Editor’s note: Allan Krans is senior analyst with Microsoft said Thursday that its net income in the most recent quarter rose 35 percent, helped by strong sales of Windows 7. Here’s Krans’ analysis of Microsoft based on the earnings report.

By ALLAN KRANS, special to LTW

HAMPTON, N.H. – Vista’s in the past

With a majority share of the PC operating system market, the best case scenario for (Nasdaq: MSFT) was to retain that leadership position, and its results indicate it’s done just that.


Although the long-term test of Windows 7 will be corporate adoption over the next two years, at this point it appears Microsoft has weathered the storm of customer uncertainty created by Windows Vista. Despite fielding poor reviews from analysts, business, and consumer customers alike, Microsoft was able to retain its hold on the operating system market due to weak competition and by leveraging its strong distribution partnerships. Vista customers may not have been satisfied with the product, but few better choices existed, and those that did were more difficult to find and purchase.

Windows 7 Reinforces Microsoft’s Market Dominance

While TBR does not believe Windows 7 demand drove the 25 percent increase in PC unit shipments during 1Q10, the product does go a long way towards reinforcing Microsoft’s position atop the PC operating system market. Though Microsoft cited strong demand for Windows 7 as driving its results during the quarter, in reality its performance was largely driven by the underlying PC market.

After businesses and consumers alike postponed technology purchases during the recession, PC purchases improved for the second consecutive quarter, as Microsoft estimates PC unit shipments increased by 25 percent year-to-year. Customers are beginning to replace aging PCs that were held onto over the past year, and the wave of technology refreshing is lifting Microsoft’s boat along with the PC OEMs and associated supply chain partners, including Intel, whose revenue growth rate of 44.1% during 1Q10 is its highest since 1995.

Hardware purchases are a powerful sales tool for IT suppliers, but neither Microsoft nor other suppliers can rely on a prolonged double-digit increase in hardware unit shipments. Once the wave of recession-borne pent-up demand is gone, hardware unit shipment rates are likely to settle into more typical single digit growth patterns, taking double-digit Windows revenue growth with them.

However, the good news for Microsoft is that Windows 7 appears to reinforce its strong hold on the market. With a product that is being met with broadly positive reviews, Microsoft customers will have fewer reasons to seek out alternatives, and continue to face more difficult in purchasing alternatives due to the company’s strong distribution partnerships.

Office 2010 Faces a Tougher Grind

PC shipment growth and weak competition may have greased the wheels for Windows 7 release, but Microsoft will face a significantly more challenging introduction with the release of Office 2010. Unlike Windows, sales of Microsoft Office are less correlated with PC hardware sales, making the current PC refresh cycle less of a factor for Office 2010 adoption.

During the current quarter, for example, Microsoft Business Division revenue, which is largely composed of Office revenue, increased by 1 percent after adjusting for Office 2010 revenue deferrals, significantly lagging the 25 percent PC unit shipment growth during the quarter. Microsoft’s success in Office will be much more hard-fought compared with Windows, as customers, particularly business customers, will need to clearly understand the Office 2010 value proposition.

Additionally, Microsoft is also facing more pressure in Office compared with the Windows business. Multiple alternatives exist, including productivity offerings from Google and Zoho that are much easier for customers to find and purchase via as SaaS model.

Microsoft Slaps Google with Free Office Apps

To address competitive threats to its Office franchise, Microsoft is willing to leave money on the table for customers. After successfully competing with free offerings for years, Google’s recent traction with Google Apps, particularly winning a high profile competitive deal for the City of Los Angeles, got Microsoft’s attention. Though overall traction by competitors in the productivity applications space remained limited, the risk to not responding was clearly mounting.

Office is a $15 billion business that generates operating margins of more than 50% for Microsoft, and any erosion of the business would have significant ramifications on the company’s investments in search and entertainment, which continue to require subsidization.

The stickiness Microsoft maintained within Office accounts, even though free alternatives exist, indicates customers are not purchasing productivity applications solely on cost. Microsoft will segment its Office portfolio with the release of Office 2010, providing free limited functionality versions delivered both traditionally and via SaaS models to combat free offerings from Google Apps and other competitors, while maintaining the full featured, full priced versions for more demanding users.

Using this strategy, Microsoft can head lower-cost competitive solutions seeping in around the edges, while maintaining the core base of Office users that are willing to pay for the certainty, reliability, and performance of the Office suite.

Get the latest news alerts: at Twitter.