What Is Going On At Microsoft?

| About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT), historically never too big on hardware, symbiotically partnered with Nokia Corporation (NYSE:NOK) to get more traction in the mobile phone space. The broad strategic partnership announced in February 2011 was supposedly meant for complementing their "strengths and expertise to create a new global mobile ecosystem."

We were not surprised, because we knew that it was really to counter the Apple (NASDAQ:AAPL) juggernaut, that half-a-trillion dollar, $700/share, 300% ROI behemoth which was creating a brave new world every year while making the story of every other tech company read like an anticlimax. So Microsoft partnered with Nokia, which promptly dropped Symbian, that boring, efficient un-operating system maintained by Accenture (NYSE:ACN), and switched more or less fully to Microsoft.

Things have not stopped happening since then and there is a lot more that is going on at Microsoft. Before we go into specifics, let us briefly examine the importance of partnerships and support to the smartphone industry.

Importance of Partnerships, Collaboration and Acquisitions in Smartphone Industry

The highly competitive smartphone industry makes strange bedfellows. Apple sued Google (NASDAQ:GOOG) over patent issues relating to its operating system, iOS. However, both companies are also partners and Google pays Apple for being the default search engine on Apple's iOS under what is believed to be a per-device deal. This means that as the iOS sales keep growing, so does the amount that Google pays to Apple. In 2009, $82 million was paid, and by 2014 it could be as much as $1 billion.

One reason for the high cost is that Microsoft kept on upping the bid in an effort to make its own search engine, Bing, the default option on iOS.

Google gives a 75% cut to Apple - from every dollar that Google makes on iOS, it pays 75 cents to Apple. It may be that Google is paying more for the deal but the end point is that collecting data is important for Google as it makes most of its money from advertisements.

Google's aim is monetizing the world's need for information. Google believes in targeted advertising so as to provide a rich source of information to users. For this purpose, it offers a wide range of online tools such as Gmail, Google Maps, YouTube and social media service, Google+, most of which are free.

The Latest Partnership

The latest that has happened is that Microsoft, Nokia and VimpelCom Ltd, (NYSE: VIP) announced on February 18, 2013 that they have entered into an agreement which will allow VimpelCom customers to use their mobile accounts to locate and buy digital content from the Windows Phone Store.

VimpelCom is a global telecommunication provider that offers mobile as well as fixed line telecommunication and Internet services to its subscribers. Majority of its revenue is from services provided in Russia and Italy.

A "VimpelCom Shelf" is to be created by the end of the year to facilitate payments for digital content purchased from the Windows Phone Store through VIP's mobile accounts across the globe. Smartphones and mobile devices with Windows operating system are to be launched in over 70 countries in the coming months. Nokia is not only Microsoft's partner; it is also a leading mobile phone brand in countries where VimpelCom offers its services, which makes the deal a profitable proposition for all three.

The agreement is obviously an attempt on the part of the telecom provider to cash in on the expanding Windows Phone ecosystem. Microsoft, on the other side, is probably looking for expanding its customer base for the Windows Phone Store and for testing the market for its future plans. Microsoft has already confirmed that it is going ahead with its plans to expand its Surface family that includes Windows 8 Pro tablet. However, the company has not been specific regarding its future plans despite rumors in the past that Microsoft may launch a branded Surface Windows Phone and a Surface Book with a larger 14.6 inch display.

How Is It Expected To Pan Out

It is evident from the launch of the Surface tablet that Microsoft is eyeing the hardware market. The question is why Microsoft, a dominant player in the software space, chose to do so. Did it want to take on the tech giant Apple on its home turf? Or was it going after the low-end Android-based devices?

It seems that it was neither of the two. It was apparently compelled to develop its first computer in order to "demonstrate to customers and original equipment manufacturers (OEMs) the possibilities of the new interface, which is radically different from any previous version of Windows and optimized for touch". The interface being referred here is Microsoft's newest version of its operating system, Windows 8.

Further credence to the theory is provided by what Steve Ballmer, CEO of Microsoft says in a Q&A session with Jason Pontin, MIT Technology Review's editor-in-chief. He said that Surface is a real business but he doesn't "think Surface is going to dominate volume". Mind it that Mr. Ballmer is talking about his company's product and not of one of its competitors. I may be wrong but that forces me to draw an inference that Microsoft's latest hardware venture is just about supporting the Windows 8 operating system.

In the last quarter of 2012, the company was able to increase the market share of its Windows Phone 8 from 1.8% to 3%. Things aren't going to be that easy this quarter as competition from Google's Nexus 4 is expected to rise and there will also be pressure from BlackBerry's (NASDAQ: BBRY) BlackBerry 10.

So, for the time being investors can stop hoping for great news on Microsoft's Surface segment.

However, Microsoft does have a feather on its cap in hardware. With 281,000 units sold in January this year, Microsoft's Xbox 360 continues to remain the top gaming console, the spot that it has been able to retain for 25 months on the run.

Bottom Line

Microsoft has made the right moves recently and some of its earlier moves are showing signs that the company was not wrong in its choice. The most successful until now have been in the software space and it is likely to remain so.

During the earnings call on January 24, 2013, Microsoft's CFO, Peter Klein said, that "it has been an exciting quarter with the launch of Windows 8 and Windows Phone 8." With Windows 8, Microsoft offers a single core operating system for phones, tablets, laptops and desktops. It is different from anything that Apple or Google have to offer. While some critics welcome it guardedly, others are confused about the single operating system across all types of devices.

Performance of its stock is another story altogether. The stock did respond to F2Q results and rose by a percent and half, when they revealed a record $22 billion revenue riding on support from multi-year licensing which grew 17% and helped in earning a record $0.81 per share.

With a book value of $8.67 per share, the stock is trading at 3.22 price-to-book ratio. At $27.87 the P/E ratio is slightly on the higher side but forward (June 2014) P/E of 8.82 and also the dividend yield (3.30) look attractive.

Regardless of the company's plans in the hardware sector, I would still consider it as only a software play. The stock is likely to respond to news and earnings in the short term. Growth however is expected to be a low 2.66% (June 2014) to a modest 9.92% (long term- 5 years).

If you ask me, I would wait and buy this stock when it trades at P/E of below 12 if I am looking for appreciation. Investors looking for a steady income may buy this stock but I do not see any great appreciation in the near future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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