The only positive way to spin Microsoft's attempt to gain tablet marketshare with the Surface is; at least they tried.
To put how bad 1.5M units is, Apple (NASDAQ:AAPL) sold 22M+ units of the iPad in Q4 2012. Microsoft's tablet numbers are even bad enough to put it in the category with Blackberry's (NASDAQ:BBRY) Playbook, which sold 0.7M units in its first 2 quarters of availability.
The Surface is important in evaluating Microsoft's stock because it marked a crucial attempt for Microsoft to become a mobile hardware manufacturer. Not only was Microsoft trying to make up for lost time in mobile by releasing the Surface, but it tried to do sop at a premium price point as well. Price-wise the Surface is most comparable to the iPad, and is seriously undercut by many cheap Android tablets. This was clearly the huge downfall with the product, which couldn't differentiate itself from Google (NASDAQ:GOOG) and Samsung's cheaper alternatives.
Without being able to rely on the Surface (or entire retail) division, where is Microsoft's growth going to come from? Recent quarterly reports would indicate that the answer is nowhere.
|Year||FY 10||FY 11||FY 12||FY 13|
|Revenue Growth||6.9%||11.9%||5.4%||7.9% Projected|
Microsoft's growth fell to anemic levels in FY 12 but has managed to stay between 5-8% in FY 13. Analysts are pricing in much higher growth in Q3 and Q4 of FY 13 (18-20%), this is the reason for increasing revenue for all of FY 13.
Most of this growth is due to the revamp of Microsoft's product line in late 2012, that analysts' forecast will further boost sales in the first half of 2013. This 'revamp' had to do mostly with an entrance to mobile and tablets specifically.
Because of very low traction with consumers (in these core new products) Microsoft has potential to miss analyst consensus estimates to the downside if Surface sales continue to disappoint.
Although Microsoft was able to grow revenue in FY 12, its operating income actually fell 19% from $27B to $22B. This was caused by significantly lower gross margin (76.2% vs 77.7%), and increasing R&D and SG&A expenses.
FY 13 will be a critical year in determining how Microsoft's margins will look going forward. Microsoft's declining revenue growth will be significantly more detrimental to EPS numbers if margins continue to erode.
To inflate EPS Microsoft has been using some of its huge cash hoard to buy back stock. In the past 2 years Microsoft's outstanding shares have been reduced from 8.93B to 8.34B, a decrease of 6.3%. Management's gradual accumulation of shares has given the illusion that EPS are growing much healthier than they really are.
High Price/Sales Multiple
On a P/E basis Microsoft is valued pretty cheaply at 11x FY 12's numbers. On P/S basis, Microsoft appears almost overvalued because of its stalling growth. Currently Microsoft's P/S ratio is 3.2, that's actually significantly higher than Amazon's (NASDAQ:AMZN) 1.9 multiple. In fact, Microsoft has one of the highest P/S multiple's in all of the tech space.
This indicates that if Microsoft's margins continue to fall then its valuation will change dramatically from where it is today.
This is the only reason I can find not to short Microsoft's stock. The only positive from a bearish viewpoint, is the dividend does leak $2B out of Microsoft's coffers each quarter. But that's beside the point, as a short seller a 3% yield and rising hurts.
But what if the dividend were to disappear, or just stop increasing? That could be a major negative catalyst for Microsoft stock. If its financials continue to deteriorate, it's increasingly likely Microsoft will be held up solely by its dividend (like so many late stage tech giants). This will in turn put rising pressure on management to increase the dividend or at least keep it stable.
Dividends are a lagging indicator of profitability. How fast will Microsoft be able to continue raising its dividend if its profits are actually falling? This is a divergence that cannot continue forever.
Microsoft's best days are behind it. Growth stalled significantly in FY 12 and the company's savior (Surface) has been an utter failure.
Besides a steadily increasing divided (which is increasingly at risk), I can't see a reason to own Microsoft stock. If its financials continue to deteriorate and margins are indeed eroding, then Microsoft will make an exceptional short candidate.