Stifel analysts Brad R. Reback, Arvind Rajamohan, Adam Borg, Kevin E. Cassidy and Aaron C. Rakers lower their FY15 estimates on Microsoft as they look into the future of Chromebooks.  They opine that Chormebooks fill a previously untapped market space, and even if the first wave of notebooks doesn’t wow consumers, the concept itself is here to stay.

Google Chromebook

Late in 2010, Google Inc (NASDAQ:GOOG) made headlines with its launch of the Chrome OS and associated hardware. While the announcement garnered attention, the devices, until recently, failed to gain meaningful traction. The lukewarm uptake was due to sub-optimal hardware (pricing/performance) and limited options/capabilities. However, demand has picked-up due to OS improvements, enhanced hardware performance, increased marketing efforts and an emerging app-ecosystem. We view these gains, coupled with Apple Inc. (NASDAQ:AAPL)’s recent decision to no longer charge for its Mac OS, and consumer’s desire for ever cheaper PC/Tablets, as indicative of a tectonic shift in Microsoft Corporation (NASDAQ:MSFT)’s ability to monetize Windows in coming years. Today, when looking at the aggregate OS market (phone/tablet/PC), Microsoft is the only vendor that explicitly charges for the OS software. We believe this could prove untenable in coming years, forcing Microsoft to give away the OS and attempt to monetize Windows usage/support via various methods depending on the end-customer. We believe this is the single biggest challenge Microsoft’s new CEO will face in coming years and likely limits their ability to spin-out Bing.

Chromebooks here to stay

We were an early adopter of netbooks and have been using various Chromebooks for the past few months and our initial experience with both devices is vastly different. While we wanted to throw our netbook out the window shortly after we got one (due to a lack of functionality/performance), we find the Hewlett-Packard Company (NYSE:HPQ) and Acer Incorporated (TPE:2353) Chromebooks to be solid devices. In fact, this report was partially written and published via a Chromebook. We are not suggesting Chromebooks are a replacement for the enterprise, but we do think they have a place in the market (i.e. education, low-end of the market, tech focused enterprises, etc.) and are a viable alternative for those looking for sub $300 devices. We believe it is very reasonable to expect Chromebooks to ship 10-15 million units in CY14.

Chromebooks sold well this holiday

Data from NPD and Digitimes implies that ~20% of PCs sold in the US commercial channel during the holiday-season were Chromebooks (Amazon highlighted 2 out of 3 of its top selling laptops were Chromebook) and with the strong demand during the holiday season, we estimate Chromebooks sold >2 million units in 2013 (up from 100K in 2012). This strong sell-through data and increasing uptake is not surprising given Microsoft Corporation (NASDAQ:MSFT)’s latest “Scroogled” marketing-campaign, in which they use reality TV stars from “Pawn Stars” to try and paint Chromebooks as nothing more than a brick when not connected to the internet (not true, as you can use certain apps, view/edit pictures, listen to music, view emails, etc.). We think Microsoft realizes Chromebooks are a viable threat that is quickly gaining OEM support as customers show an increased interest in the low-cost platform.

Windows ASPs face massive contraction

In order to combat the above threats, we believe Microsoft Corporation (NASDAQ:MSFT) will need to offer OEMs aggressive concessions on its OS license fees ($10-$30/ device vs ~$40 today) in the near-term, so its partners can profitably deliver sub $300 devices. Microsoft has already formed a partnership with Asustek Computer, Inc. (OTCMKTS:AKCPF) (TPE:2357) and Lenovo Group Limited (ADR) (OTCMKTS:LNVGY) (HKG:0992) to try and do exactly that and we expect more deals with other OEMs to be announced soon. Over the medium to longer term, we believe Microsoft will be forced to follow Apple Inc. (NASDAQ:AAPL) and Google Inc (NASDAQ:GOOG) and give away the OS, especially in the consumer market, and use services like Bing, Skype, Office 365, etc. as its primary monetization engine. That said, we expect Enterprises to continue to pay for support via various enterprise agreements.