks associated with declines in the More Personal Computing and the Productivity and Business services. Microsoft has been an evolving business overtime, and has generally managed to keep up with the shifting tides in the tech world. Launching Microsoft Azure was a stroke of genius and has allowed Microsoft to assert itself as one of the ‘Big 3’ cloud service providers on the market and should Microsoft continue to successfully diversify, it could nullify some of the catalysts in my narrative.

OpenAI Partnership Could Spark Growth In Office Suite Seat Growth

Microsoft’s partnership with OpenAI could be play a role in reinvigorating the market’s interest in Microsoft’s Office Suite. Despite being the most rampant buzzword in the tech industry at the moment, large language models (LLMs) like ChatGPT have revolutionised the way we work in a lot of ways. From helping with input during the creative process, to summarising full essays to even formatting data, AI delivers a lot of functionality many users will pay for.

If Microsoft continues to collaborate with OpenAI - arguably the leader in AI at the moment - then we could potentially see an Office Suite that has far greater capabilities than its competitors. If this were to happen, it would almost counter my anticipations of a slowing seat growth entirely, as I’d believe both home and commercial users will flock to an AI-equipped Office Suite (far better than what’s currently available now).

The Activision-Blizzard Acquisitoin Opens A Path To The Mobile Gaming Industry

Mobile gaming has taken the world by storm and is by far the most profitable aspect of the gaming industry. Microsoft’s presence in the mobile gaming space was fairly minimal, but the recent acquisition of Activision-Blizzard has brought several major mobile titles like Hearthstone, Diablo Immortal, Warcraft Rumble and Call of Duty: Mobile under the control of Microsoft.

While I still stand behind my expectations of continued difficulty with Xbox console sales, entrance into the mobile game industry could more than offset and poorer performance from the Xbox side of things.