Microsoft And Intel Are Getting Desperate

Oct.18.13 | About: Intel Corporation (INTC)

In his May 14, 2013 interview with Fortune Magazine, ARM (NASDAQ:ARMH) CEO Simon Segars mocked the personal computer market as a place "where two people have controlled it and the person that makes PCs runs on 2% profit margin and can't afford to innovate anything other than which shade of grey the plastic is." At the time, Segars's ridicule of the personal computer industry came against a Company Overview backdrop of claims that ARM architecture has been installed within more than 95% of the world's mobile phones. Over the past 24 months, of course, Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) have expressed their financial and ideological commitment to building out mobile businesses. The moves out of Segars's "two people," however, have increasingly reeked of desperation. For once, Microsoft and Intel are finding themselves largely shut out and unable to bully their way into a lucrative market.

PC Market in Decline

For decades, Microsoft and Intel have largely operated as the twin engines driving the personal computer market. Ironically, these two Goliaths remained literally befuddled by Intel's very own Moore's Law that hypothesized that the number of working transistors that may fit upon one particular integrated circuit would double every other year. According to Moore's Law, the shift towards mobile computing at the expense of relatively bulky desktops and laptops was inevitable.

On October 9, 2013, research firm Gartner estimated that the global PC market contracted by 8.6% between Q3 2012 and Q3 2013, in terms of unit shipments. Mikako Kitagawa, Gartner principal research analyst, claimed, "Tablets will continue to impact the PC market, but the U.S. PC market will see a more moderate decrease rather than a steep decline in the next two years." Apparently, Microsoft and Intel bulls may have been consoling themselves with ideas that the U.S. personal computer market will deteriorate slowly, instead of promptly collapsing into oblivion. Last quarter, Gartner data did indicate that PC shipments to consumers in Western Europe declined by 25.8%, on a year-over-year basis.

Microsoft now classifies its businesses according to Windows, Business, Server and Tools, Entertainment and Devices, and Online Services operating segments. Be advised that Microsoft Office software sales have traditionally accounted for more than 90% of Microsoft Business Division Revenue. Microsoft has also folded its mobile sales into its Entertainment and Devices segment that does include the popular Xbox gaming console. Taken together, Microsoft Windows and Business divisions accounted for $43.4 billion out of $77.8 billion in 2013 total net sales. Microsoft's running partner Intel has featured a similar business model, where its PC Client Group typically generated two-thirds of annual revenue at the chipmaker. Mobile sales at both companies have remained in the high single digits, in terms of percentages of revenue, over the course of the past several quarters.

Windows 8 and 8.1 Fail

On October 26, 2012, Microsoft brought its Windows 8 operating system to market, as the first major product launch out of the company in three years. Microsoft designed Windows 8 as a fusion between traditional smartphone, tablet, and desktop interfaces. Upon launch, however, the Windows 8 attempt to be all things to everybody ended up pleasing nobody. Dan Rowinski of Tab Times and Woody Leonhard of Info World both went on to rip Windows 8 as a "boondoggle." According to September 2013 Net Market Share statistics, Windows operated roughly 90% of all desktop computers, while Microsoft had established an 8% share of this total market for Windows 8. Still, Windows 7, with its 46% market share, was the most popular desktop operating system. To date, all evidence has indicated that consumers have opted to maintain old Windows 7 machines, instead of upgrading to Windows 8.

Enter Windows 8.1. On October 17, 2013, this upgrade was made available free of charge for users running Windows 8. Prior to launch, Brad Chacos and PC World labeled Windows 8.1 as "The Great Compromise" between Microsoft aspirations for a modern tablet interface and the comfort of the standard desktop user base. As such, the new Windows 8.1 Start Button now opens up into the modern tile format, instead of the traditional desktop headers, documents and applications. From there, Windows 8.1 does offer a streamlined Search feature that includes results from both online Bing and saved computer files. Still, Chacos dismissed Windows 8.1 as a "tablet interface mashed together with a desktop UI, a funky hybrid of old and new." Taken further, Julie Bort and Business Insider threw out the term "hate" to describe feelings for Windows 8 and Windows 8.1. If anything, the Windows 8.1 event will be far from revolutionary.

Last September, Microsoft announced that it was set to acquire Nokia (NYSE:NOK) devices and services businesses for $7.2 billion. Meanwhile, Intel had also backed up its talk of a commitment to mobile with a steady increase in research and development spending towards 20% of total revenue over the past several years. Weak demand for Windows 8 and 8.1, of course, will sabotage sales throughout the entire Windows ecosystem. For now, the business aspirations of both Microsoft and Intel intersect at the Bay Trail chip. Intel has aggressively marketed its Bay Trail platform as an ideal engine for both smartphones and hybrid machines, such as the Surface tablet, that have bridged the technical gap between laptops and desktops. Microsoft, however, has already taken one $900 million Surface inventory charge, while recent information out of research firm comScore estimated that Windows operated a meager 3.2% of U.S. smartphone subscriber handsets during the June 2013 to August 2013 quarter. Adjectives "pathetic" and "disaster" have been used to degrade the ongoing efforts of Microsoft and Intel to gain mobile sector traction.

The Bottom Line

Going forward, both Microsoft and Intel shareholder returns are likely to be compromised by both Moore's Law and the Law of Large Numbers. Microsoft and Intel shares closed out the October 17, 2013, trading session at $34.94 and $23.92, respectively. Taken together, Microsoft ($292.6 billion market capitalization) and Intel ($119.1 billion market capitalization) do carry a combined $411.7 billion in market capitalization.

Over the course of the past five years, Microsoft and Intel together have generated $41.8 billion in average annual cash flow from operations. Mass volume is therefore a necessity for the bottom line needle to budge at both companies. Mobile literally reads as a Catch-22 story at Microsoft and Intel, where Surface tablets, Lumia smartphones, and Bay Trail chips are now competing upon price, instead of offering premium quality above Apple iOS, Google Android, and Qualcomm (QCOM) Snapdragon competition. As such, nominal mobile unit sales success would therefore also translate into weakening aggregate profit margins at both Intel and Microsoft.

According to several measures, estimates, and projections, Microsoft and Intel both trade for near 15 times current earnings. The stock market, of course, functions as a pricing mechanism that discounts future growth. As such, the current price-to-earnings ratio of 15 is too much to pay for underlying businesses that have offered nothing, in terms of real growth, for more than one decade. If anything, investors should only expect Microsoft and Intel to return greater percentages of capital back to shareholders, in the form of aggressive dividend increases and stock buyback programs. Consumer staples stocks, such as Coca-Cola (NYSE:KO) and Altria (NYSE:MO), however, offer more favorable risk versus reward metrics as income investments. Both Microsoft and Intel deserve sell ratings.

Disclosure: I am long KO, MO. 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.