Can Microsoft Turn Things Around?

Aug.27.13 | About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) has received a lot of negativity during the last couple of years, particularly after the launch of Windows 8. Once a giant in technology, Microsoft has been falling behind competitors including Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG). All that was about to change at Microsoft's "revolutionary" Windows 8 event; however, things didn't go as well as the company hoped and Windows 8 is far from being a success.

Microsoft's colorful surface campaign along with the "endless possibilities" of its Windows 8 platform didn't turn out that well and the company finds itself struggling in almost all of its divisions including software, hardware and gaming. Despite some investors writing off Microsoft, especially because of the declining PC market, the company could make a comeback surprise by the end of the year.

Valuation

With a market cap of $289.47bn, Microsoft is currently trading around $34.7. The company's shares dipped over 12% last month after it posted disappointing earnings for the quarter. The company posted a profit of around $4.97bn on a revenue of around $19.9n for the latest quarter. Even though the results were significantly better YoY, the company failed to beat expectations of analysts.

Apple, on the other hand, has done relatively well in the last few days and the company has already crossed the $500 mark. With a market cap of $455.18bn, Apple is currently trading around $501 to $502.

Microsoft's biggest competitor in its search engine division, Google, is currently trading around $870.2 with a market cap of $289.8bn. The company did cross the $900 mark last year but since then, the company's stock price has dipped.

Why Are Some Investors Writing Microsoft Off?

Firstly, the performance of Microsoft's Windows Phone OS has been poor and even though Nokia is constantly trying on improving its devices, the Windows Phone OS is still pretty far behind Apple's iOS and Google's Android. With only a 3.3% share currently in the market, WP8 is still struggling against the industry giants.

Secondly, the declining PC market has been troubling Microsoft for quite some time now and according to Gartner's recent report, Q2 PC shipments declined nearly 11% YoY. The release of the latest Window 8 platform also didn't help much and the idea of combining a touch screen interface along with a PC like experience didn't pay off, at least not yet. Tablets have already affected PC sales in a major way and Microsoft's attempt at entering this particular market against Apple and Google also didn't go so well. Apple's iPad tablet is already a major player in the market, along with Google's Nexus 7 & 10 tablets and other Android based tablets.

Microsoft's entry into the gaming market was quite successful and the company, along with Sony (NYSE:SNE), dominated the market for gaming consoles for the past couple of years. This emerging division under Microsoft was just what the company needed in order to offset any disappointments from other divisions; however, Microsoft's latest attempt on competing with Sony's PS4 might well be dead and investors were quite disappointed by the company's Xbox One event earlier this year. Loyal consumers have already showed their disappointments in this report and aside from charging a higher price than the PS4, the Xbox One's strict game sharing policies might be enough to drift loyal Xbox consumers away towards Sony.

Why I Believe That The Company Has The Potential To Turn Things Around

While WP8's absolute sales numbers might not look that good, the platform's growth tells a different story. Windows Phone 8, despite having only 3.3% of the market, is now third in the market, overtaking BlackBerry. The platform's share grew by over 26% YoY and I don't see the growth stopping anytime soon. The future lies heavily on what Apple's upcoming 2 versions of the iPhone will do and how Google's Android platform will improve but Nokia and Microsoft have been working hard in getting WP8 smartphones to pick up pace. According to this report, Gartner's research analyst believes that Windows Phone OS will continue to grow, but Microsoft will need to focus on support from app developers. Despite several apps already being available in the Windows store, there is still a lot that consumers are waiting for. Google's Play Store and Apple's app store already have millions of apps: a place where the Windows Phone 8 platform comes short.

I also believe that the company's latest "One Microsoft" strategy will definitely boost the company's performance. From greater speed and efficiency to a strategic alignment, this might finally be the time that can shape Microsoft's future. Sony's latest strategy under new CEO Kazuo Hirai is already paying off and if Microsoft can implement its strategy across all its divisions, then it could definitely add value.

Microsoft's Bing search engine is also improving since the last couple of months and despite being far behind Google, Bing's share has gone up to nearly 18%, which makes it second to only Google. Upcoming quarters will see Bing strengthen its position, which could turn into a major income source for Microsoft. Growth in Windows 8 and Windows Phone 8 could also improve Bing's share further, as the service is integrated quite well in the latest Windows platform.

Having said that, Xbox One could be a major failure, things could go in a different direction and Microsoft's plan at creating an eco-system could pay off in the future. The company is basically trying to do what Google and Android have already done i.e. to create an attractive eco-system for people to buy various Microsoft products.

Also, Microsoft's strong enterprise business is still one of its core strengths and the company's ability to generate billions of dollars in free cash flows, translating into an excellent dividend growth opportunity, is one of the reasons why Microsoft seems like a great buy. Any downside is limited by the company's stable cash flows and the major concern is in the consumer business which is only one third of the company's business, while enterprise is still a solid division.

Steve Ballmer's Departure

On Friday, Microsoft announced that CEO Steve Ballmer will retire within 12 months. Soon after the announcement, Microsoft's shares surged over 7% due to optimism for a new restructuring plan under new leadership.

Steve Ballmer has been criticized for several failures at the company including the Surface Tablet, the Zune music player and the Windows Phone. If Microsoft gets the right person for the job, then I don't see why Microsoft can't become the company that it used to be.

It's clear that the company needs someone who is focused on the latest and upcoming consumer technology and is experienced enough to turn things around at large companies. It is likely that the company gets someone from the inside and names for a potential replacement include Julie Larson, Kevin Turner, Qi Lu, Tony Bates and Terry Myerson.

All of these top executives could be shortlisted, however, there is a slight chance that the company gets someone from the outside including current or ex-executives from Apple, Facebook or Google. Whether it's from the inside or the outside, a restructuring plan and a new strategy along with a new leadership is just what Microsoft needs in order to improve its positions in all of its divisions.

Key Things To Monitor At Microsoft

Despite the news of Steve Ballmer resigning in under 12 months, the fundamentals at Microsoft are still the same but there are certain key things that investors should watch at Microsoft.

Firstly, rumors of an upcoming cheaper surface tablet are already circulating around. This is a key area why Microsoft has failed after a $900mn excess inventory charge.

Secondly, the Xbox One should also be followed by investors. How the console performs compared to the PS4 will be crucial in determining the future of the company's gaming segment.

Then comes dividend growth. Microsoft has a huge reputation in paying decent dividends, which is likely to grow further in the future as the company will keep on generating piles of free cash flow.

Steve Ballmer's "One Microsoft" restructuring strategy comes next. This could be huge for the company if the restructuring plan goes as well as expected, improving efficiency across all the divisions. The new CEO along with a major restructuring is exactly what the company needs right now.

Lastly and most importantly, I would focus on ValueAct's activist agenda on Microsoft. The company has a $2bn investment in Microsoft and getting board representation could create value for shareholders. ValueAct's agenda is likely to include a major share repurchase plan, a growth in dividend payout and bringing out Office for the iPad rather than keeping it only for Windows Tablets. The group is also likely to pressure the company in changing different things to turn around Bing's consecutive yearly losses and to improve profitability on the Xbox.

Conclusion

Microsoft is definitely not in a great place at the moment; however, I don't see why the company can't improve its performance in upcoming quarters. The upcoming holiday season will also be crucial in determining Microsoft's future and sales are likely to pick up at that special time of the year. Aside from that, the company still has over $70bn in cash reserves, which could help the company spend more on research and development than it already does. The cash could also help the company keep shareholders happy as it already has a decent payout ratio, translating into relatively impressive growth in dividend payments.

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.