Heading into the launch of its Windows 8 operating system, the market is not giving Microsoft any respect, selling its shares off in recent weeks. I can see why the market is concerned. In the first quarter of its 2013 fiscal year, Windows division revenue was off by a third and segment operating income was cut in half. It is not surprising to see sales of Windows 7 fall off when a new OS is on the horizon, but the market is clearly worried that the era of Microsoft's operating system dominance is over.
The transition of consumers' computing preferences toward smartphones and tablets, devices on which Microsoft has so far failed to gain traction, does mean that its days of controlling over 90% of the computer operating system market are gone. However, that is not necessarily a catastrophic outcome for the company. Knowing that it is under intense pressure from Apple and Google, Microsoft has woken up and is in the process of reinventing itself. Its homegrown Surface tablet running Windows 8 looks pretty slick and has garnered positive reviews. Surface pre-orders ahead of its Oct. 26 release quickly sold out. The Surface tablets are an interesting opportunity for Microsoft to exercise complete control over the user experience, including software and hardware. Up against well-designed Apple and Samsung products, Microsoft cannot risk its OEM partners building cheap and shoddy tablets and laptops. It was important for Microsoft to set the standard for what a Windows 8 tablet could be, and with Surface, it looks like Microsoft has a hit on its hands.
While Surface appears able to secure Microsoft a foothold in the tablet space, investors should be holding their breaths about the Windows Phone 8, which launches on Oct. 29. Handsets from HTC and Nokia look well-designed and are competitive on hardware specs with Android devices and the iPhone 5, but I have concerns about the carrier relationships and the strength of the marketing push needed for Windows Phone 8 to gain meaningful market share over the next year. Nokia's flagship Lumia 920 looks to have striking camera and video capabilities as well as a bright splash of color in a field dominated by bland black handsets. The Lumia 920 is competitively priced at $149, which may sway some consumers away from the pricier iPhone 5 and Samsung Galaxy S III. If Windows Phone 8 can move toward 15% market share in 2013, that would represent approximately 100 million in global handset sales. That's a lofty target, but it's crucial to proving that Windows Phone 8 is a viable third smartphone ecosystem.
Coming out of the most recent quarter, there are reasons to be cautiously optimistic about Microsoft's future. Its Server and Tools division is grossly underappreciated by the market, despite delivering $1.8 billion in operating profit. Additionally, Office 2013 is set for release in January. Office is one of Microsoft's biggest cash cows and it is in a stronger competitive position than Windows OS. I view uptake of Office 2013 as an earnings catalyst next spring.
At the time of publication, Charly owned no shares of the companies mentioned. The Motley Fool owns shares of Microsoft and Google. Motley Fool newsletter services have recommended buying shares of Google and Microsoft. Motley Fool newsletter services have also recommended creating a bull call spread position in Microsoft.