Quantifying the Tablet Market's Potential to Cannibalize Demand for Personal Computers ‘The worldwide tablet market experienced a major technological development. with the introduction of the Apple iPad in April 2010, which has important implications for the personal computer (PC) industry. A tablet can be thought ofasa porteble personal computer with a touchscreen interface instead ofa key- board, which is commonly used as the input device in traditional PCs. Another distinguishing feature of tablets is that, unlike the majority of PCs that run on the Microscft Windows platform, most tablets run on a non-Microsofi operating system, including Apple's (OS and Google's Android. Given the tablets ability to perform many of the most common tasks ofa PC, including e-mailing, browsing the web, sharing photos, playing music, watching movies, playing games, keeping a calendar, managing contacts, and so on, an analyst might reasonably wonder to what extent sales of tablets might cannibalize demand for PCs and the potential impact that might have on Microsoft's sales and earnings. Exhibit 31 presents cone approach to answering these questions.Exhibit 31 Unitand Revenue Projections (thousands, unless noted) PRE-CANNIBALIZATION PC PROJECTIONS Fy2011FY2012E-FY2013E—FY2014E—-3-Year CAGR Consumer PC shipments 170022174430 =—«184,120 193,811 45% Non-consumer PC shipments 180881 185,570 195,880___206,189 45% Total global PC shipments 350903 360,000 380,000 400,000 45% {% of whichis consumer 48% 48% 498% 48% °% of which is non-consumer 52% 52% 52% 52% Consumer tablet shipments 363 82,800 111,250, 59.3% Non-consumer tablet shipments 1686 13750 149.7% Global tablet shipments BRAT | 90,000 125,000 57% {% of whichis consumer 56% 92% 89% 85% {% of which is non-consumer a 8% 1% 1586 Cannibalization factor, consumer 30% 30% 30% 300% Cannibalization factor, non-consumer 108% low 10% 108% # of consumer PCs cannibalized by tablets 11036 7484033375 44.625 +# of non-consumer PCs cannibalized by tablets 169 70 1375 Total PCs cannibalized by tablets 11208 560850 %% of total PCs cannibaized by tablets 32% 7% 91% 11.8% POST-CANNIBALIZATION PC PROJECTIONS Consumer PC shipments 158986 149,590 150745 149,186 “21% Non-consumer PC shipments 10712184850 194505 203,568 4.0% Total global PC shipments 359,698 SAM ——345,250__—_352,750 13% Microsoft implied average selling price (ase)bit31 (Continued) POST-CANNIBALIZATION PC PROJECTIONS Consumer S85 Non-consumer 155, Revenue impact for Microsoft (S millions) Consumer 938 Non-consumer 26 Total revenue impact 968 2a 12 2.228 se S85 155 155 2.837 213 3,050 des enterpre Source: Based on dats from Gartner, JPMorgan, Microof, and authors’ analysis. education, and government purchasersTo begin, worldwide market shipments of PCs in FY2011 were 350.9 million units and worldwide shipments of tablets were 38.5 million units.!° Shipments of tablets to consumers represented 96% of total shipments during fiscal year 2011. Next, we estimate the magnitude of the potential substitution effect, or cannibalization factor, that tablets will have on the PC market. Because the cannibalization factor depends on many different variables, including user pref- erences, end-use application, and whether the purchaser already owns a PC, just to name a few, we usea range of potential estimates. Moreover, we also divide the worldwide PC market into consumer and non-consumer (enterprise, educa- tion, and government purchasers) because the degree of substitution is likely to differ between the two. For purposes of illustration, we assume a cannibalization factor of 30% for the consumer market and 10% for the non-consumer market in our base case scenario. In addition, the base case scenario assumes that non-consumer adoption of tablets increases to 15% of the market from 4% in 2011. Moreover, although the composition of the global PC market is roughly evenly divided between consumers and non-consumers (48% and 52% in fiscal 2011, respectively), the non-consumer segment is significantly more profitable for Microsoft because approximately 80% of the company’s Office products are sold to enterprise, edu- cation, and governmeat institutions. The average selling price (ASP) estimates are derived by dividing Microsoft's estimated average revenue for the prior three years by customer type by Microsoft's estimated PC shipments for each type of customer. By multiplying the projected number of PCs cannibalized by tablets by the estimated ASP, we are able to derive an estimate of the revenue impact for Microsoft, For example, in FY2012 it is projected that 24.8 million consumer PCs will be cannibalized by sales of tablets. With an average consumer ASP of $85, this cannibalization implies a revenue loss for Microsoft of $2.1 billion (248 million units x $85 ASP per unit = $2.1 billion). Once the revenue impact has been projected, the next step is to estimate the impact of lower PC unit volumes on operating costs and margins. We begin by analyzing the cost structure of Microsoft, and more specifically, the breakdown between fixed and variable costs. Most software companies have a cost structure with a relatively high proportion of fixed costs and a low proportion of variable costs because costs related to product development and marketing (mostly fixed)are sunk and unrecoverable whereas the cost of producing an additional copy ¢ the software (mostly variable) is relatively low. Because very few, ifany, companie provide an explicit breakdown of fixed versus variable costs, an estimate almos always needs to be made. One method isto use the formula, A (Cost of revenue + Operating expense)/%6A revenue ‘here %A is “percent change in’ asa proxy for variable cost percentage. Anothe approach is to assign an estimate of the percentage of fixed and variable costs t the various components of operating expenses. Both approaches are illustrate in Exhibits 32 and 33, Exhibit32__Estimationof Variable Costs for Microsoft, Method 1 ($ mil Selected Operating FY2011FY2009 Percent Segments Fv2009 Fy2010 Fy2011 Change ‘Windows and Windows Ive 8792 8778 Microsoft business division 19,345 21986 37 0764 17% Total segment reverie Windows and Windows L 6191 5810 Microsoft business division 8/058 8,159 Total operating expense 14209 14969 386 ‘Variable cost =n (Cost revenue + Operating expense) A revene ‘sine cost = 1~ AVarable oat = = 28% 671% Exhibit33_ Estimationof Variable Costs for Microsoft, Method 2($ mil ES Fv2009- %of Operating FY2011_ Total Op Estimated % Fixed Cost Expenses FY2009 FY2010 _FY2011__ Average Expense of CostFixed Contribution Cost of rev enue (exc. deprecation) 1595135771161 29% 2086 6% Depreciation expense: 170 __1,800__2,000 838 10035, 5% Total cost of revent 1s 1239515577 —13,876 308 1% Research and development S714 9013892 22% 100% Sales and marketing ag 132lk 13900 13,888 30% 80% General and admin. aor 406342224105 1 100% 10%, Total opera Ingexpenses 38074 38,386 42,782 os oneEee) FY2009-_%of Operating FY2011 Total Op Estimated % Fixed Cost. Expenses FY2009 _FY2010__FY2011_ Average Expense of CostFixed Contribution of Microsoft total cost structure that is fixed 70% Estimated percentage [Note Feel year end in June Sure of data: Miceosft 2011 Form 10-K and author’ analysis As can be seen, Microsoft's cost structure appears to consist of approxi- mately 70% fixed costs and 30% variable costs. Note, however, that a growing, company like Microsoft will typically re-invest in property, plant, and equip- ‘ment to support future growth, so even those expenses that appear to be “fixed” will increase over time. To adjust for this expected growth in fixed costs, this example includes an assumption that the change in fixed costs will be half the rate of the change in sales. Variable costs are projected to change at the same rate as sales. As shown in Exhibit 34, after incorporating these assumptions into the projections, an assumed 7.0% compound annual growth rate (CAGR) in revenue through FY2014 would translate into a 10.6% CAGR in operating income [(36,757/27,161)"3 ~ 1 = 0.106, or 10.5%. In addition, these assumptions, ‘would result in an operating margin expansion of 410 bps over the same period (12.9% ~ 38.8% = 4.1%, or 410 bps) because ofthe significant amount of operat- ing leverage that exists as a result of a relatively large fixed cost base. With the farther assumptions of no change in other income, a constant effective tax rate, and no change in shares outstanding, the pre-cannibalization model Exhibit 34 results in projected revenue of $85.7 billion, operating income of $36. billion, aan operating margin of 42.9%, and earnings per share (EPS) that increases at a CAGR of 10.3% to $3.62 in FY2014. Ee meeareunn EPS Projections ($ millions) FY2011—FY2012E—FY2013E_—FY2014E_——3-Year CAGR Revenue 59,943 74,839 80078 $5,685 70% Year-ov change 70" 7.0% 7.09% Operating Expenses Foxed (70% 2998 30,996 33,203 35% Variable (30%) 2835 13,738 15,72 70% fotal operating expenses 42,782 w729 98,926 46 Operating income 2761 30,110 33,308 36,757 Los% Operating margin 38.838 40.23% 41.59% 42.50% (Other income (Expense) 10 s10 s10 910 Pretax Income 31,020 ai 37.667Elec Provision for income taxes Effective tax rate Net income Weighted average shares outstanding, lated Estimated EPS pre-cannibalization Fy2011—-FY2012E——FYZ013E—=FY2014E_—3-Year CAGR aon 5aae 6,608 17.53% 17.53% 23,150 2.215 31,064 8593 8593 8 sue S298 $3.28 $3.62 103% In tke post-cannibalization scenario, as shown in Exhibit 35, revenue is reduced each year to reflect the expected impact from cannibalization. ‘the ‘expected impact of cannibalization results in a decrease in the CAGR of revenue ‘over the period to 5.2%, down from 7.0% in the pre-cannibalization scenario, Given the reduction in revenue growth, and holding the cost structure constant at 70/30 fixed versus variable costs, operating income growth slows toa CAGR ‘of 80%, down from 10.6% in the pre-cannibalization scenario. Operating mar gginat the end of the period is reduced by approximately 100 bps from 42.9% to 41.9% because the company is unable to leverage its fixed cost base to the same degree asa result of slower revenue growth, Overall, in the post-cannibalization scenario, Microsol is expected lo generate revenue of $81.5 billion, operating. Income of $34.2 billion, an operating margin of 41.9% and EPS that increase at a CAGR of 7.8% to $3.37 in FY2014, Thus, the cannibalization of PCs asa result, of projected growth in the tablet market is expected to reduce the company’s annual revenues in FY2014 by $4.2 billion, operating income by $2.6 billion, ‘operating margins by 96 bps, and EDS by $0.25 Saree eee Poe enna ened noted) Fy2011—-FY2012E = FY2013E—FY2014E_——_3-Year CAGR Revere 69,948 72816 7028 LANs 5.2% ‘Year-over-year percent change 48% 61% 5% Dpenating Expenses Fixed (70K) 200 30520 a7 2.6% Variable (0%) 12,85 13,325 1435 149 5.2% Total operating expenses 185 45,581 7208 1a% (Operating income ze 7 3146 a5 sox (Operating margin 38.83% 3952% 4082% 1.90%, Other income (Expense) ou suo 910 29,681 32.356Enon Tz) Fy2011—FY2012E—=FY2013E—«FY2014E_——2.Year CAGR Provision for income taxes Effective tax rate 6151 Net income 23,50 ware 26684 28,934 Weighted average shares out standing, dilated 8598 3593 8.593 8593 Estimated EPS post-cannbalization $2.69 S245 sau saz 73% Fstimated impact on operat ing margin “61 bps 76 bps -96 bps Estimated impact on EPS (033) (018) (60.25) Answer the following questions u 1 g Exhibits 31 through 35 on Microsoft: Estimate post-cannibalization global PC shipments in FY2012 assuming a cannibalization factor for consumers of 40% and 15% for non-consumers. Using the results derived in Question 1, estimate the post-cannibalization revenue in FY2012 for Microsoft. Using the estimate for post-cannibalization revenue derived in Question 2 and the cost structure provided, estimate post-cannibalization operating income and operating margin in FY2012 for Microsoft. Assume that fixed costs change at half the rate of the change in sales.