Last week, shares of Microsoft (MSFT) hit a new 52-week low after an analyst downgrade from Morgan Stanley. The firm echoed many themes we've heard recently: PC sales are weak, Surface tablets may not be selling well, and Apple (AAPL) is eating everyone's lunch. Since September 20th, Microsoft shares have lost $4.36, a decline of 14%. Many seem to be counting out Microsoft, but should you?
Recent analyst action and news:
The Morgan Stanley note provided the following summary:
"MSFT is far too cheap, has multiple non PC drivers and an attractive 3.5% dividend yield. However, Win 8 is disappointing, the PC market will remain weak for awhile and margins are likely capped. As such, the stock is likely range-bound. … PC weakness is not new, and may be in the stock at 8x EPS (implying negative EPS growth in 3 years), but PCs are not likely to improve near term as competitive offerings and the lack of touch devices, Win 8 RT apps and compelling price points are weighing on Win 8. With 60%+ of co.'s now on Win 7, corporate PC growth will also slow, while it may take MSFT longer to penetrate the tablet/ convertible market than first expected."
As we recently heard from IDC, global PC shipments fell 6.4% in the fourth quarter of 2012 to 89.8 million units. While the decline was not as bad as Q3's 8.6% drop, the decline was much larger than the 4.4% expected decline. The US market recorded a 4.5% decline in the fourth quarter, contributing to a 7% decline for the full year in 2012. The following quotes from IDC are a bit worrisome.
"Although the quarter marked the beginning of a new stage in the PC industry with the launch of Windows 8, its impact did not quickly change recently sluggish PC demand, and the PC market continued to take a back seat to competing devices and sustained economic woes. As a result, the fourth quarter of 2012 marked the first time in more than five years that the PC market has seen a year-on-year decline during the holiday season."
In regards to activity in the United States:
"Some consumer activity took place in conjunction with the release of Windows 8. However, limitations in product offerings, in particular for touch screen Tablet PCs, led consumers to once again delay purchases. Consumer-focused vendors like HP and Asian majors like Lenovo, Asus, and Samsung managed strong performances, partly in response to modest consumer demand, and partly due to channel activity in December ahead of the anticipated 1H13 Windows 8 push. The rest of the industry continued to take a wait-and-see approach as consumer attitudes toward Windows 8 are clarified."
We've seen similar analyst actions in recent weeks. Argus downgraded Microsoft from buy to hold, citing weak surface sales and a slow Windows 8 adoption rate. Microsoft did announced recently that 60 million Windows 8 licenses have been sold, up from late November's figure of 40 million. However, that number "includes "both upgrades and sales to OEMs for new devices", meaning that OEMs could be holding millions of those licenses in inventory. If that is true, those licenses could be sitting on shelves for quite some time as PC sales remain weak.
Windows 8 has appeared to get off to a slow start compared to previous operating systems. According to Net Applications, Windows 8's online usage share through Dec. 22 was 1.6% of all Windows PCs. While that figure is up from November's 1.2%, the 1.6% figure at the two-month mark trails Vista's 2.2%. Both of those numbers pale in comparison to Windows 7, which was a bit over 6.0% at the two month mark. The firm also notes that even if Windows had a good end of the month, Vista's third month was very good. Windows 8 would have to double its current share (as of Dec. 22) by the end of January just to match Vista.
Surface and the problem with RT:
Davenport's Drake Johnstone recently cut his estimates on Microsoft to reflect lower sales of the Surface tablet. He cut his Surface forecast to roughly 700,000 units from an approximate 2 million, as checks at local retailers were rather disappointing. Johnstone stated that Microsoft's Surface RT, selling for $499 or $599, was priced too high. He believed that other models, such as Apple's iPad mini, selling for $329, Google's (GOOG) Nexus 7" at $249, and Amazon's (AMZN) Kindle Fire 7" at $159 were much better values. Johnstone believes that the Surface Pro tablet can eventually do well in place of the Surface RT, and he stated the following:
"It is possible that Microsoft could generate solid enterprise demand for the new Surface Pro tablet, which launches later this month. The Surface Pro tablet will run legacy Windows 7 software applications (including Microsoft Office) and will also run Windows 8 applications. It is possible that corporations could be attracted to the Surface Pro tablet as a replacement for laptop PCs. If Microsoft is able to sell at least two million Surface Pro tablets per quarter over the remainder of fiscal 2013, then investors might assume that Windows 8 PC/tablet sales could improve in the second half of calendar 2013 as Microsoft's manufacturing partners introduce a wide range of Windows 8 devices."
Even before Christmas, Baird's William Power said that Surface was off to a slow start. Power spoke to several different retailers and representatives, which all stated that Surface was off to a slow start. Apple's iPad remained the clear leader from all accounts. However, continuing the theme from above, the Surface models running Intel (INTC) chips were later to arrive, and those were expected to do much better than the RT models using an Nvidia (NVDA) processor.
We also heard a few days ago that Samsung has decided to not sell its RT units in the United States. The electronics giant stated that RT demand has been modest, and educating consumers on RT would require "heavy lifting". Samsung stated that the investment required to educate consumers on the difference between RT and Windows 8 just wasn't worth it. They have decided to wait on US sales, although their plans for other markets is unclear at this point. If we continue to hear negative notes about RT like this one going forward, Microsoft will seriously need to consider its future.
The Surface is off to a slow start, and has a long way to go. Right now, the tablet space is dominated by Apple's iPad, which isn't a surprising fact. But here's how big the iPad is currently, and this is something that may surprise you. If Apple were to spin off the iPad into its own company, it would be the 11th largest technology company in the United States. Bernstein analysts think the iPad brought in roughly $32 billion in revenues in 2012, 60% of all tablet sales, and could do $46 billion in 2013. Here's an even more impressive stat. The iPad would come in at #98 in the Fortune 500. The device does more in annual sales than McDonald's (MCD), Nike (NKE), and Macy's (M). That's amazing considering the iPad has been out less than three years. What's my overall point? Well, Microsoft's Surface may never become this big. Only time will tell. But for now, Apple's iPad dominates this space, and Microsoft won't exactly be knocking it off the pedestal anytime soon.
There still is hope:
Surface has only been out a few months, so while it has been a slow start, we can't say Microsoft has failed yet. Apple's iPad only sold a few million units early on, and look what the iPad is doing now. Microsoft will count on Surface Pro to lead in 2013. Microsoft is also expanding its retail footprint. The company announced it was opening 6 new locations at the start of the year, on top of the 51 stores opened in 2012.
It remains to be seen whether all of this negativity is a good thing or a bad thing. If estimates are cut too much, there's a good chance that Microsoft could beat. We saw that happen with Apple and its revenues last quarter, and Apple could be in for a repeat this quarter. Don't forget, while Microsoft is approximately 18.6% off its 52-week high, Apple is currently 26.2% off its 52-week high.
Sometimes, everyone counting you out is the best place to be. Recently, we saw a ton of negativity surrounding Intel. As Intel issued lower than expected revenue and margin guidance, analysts kept slashing their forecasts on the chip giant. Goldman Sachs even put a $16 price target on Intel, and they seem foolish now. Intel hit a 52-week low of $19.23 in late November, and the stock is up nearly $3 since then, a 14.4% rally since the low. Could Microsoft be next?
Does the valuation fit?
You might be surprised, but Microsoft's valuation is quite reasonable at the moment. The table below shows Microsoft against a few other top tech names, including Google and Cisco Systems (CSCO). The growth numbers are for each company's current fiscal year. Google and Intel use calendar years for 2013, Microsoft's year ends in June, Cisco's ends in July, and Apple's ends in September. The P/E is based on the expectations for the current fiscal year. All numbers are as of Friday's close.
*Apple's growth adjusted to account for 53rd week in prior fiscal year.
Microsoft's growth can't compare with Apple and Google currently, but the company pays a much higher dividend, and shares trade at a discount to both. In terms of Microsoft versus Cisco and Intel, Microsoft is expected to show the most revenue growth in its current fiscal year, and second highest earnings per share growth. Despite all of that, the company trades at a significant discount to every name on this list. A number of the fears I mentioned above may be priced into the stock currently, but I can't see the pure P/E valuation number going too much lower. If the stock does go lower from here, I think it has to do with earnings contracting, and not the P/E multiple going significantly lower. One other note on these five names. Four of the five names currently have stock buyback plans going, with Google being the only one that doesn't. That gives even more value to shareholders.
Microsoft is trading near its 52-week lows because Windows 8 and the Surface RT have been disappointing to most. Microsoft launched its new devices and operating systems into a tough PC market, some of the worst industry conditions in 20 years. We've seen a ton of analyst negativity lately, something we've seen with a lot of large cap tech names recently. With expectations coming down, so has Microsoft's valuation. At this point, it seems like everyone is counting out Microsoft. Should you be doing the same?
Well, I don't think so, not yet anyway. You still get a 3.43% dividend yield and an extremely reasonable valuation. The company is producing a huge amount of cash, allowing it to spend a billion dollars a quarter on stock buybacks. Windows 8 and Surface may be off to a slow start, but that doesn't mean they are doomed. It hasn't even been three months yet, and we are due for an eventual PC rebound. Microsoft still has plenty of other businesses, like the industry leading Xbox gaming console. Sometimes, when expectations are at their lowest, it's the best time to buy. I'm not counting out Microsoft at this point, but the real question is, are you?
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.