Shares of Microsoft (MSFT) jumped 3.4% on Friday, outperforming the general market as the company came in close to the consensus on revenue and beat estimates on earnings per share. The market has turned bullish for the shares, sending the stock up almost 8% since the beginning of the year as investors argue for a valuation theme and revenue growth from a new product cycle. The fact is that neither the growth nor the valuation story is that compelling and there is no reason to believe the shares can break their decade-long story of underperformance.
The company reported revenue for the third quarter of $20.49 billion that just missed the consensus estimate of $20.5 billion. Expense management and higher margins helped Microsoft to beat on earnings with $0.72 per share compared to estimates of $0.68 per share.
Microsoft grew into being the world's largest software maker primarily as a result of having a near monopoly on desktop operating systems and its Office productivity line. What was once a driver for growth has now become the company's albatross with the secular shift to tablets and smartphones.
Windows revenue came in at just $5.7 billion, below expectations for $5.9 billion and a good portion of that was from the recognition of $1.1 billion related to the Windows 8 deferral announced in June 2012. That's not current period revenue but income statement management to help meet expectations.
Of course, the shrinking PC market is not a new development but it also does not appear to be moderating as some have hoped. The Goldman Sachs hardware team expects PC market share, as a total of the combined PC and tablet market, to fall from 73% in 2012 to 65% in 2013 and just 59% in 2014. This view drove the bank to downgrade shares to sell with a $27 price target earlier this month.
And what of the new product cycle on which investors are hoping? Microsoft will end its support of Windows XP in April 2014 and this has driven investor expectations for temporary support to PC revenues as enterprise customers upgrade to newer versions. The problem is that the company has said that two-thirds of enterprise desktops are already running on Windows 7 so while the termination of support on XP could bring in incremental revenue, it probably won't be as much as investors are expecting.
Much of the growth argument hinges on a bottom in the PC market and a turnaround with new Intel chips driving increased adoption of Windows 8. While the launch of the Haswell chips has enabled a strong boost to battery life and graphics performance there has not yet been the enthusiasm for the Windows touch interface that was supposed to be the big upgrade in Windows 8.
Besides the tough environment for revenue, the sector-beating dividend yield that has many investors sticking with the company may not be helping. The company's payout ratio has increased to 45% of net income, up from 38% last year and nearly double its 28% five-year average. Paying out half of your net income makes it difficult to fund growth, especially when return on equity has fallen to 27.5% from a five-year average of 41%. The reliable income stream may be nice but not if it comes at the expense of growth.
The flat performance in the shares over the last decade have caused many investors to jump in on a valuation basis. As earnings have steadily increased, the price-earnings ratio for the shares has fallen from 25 times trailing earnings in 2005 to just 16.4 times on the last four quarters' earnings.
Investors blindly betting on price multiples to revert higher only need to look at other tech bellwethers like Apple (AAPL) with a trailing multiple of 8.9 times or Intel (INTC) with a 10.5 times trailing multiple to see that Microsoft could have further to fall. In fact, Microsoft has traded well under the current multiple with a 9 times P/E just last year.
A shrinking price multiple over the last decade while earnings continue to increase does not necessarily mean that the stock is a value play. Investors need to look at future revenue growth and the company's business model.
Many people will no doubt point to Microsoft's dividend yield of 3.1% as a reason to park their cash even if the shares don't do much. If you want a stable dividend-payer then the consumer staples and utility sectors offer more than enough opportunities and in a competitive environment that does not threaten obsolescence with every product cycle. An income stream of 3% with few prospects for share growth, leaves an investor earning little more than the rate of inflation. Even if the shares do not sink further in a classic value trap, investment is essentially dead money.
A Tale of Two Stories
Over the last decade, investors in Microsoft have tried to rationalize the shares as either a growth play on the launch of new operating systems or as a valuation play but have received little more than a dividend stream. The price multiple is now down to the mid-teens and the company expects Windows 8 adoption to increase over the coming quarters, but the fact is that neither story is really very compelling and there's little reason to believe that the shares will do any better over the next year or longer.
Much of the enterprise growth holding up investor expectations has already occurred and is priced into the shares. The company will continue to generate cash but its fortunes are ultimately tied to the dwindling PC market. Investors can be confident in the dividend yield but more stable opportunities for income exist in sectors like consumer staples and utilities that do not face structural changes to their markets.