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The Seattle giant Microsoft (MSFT) has seen its stock increase by ~10% in the past month despite Windows 8 seeing disappointing sales. The IDC PC shipment report had led to dumping of "PC stocks" as PC sales declined by a greater than expected 14% in Q1 2013. Microsoft has not really set the world on fire with its new product launches. The Surface RT tablet has pretty much been given up for dead with Nvidia CEO citing the absence of Outlook as one of the reasons for the low sales. After the end of the promotional pricing period, Windows 8 sales have been lackluster and Microsoft has been forced to reduce the prices of some key new products to boost sales. Despite the bad news, MSFT stock has climbed up and crossed the crucial $30 level.

The recent stock surge was attributed to a $2 billion stake taken by a value oriented hedge fund. It is being hoped that the new equity owner will be able to push through some major positive changes in the company. However, I think the real reason is that Microsoft is showing tremendous resilience to the PC industry decline. Its server and Office divisions have managed to compensate for the Windows 8 decline while other product lines are growing at a decent pace. I have been positive about MSFT stock and had written that most of the negatives had been priced into the stock. MSFT has a dominant presence in the global software industry with a monopoly like position in PC and server operating systems. It is also one of the largest players in the computing games industry and is making rapid strides into the mobile devices space. I continue to remain positive on MSFT stock and would look to add on pullbacks.

Why is Microsoft under pressure?

a) PC sales keep declining - The "Wintel Empire" has seen its valuations contract as Google (GOOG) and Apple (AAPL) have shifted the technology industry towards mobile devices. PC sales had declined for the first time in 2012 in 11 years due to the growing popularity of tablets and smartphones. All PC companies have realized that they face an existential threat if they don't move into the mobile computing space. In 2013, tablets are expected to grow by ~67%, smartphones by ~28% while PCs/laptops will remain flat at best.

b) Windows 8 is not selling well - It was hoped that Windows 8 operating system would revitalize PC sales and help spark a new upgrade cycle. However, Windows 8 has failed to meet expectations as users have been somewhat confused with Windows' new interface which misses the familiar "start" button. Android tablets have cannibalized the sales of PCs and laptops especially in developing markets where price is the main consideration. Microsoft has lowered the prices of key products in its store as it tries to compete better with cheaper competitors.

c) Google and Apple have become very strong competitors - Apple and Google have surpassed Microsoft in market value and are putting the company under severe pressure. Apple's iOS and Google's Android ecosystems are rivaling the dominance of Windows in the software industry. Google is attacking MSFT on all software fronts with a plethora of new products and services. Google Apps is pressuring Microsoft Office while Android and Chrome are stealing market share from Windows. Microsoft has been unable to sell its Office software in Apple devices as it does not want to give a 30% revenue share to Apple.

So why is the Microsoft stock rising

1) Results have been surprisingly good - Microsoft managed to beat analyst estimates during its most recent quarterly results with revenue rising up by ~18% and profits by ~19%. The revenues at its Windows division remained flat despite a sharp slowdown in global PC shipments. Revenue in its other segments grew strongly, offsetting the decline in the Windows division.

2) ValueAct Capital Management buy $2 billion of MSFT stock - Microsoft stock jumped up after it was revealed that a value oriented hedge fund ValueAct Capital Management had taken a $2 billion position in MSFT stock. The hedge fund had taken a big position as they think that MSFT would continue to dominate the global software industry and become the No.1 cloud computing provider in the next 5 years.

3) Valuation is still dirt cheap - Microsoft has gone up by more than 10% since I had recommended buying MSFT stock based on valuation. The stock, like Intel, continues to trade cheaply with a forward P/E of ~10x and gives a nice dividend yield of ~2.7%. MSFT has more than $60 billion in net cash and continues to generate more than ~$20 billion in operating income each year.

4) Microsoft has a huge moat in Server and Office segments - Microsoft is primarily thought of as a seller of Windows OS to PCs and laptops. However, the company's server and tools software segment as well its Office segment contribute $5-6 billion each to the overall revenue. In fact its business division contributed more revenue to MSFT than its Windows division (if you take out the $1 billion in deferred revenue). While the Windows segment was roughly flat, server segment revenues grew by 11% while Office segment revenue grew by 8%.

5) Mobile Device entry will pay off - Microsoft has introduced both hardware and software products for the mobile industry. The company has launched Windows tablets based on both ARM (ARMH) and Intel (INTC) processors. The company has also made its Windows 8 much more mobile friendly with a totally new interface (Live Tiles). The company has also partnered with the world's second largest mobile seller Nokia (NOK) so that Nokia smartphones will only use Windows operating system. PC vendors like Acer, Lenovo etc. have also introduced new products like the PC-tablet hybrids which make use of the new Windows 8 operating system. The new "Windows Blue" operating system will go further in making Windows more tablet/smartphone friendly and it is rumored that it will unite the mobile and PC versions of the Windows OS. IDC expects that Microsoft will capture a ~10% market share of the tablet operating system segment by 2017 (up from almost 0% now).

6) Xbox 720 - Microsoft will announce the new version of its blockbuster Xbox game console next month. Its main competitors, Sony (SNE) and Nintendo (NTDOY.PK), have already announced their new game consoles. Xbox has been a tremendous success for Microsoft and has allowed it to gain millions of subscribers for its Xbox LIVE service.

7) New Intel processors - Microsoft has been hurt as its software is not compatible with the ARM architecture. Intel's processors are not optimized for mobile devices because they are not very energy efficient. Intel is still in the process of developing new chips for the mobile devices market which can take on ARM chips. I think that Intel's new 22 nm processors will equal if not beat ARM chips in the next couple of years. Intel is making power consumption the central focus of its R&D division. According to Intel management, its next generation Haswell chips will be twice as efficient in energy consumption compared to its predecessors. Intel is also introducing "Baytrail" and "Merrifield" processors for the tablet and smartphone markets.

Summary

Microsoft is the world's largest software product company generating more than $70 billion in revenues annually. Its Windows operating system is just one part of its huge software suite of products. While Windows is facing a slowdown, other segments are continuing to grow strongly. The company is set to generate new revenue streams from new areas like cloud computing. While its initial foray into mobile devices has not resulted in much success, MSFT will become one of the biggest players in this industry. Microsoft is the only company to have a strong presence across both the enterprise and consumer technology segments. The company faces increasing competition from Apple and Google. However, MSFT's current valuation discounts most of those risks. I would look to buy MSFT stock during pullbacks.

Source: Why Microsoft Stock Is Going Up Despite Windows 8 Going Down