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As I look into Microsoft (NASDAQ:MSFT), mixed feelings emerge. On one hand, the stock seems painfully cheap. It carries a supposed forward 2013 P/E of 9.5 and trades on a TTM EV/EBITDA of 6.1 times. It even yields 3.4%. Those don't seem like the multiples you'd expect to find in a huge cash cow dominating several markets, from the OS driving the entire desktop and laptop scene, to the most common business software, to console gaming. This would be the kind of enterprise whose shares should shine in a zero percent interest rate world where lunacy has taken hold of monetary policy.

Yet, even with all that going for it, there are very good reasons to avoid Microsoft. Some of those reasons are analogous to what is punishing Intel (NASDAQ:INTC): The computers have gotten "good enough," slowing down replacement, and the mobile revolution -- where neither Microsoft nor Intel command much share -- is eating away at both of these companies' core businesses.

But when it comes to Microsoft, the problem might be even deeper than Intel's. Intel has an insurmountable technological edge, both in product technology and in production technology. This gives it a decent chance that it might end up penetrating the mobile device world sooner or later, and maybe even dominating it. Not so with Microsoft. Microsoft's main advantage was its OS (Windows) ecosystem. The market was dominated by Windows computers so developers made Windows applications, which just ran on them. And since most of the applications that existed ran on Windows, users bought only Windows machines, which completed the circle.

Today, however, this dynamic is under two different attacks:

  • First, the mobile world has organized itself around entirely different ecosystems -- iOS and Android -- which enjoy advantages similar to what Microsoft saw in the past, but this time, they accrete to Microsoft's competitors, Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG). The same dynamic that once kept competitors away from Microsoft's cake now keep Microsoft on the outside of the mobile world, looking in and having a lot of trouble breaking in.
  • Secondly, the evolution towards cloud-hosted and browser-delivered, standards-compliant (HTML, CSS, Javascript) content means that the Microsoft OS has lost relevance for many applications. Where once your app was designed to run on top of a specific OS (usually Windows), now the app just needs to have access to a browser that respects the standards, and those are available in many different platforms. It became possible to perform many tasks regardless of what machine and OS one was using. This is slowly corroding the need to have a Windows box. Here, I might add the fundamental difference that might help Intel while not helping Microsoft -- you still need a box, and it still needs a CPU, so Intel still has hope. An example of this would be Apple's Mac retaking share from the Windows world.

Finally, it's not just computers that have gotten good enough. For basic word-processing or spreadsheet jobs, it might happen that free alternatives such as Google Docs or Open Office are already at a stage where they, too, are good enough. And these platforms can both import and export legacy doc formats, so the existence of a large installed base does not impede their adoption (except in complex documents using macros, for instance).

It will thus increasingly become hard to justify spending tens or hundreds of dollars per year per worker to have access to these applications where most of those workers will only use them for their basic functionality. Obviously, the erosion might be a long process, but if you were starting a small enterprise today, would you spring for Microsoft Office for basic tasks?

To Top It Off

What is also worrisome is that while we're seeing news that Windows 8 is suffering from multiple sources including the downgrade today by Argus precisely due to the weakness of Windows 8 sales, Microsoft's estimates still paint a rosy picture. Next quarter's consensus has the expectation of a 19.7% jump in revenues. This sets up the likelihood that, at some point, Microsoft will be forced to guide down these numbers.

Conclusion

In spite of its low valuation, Microsoft is seeing a set of threats emerging and getting worse, and these threats are eating at the very core of Microsoft's business. To compound the problem, Microsoft's near-term estimates seem not to incorporate the weakness that these threats are already producing, which might bring about a short-term negative catalyst for the stock in the form of downward guidance.

Investors probably would do well to steer clear of the stock, or at least avoid excessive exposure in it. I'd have trouble recommending a short, however, due to the low valuation and the fact that the Federal Reserve is printing money willy-nilly, making most short positions too risky.

Source: Microsoft Seems Ripe For Continued Pain