Microsoft - Poor Quarter, Valuation Provides Support

| About: Microsoft Corporation (MSFT)

Shares of Microsoft (NASDAQ:MSFT) took a serious beating following the release of its fourth-quarter results.

Beside the headline news of almost a billion charge related to its Surface tablets, the general performance of the business was not very solid during the quarter. Yet the strong cash balances and healthy performance of enterprise business and server and tools business should provide sufficient support at these levels.

Fourth-Quarter Results

Microsoft generated fourth-quarter revenues of $19.90 billion, up 10% on the year before. Note that non-GAAP revenues rose by merely 3% to $19.11 billion due to a $782 recognition of previously deferred revenues related to the Office Upgrade Offer. Revenues missed consensus estimates of $20.73 billion by a wide margin.

Net earnings came in at $4.97 billion compared to a $492 million loss in the comparable period last year. Last year the company took $6.19 billion in impairment charges in its entertainment business.

Diluted earnings per share came in at $0.59 per share. Microsoft took $900 million in impairment charges on its Surface tablet, which reduced earnings by seven cents per share. Excluding this, earnings per share came in at $0.66, which severely missed consensus estimates of $0.75 per share.

CEO Steve Ballmer commented on the developments during the final quarter of its fiscal year:

We are working hard to deliver compelling new devices and high value experiences from Microsoft and our partners in the coming months, including new Windows 8.1 tablets and PCs. Our new products and the strategic realignment we announced last week position us well for long-term success, as we focus our energy and resources on creating a family of devices and services for individuals and businesses that empower people around the globe at home, at work and on the go, for the activities they value the most.


Microsoft ended its fiscal 2013 with an unprecedented $77.0 billion in cash, equivalents and short-term investments. The company operates with $15.6 billion in short- and long-term debt, for a net cash position of around $61 billion.

Revenues for the whole of 2013 came in at $77.8 billion, up 5.6% on the year before. Net income rose by almost 29% towards $21.9 billion with diluted earnings per share coming in at $2.58.

Trading around $31.50, the market values Microsoft at $262 billion or its operating assets at $201 billion. This values operating assets of the firm at 2.6 times annual revenues and 9.2 times annual earnings.

Microsoft currently pays a quarterly dividend of $0.23 per share for an annual dividend yield of 2.9%.

Some Historical Perspective

Over the past decade, shares of Microsoft have essentially gone nowhere with returns of merely 15%. Shares rose from $30 in 2004, to peak around $37 in 2007. Shares have fallen to lows of $15 in 2009, in the aftermath of the recession.

Shares have rebounded from those lows toward the $30s. Despite the 11% correction on Friday, the stock still trades with year-to-date returns of 18% on hopes of a restructuring of the company. The dividend yield, which has risen to 3% at the moment has softened the pain of lack of capital gains for shareholders in recent years.

Between the fiscal year of 2010 and 2013, Microsoft has increased its annual revenues by roughly a quarter towards $78 billion. Net earnings rose by almost 17% on a cumulative basis towards $21.9 billion. Earnings per share growth was even higher as the company retired roughly 5% of its shares in the meantime.


Despite the fact that shares are trading at five-year highs, activist investor pressure is mounting. Alternatively, one could make the case that shares could be increasing on the back of this shareholder activism after years of moderate results.

ValueAct Holdings made a $1.9 billion investment in Microsoft urging the company to focus on business software, cloud-based offerings and reduce its focus on consumer products.

In a response, CEO Ballmer already revealed the biggest reorganization since 2002 in recent weeks. This should speed up development and execution within the firm. Consequently, Microsoft will reduce the number of business units, as it has acknowledged that it is behind in tablets and mobile. The firm's cloud initiatives and hardware, including Surface and Xbox, will be consolidated.

Yet the latest poor results play in the cards of ValueAct and will undoubtedly increase pressure on the firm to make more drastic moves. In a response to the poor results, Microsoft cut its operating expenses guidance for 2014, from $31.8 billion towards $31.3 billion. This implies that operating expenses will rise by roughly $500 million compared to last year.

Investment Thesis

Investors and the wider investment community are shocked by Microsoft's poor results over the past quarter, both in terms of revenues and profitability. The headline results of a $900 million inventory charge to its Surface RD tablet is partially to blame. Excluding this charge, results came in below consensus estimates as well.

For a long time, investors have been criticizing Microsoft's loss making operations including its Surface tablet but also Xbox LIVE. The reality is that divisional accounting cannot accurately grasp the important strategy of creating an ecosystem for a company like Microsoft.

The company competes with many competitors including Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL) and (AMZN), just to name at a few. The once so clearly defined lines between search, cloud, software, hardware, distribution and content are rapidly converging and blurring as each company hopes to create leading ecosystems.

Microsoft has solid products including a still strong operating system Windows, a game console known as Xbox, its Surface tablet, Skype and search engine Bing. Calls from activist investors to divest these loss-making divisions, might underestimate the reduced value to the overall ecosystem at large as well.

Before the earnings announcement shares were trading at five-year highs on the back of increased expectations for a restructuring, or partially break up of the company. Such a scenario still seems far-fetched, yet there are clear indications of struggles.

While Window 8 has sold more than 100 million licenses since October of last year, many consumers are not signing up as they are confused by the new design. The consequential struggles have resulted in a more than 50% fall in operating income for the business, with operating earnings falling to $1.1 billion for the quarter. The blended Windows 8.1 version should avoid the confusion and will be freely available to its customers.

The struggles at the $500 priced Surface tablets become noticeable as well. As such, Microsoft has slashed prices by $150 and increased the distribution points of its tablets in order to compete with Google's Nexus and Apple's iPad.

Overall the struggles have become apparent, but Microsoft seems to recognize the need for action. Luckily the rock-solid cash balances give the company sufficient flexibility to make strategic acquisitions if needed, while the company is making organizational changes as well. All in all, the results were very poor, but the overall valuation should support the current valuation thanks to the strong server business and solid cash flows from the business division.

I remain on the sidelines awaiting the outcome of more changes to be announced in September.

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.