Shares of tech giant Microsoft (MSFT) are trading near the lower end of their range over the past couple of months. Part of the culprit was the company's fiscal first quarter earnings report. If you exclude revenues and earnings deferred for the Windows Upgrade Offer, Windows 8 Pre-Sales, and the Office Offer, Microsoft's GAAP revenues and earnings missed handily. Additionally, there have been a number of cautious notes out regarding both Windows 8 and Surface sales. Microsoft analysts have taken their estimates down quite a bit since that report, and the stock has trended lower as a result. The question is are expectations today fair, or is the possibility that the company could disappoint again?
Starting in late November, we've seen a bunch of negative reports regarding Microsoft and where things stand. The first one came from Rick Sherlund at Nomura Securities. Sherlund noted that Windows 8 sales appeared to be off to an "awkward" start. He said this because he believed that PC vendors were slow to launch new form factors. Also, there seemed to be some bad press around the Windows 8 learning curve and dual interfaces, and the ongoing substitution of tablets for PCs. Sherlund noted, "Recent data from Asia points to a 7 percent drop in PC shipments in Q4, which is down from expectations of a flat reading previously issued."
The following sums up Sherlund's outlook for the company:
Based on checks and outlook for FY13, Sherlund is reducing his estimates on Microsoft. He largely believes that bad news is already priced-in to Microsoft shares, but notes that Street estimates still appear a little high. FY13 EPS moves from $2.93 to $2.81 and FY14 from $3.24 to $3.10. FY13 revs move from $82.97 billion down to $80.64 billion and FY13 revs from $91.05 billion to $89.22 billion.
Just a few days later, Davenport's Drake Johnstone reiterated his buy recommendation on Microsoft, but cut the price target from $40 to $35. Microsoft was also removed from the firm's "Analyst Action List" as a drop in PC sales led the analyst to cut estimates on the company. Johnstone believes that PC sales will continue to be very weak through the first half of calendar 2013. He believes that Microsoft's Surface tablet will make up for some of the lost revenues, but that the lower margin Surface will eat into the company's gross margins, which they subsequently lowered. Johnstone cut his forecast for Microsoft earnings from $3.00 to $2.90, as well as his forecast for the Windows and Windows Live segment revenues.
The next hit was a report from NPD stating that sales of Windows based notebooks were down 10% on Black Friday despite the launch of Windows 8. Meanwhile, Apple (AAPL) sales were basically flat. Microsoft numbers are given in the statement below.
The decline in Windows notebook sales came despite the fact that Microsoft recently launched its new Windows 8 platform. Devices running Windows 8 represented 89 percent of notebook sales with an average selling price of $368, while touchscreens accounted for 3 percent of sales with an average selling price of $668.
Overall, notebook unit sales were down 10% but total revenue was only down 5%. That's due to the average selling price rising from $437 to $460. You can thank Apple's expensive MacBook Pro with retina display for the increase in average selling price.
Has Microsoft messed up with Windows 8, including the phone version? Well, here's a quote from Google's (GOOG) Apps product management chief Clay Bavor, explaining why his company has no plans to build apps for the new platforms:
We invest and will go where the users are, but they are not on Windows Phone or Windows 8.
The ongoing tablet war:
Microsoft launched the Surface tablet into a very competitive space. Microsoft is obviously trying to steal some of the magic that Apple has created with the iPad, while also battling Google's Android powered line, including Amazon's (AMZN) Kindle Fire.
Recently, analysts at IDC have raised their tablet unit sales forecast for this year and beyond. They now believe the following:
- 2012 forecast raised from 117.1 million to 122.3 million.
- 2013 forecast raised from 165.9 million to 172.4 million.
- 2016 forecast raised from 261.4 million to 282.7 million.
The firm believes that Android will gain a few percentage points of market share this year, stealing it mostly away from Apple. Over the longer term, the firm believes that both Android and Apple based units will lose market share to Windows powered units. The firm provided the following market share and compound annual growth rate forecast table.
So how are things going in the tablet arena now? Well, it depends who you ask. All Things Digital reported that Windows RT powered Surface tablet accounted for just 0.13% of North American web traffic from November 12th to 18th. Traffic from Google's Nexus 7 and 10 tablets accounted for roughly 0.91%, seven times that of Microsoft's. But here's the kicker. The share from Apple's iPad was 88%. It might be poor sales that led Microsoft to increase production and expand their retail distribution for Surface.
Microsoft may not be the only one struggling in the tablet space right now. One of my fellow writers on this site, Paulo Santos, recently had a great article about Amazon's Kindle Fire situation. He explains the recent Amazon price cut on the model, trying to figure out if it is just a holiday promotion, or if there is something more going on. It is possible that poor sales of the device have led to excess inventory. Paulo and I have written about Amazon extensively. We both agree that Amazon always seemed to be focused on their top line revenue number, regardless of how it impacts the bottom line net income figure. This move would be the latest evidence of that.
Expectations - then and now:
On the day that Microsoft reported fiscal Q1 results, analysts were looking for fiscal Q2 revenues of $23.01 billion, an increase of 10.2% over the prior year's period of $20.88 billion. Analysts were expecting a profit of 87 cents in fiscal Q2 compared to 78 cents the year before.
Today, those expectations have come down quite a bit. Analysts are currently forecasting just 4.7% revenue growth for the period to $21.86 billion. Earnings per share are now expected to be just 77 cents, which would represent a one penny decline over the prior year period. Given the near 5% revenue growth forecasts, analysts are not very confident in Microsoft's margins right now.
At the same time, analysts have actually raised their revenue numbers for the full year for Microsoft, as well as the next fiscal year. Since the Q1 report, fiscal year '13 (ending June 2013) has seen its revenue numbers hiked from $80.06 billion to $80.28 billion, and fiscal year '14 has seen its numbers upped from $85.62 billion to $86.93 billion.
At the same time, earnings per share estimates for those two years have come down. For fiscal year '13, the average earnings estimate has declined from $2.99 to $2.89, with the fiscal '14 one coming down from $3.28 to $3.23.
When it comes to this fiscal year, analysts are looking for a huge fiscal Q3 for Microsoft. That quarter ends in March. Current estimates call for 19.7% revenue growth in the quarter, and earnings per share to rise from $0.60 to $0.79. Fiscal Q3 is expected to show a revenue dollar increase of $3.42 billion. For the entire year, the company is only expected to show a $6.56 billion increase. I'm not saying that Microsoft will disappoint, but just stating that analysts are expecting a huge year over year number for the company in Q3.
Other Items to consider:
I'm sure there was some impact from Superstorm Sandy, which hit almost right after Windows 8 was officially launched. I don't care who you are. If your home has been partially or completely destroyed, you are not running out to upgrade your operating system or buy a Surface tablet. I'm sure part of the November weakness can and will be attributed to the storm. The question will be if that business can be picked up going forward. So far, the answer seems no.
Microsoft does offer investors a juicy 3.39% annual dividend yield, which is about 50 basis points more than a 30-Year US Treasury bond currently. The company is also buying back $1 billion in stock per quarter, however, that doesn't always get the share count down. Options dilution can easily push it higher. But at least the buyback prevents it from going up any more.
When it comes to this space, you get more growth if you are willing to pay for it. Microsoft currently trades for about 8.5 times calendar 2013 expected earnings, with Apple and Google trading for 10 and 15 times expected earnings over the same time period, respectively. But when it comes to Apple and Google, you are getting a lot more growth. Microsoft is only expected to grow revenues in the high single digits, with Google and Apple looking to increase revenues in the low 20s, percentage wise. I didn't find it wise to compare any of these names to Amazon because of the ridiculous price to earnings valuation Amazon fetches now.
Microsoft's stock has dropped about $4 in the last three months, and I think for the short term, shares might feel a little more pressure. PC sales figures haven't been good, and it seems that Windows 8 and the Surface are off to a slow start. Until we get more clarity on the fiscal cliff, I think you might get some more downgrades and further negativity from analysts.
Right now, Microsoft could be considered a short candidate, but I have to explain what that means. I could see the stock dropping to its recent low of $26.26 again, or even $25 perhaps if the entire market goes down big. But if the fiscal cliff is averted and the market rallies, you could see upside all the way back to $30. $3 up and $2 down isn't a great risk/reward ratio for shorts at this point. The better opportunity would come at the next earnings report in January, if you believe that the company's results will come up light. For the reasons outlined in this article, Microsoft is a short candidate, but that doesn't mean I am recommending you go out and short it today.
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