In the previous part of this article ("Microsoft's Earnings Report And Its Future - Part 1"), I analyzed three divisions of Microsoft (NASDAQ:MSFT) in terms of historic performance and future outlook. In this part, I will be analyzing the remaining segments of the company. The following tables show the recent earnings release of the company pertaining to Q3 2013.
Microsoft Business Division
Microsoft Business Division (MBD) is the largest division of company, contributing around 31% of the company's revenues and 43% of operating profits. Within this division, Microsoft Office System (comprising mainly Office, Office 365, SharePoint, Exchange and Lync) is the largest contributor to the company's revenues, contributing approximately 90% of MBD revenues in 2012. According to the company's 2012 annual statement, approximately 80% of the Office System revenues came from sales to businesses, and thus is not directly affected by the drop in PC sales.
MBD's overall revenues grew by 8%, and within that business revenues grew by 10%, primarily driven by a 16% growth in multiyear licensing. The company has taken several recent steps in order to equip itself for the future. The launch Office 365 was aimed at tackling the competition it faces from its competitors, such as Google (NASDAQ:GOOG), that provide cloud-based productivity suites, and to profit from the growing use of tablets that have limited storage. The company's January launch of the new Office included features such as touch capability, social and mobile scenarios as well as a tight integration with SkyDrive, enabling access to documents from any device. The introduction of such features is also aimed at profiting from the growing trends in cloud services and tablet usage.
Microsoft Office 365, due to its subscription-based pricing, allows the company to enter into the SMB market within the broader productivity suite market. Currently the industry is dominated by Google (GOOG) Apps and Microsoft Office 365. Although Microsoft Office is the market leader in terms of the broader market, GOOG Apps dominates a niche in the market. The lower price as compared to Microsoft Office is one factor that is enabling the company to dominate the sector. However, as can be seen in the table below, Microsoft's share increases as the company size increases. Office 365 is a great initiative from the company as it not only gives the company entry into a niche, but would also help it in reducing piracy. The future growth of the company's largest product is dependent in part on the performance of Office 365.
According to the Q3 2013 earnings release, Lync achieved a growth in revenues of over 30%. The company has slowly found footings in a saturated market of enterprise telephony and per Q3 2012 results could only capture 4.6% of the market share. Integrating the software with the newly acquired Skype, Microsoft is pushing towards gaining a substantial market share in the industry that is growing at less than 2% per year. With an expected release of Lync apps coming out this year, Microsoft is aiming towards creating a number messaging clients across all platforms.
Although Lync has achieved substantial growth in recent periods, due to the slow growth in the industry, the potential for Lync is capped. However, with the cloud experience and its recent steps, the company can capture a greater market share in the future. If this happens, Lync has the potential to turn into a cash cow for Microsoft.
Entertainment and Devices Division
This division of the company experienced the largest growth in revenues and profits in Q3 2013, primarily driven by high sales of the new Microsoft Surface. The Xbox and Skype brands, and now the Surface, are the primary products of this division.
The gaming console market has seen an overall decline in revenues since 2010. The market leader in this segment is Sony (NYSE:SNE), with its PS3 console. Xbox has seen its market share increase overall at the expense of Nintendo, which has shifted its focus towards handheld gaming consoles. Microsoft's market share increased, but its revenues declined as with the rest of the industry. Microsoft has been able to generate the highest home internet gaming console revenues since 2010, and achieved close to $1.9 billion in revenues in 2012, but remains to be the only vendor not to enter into the portable console market. However, Microsoft might integrate its expected smaller tablet launch with Xbox, allowing it entry into the portable gaming console market.
According to the forecast, the industry is expected to see further decline in revenues in the coming years. Thus, in order to achieve growth, the company would either have to move into portable gaming consoles or enhance its internet gaming offerings in order to target a wider audience.
Microsoft acquired Skype in 2011 in order to generate new business and revenue opportunities. At the time Skype had around $800 million sales, and is now approaching $2 billion in sales. Since joining Microsoft, Skype has seen a phenomenal growth in traffic. Skype's voice and video traffic rose to 167 billion minutes, a growth of 44% compared to 2011, and more than double the growth achieved by all traditional international phone carriers combined. According to Microsoft's COO, 33% of the world's voice calls happen on Skype.
With the internet communications market expected to reach $14.5 billion and the anticipated integration of Skype with other Microsoft services, such as Lync, the future looks bright. However, with such growth in the market, the company is also expected to face tough competition in the future, especially from Google and Facebook (NASDAQ:FB).
In October 2012, Microsoft officially entered into the tablet market with the launch of its new Surface RT. Although the tablet market grew by 75.3% in Q4 2012, as compared to the same period in 2011, Microsoft could only capture 1.7% market share in the industry dominated by Apple (NASDAQ:AAPL). As can be seen from the table below, AAPL has a huge lead over its competitors, but it did lose its market share from 51.7% in 2011 largely to the rapidly growing Samsung.
There can be multiple reasons for a lower shipment by Microsoft, one of those is the company's decision to sell its product exclusively through its online stores and several dozen retail stores. It was only in December of 2012 that the company expanded its distribution network to other retailers. Another reason is the price tag attached to the tablet by the company.
The Surface RT starts at around $600 with a keyboard, the accessory aggressively promoted by Microsoft as essential for the tablet's usefulness. But as stated by Ryan Reith, analyst and program manager of IDC's mobile device tracking, "Microsoft and its partners need to quickly adjust to the market realities of smaller screens and lower prices." One in every two tablets shipped this quarter was below 8 inches in screen size. And in terms of shipments, we expect smaller tablets to continue growing in 2013 and beyond" said Jitesh Ubrani, research analyst for IDC's Tablet Tracker. Reith further said that "In the long run, consumers may grow to believe that high-end computing tablets with desktop operating systems are worth a higher premium than other tablets, but until then [average selling prices] on Windows 8 and Windows RT devices need to come down to drive higher volumes."
The forecasts suggest that Windows tablets are expected to remain small in the market. Windows 8 tablets are expected to achieve a 7.4% share by 2017 and RT is expected to achieve 2.7% of the market over the same period. Thus, it would be better for the company to focus on smaller versions of the Windows 8 tablets.
The company's Surface devices, both RT and Pro, are to fall below expectations according to some reports. However, with an expectation of smaller devices to be launched by Microsoft, the company might be able to grasp some meaningful market share. The success of the Surface brand is essential for the company in order to sustain growth in the future as the PC market declines and more and more people start using tablets as a means of conducting work.
Over recent years, the company's efforts to diversify its business have been fruitful. The move into cloud and mobile (tablets and smartphones) markets would potentially bring high growth for the company and make it less dependent on the declining PC market. In my opinion, the company is on the right track and moving towards extracting maximum synergies from its different business lines. These factors would certainly equate to greater earnings for the company in the coming years. Thus, I would give a buy recommendation on Microsoft stock.
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.