Microsoft (NASDAQ:MSFT) released earnings from the fourth quarter of 2013 ($0.78 per share) that exceeded the amount earned in the third quarter ($0.76 per share) and that exceeded the amount that was expected by analysts ($0.68 per share).
This was accomplished by a 14 percent increase in revenues that most reports attributed to strong holiday sales of the new Xbox game and the greater acceptance of the Microsoft Surface tablet device.
The emphasis given to these sales indicates the effort Microsoft is making to transform itself more into "a maker of devices and online services" rather than just "a software factory." These comments are from Nick Wingfield in the New York Times.
Mr. Wingfield writes "The person driving that Change has been Steven A. Ballmer, the chief executive" of Microsoft.
Still corporate sales "generate roughly two-thirds of Microsoft's gross profit" as reported by Shira Ovide in the Wall Street Journal.
This change in the composition of the Microsoft business model highlights some of the difficulty Microsoft is having in showing that its investments in recent years are producing the kinds of returns that it has earned in the past.
The most glaring numbers that relate to this fact are those reported in the piece by Wingfield: the gross profit that Microsoft is earning from its "hardware" products is 9 percent, while the gross margin Microsoft earns from its commercial segment, that encompasses the software and services it sells to corporate customers, is 83 percent.
Wingfield writes ""Microsoft's gross profit from the hardware business actually fell to $411 million, compared with $762 million a year ago, despite the surge in sales. One big the big reasons for the fall is that profit from new consoles like the Xbox One is almost always nonexistent when the devices are introduced, but they improve as component prices fall, manufacturing becomes more efficient and the audience of game buyers expands."
And, this explanation captures the whole situation. The "new" space Microsoft is attempting to invade has lower profit margins … even if they do improve over time … because the "hardware" market is more competitive and lives off of continual innovations, revisions, and updates.
This kind of a market is just what Rita Gunther McGrath is talking about in her new book "The End of Competitive Advantage," (Harvard Business Review Press, 2013). Ms. McGrath argues that in this new technological age, competitive advantages, if they can be achieved any more, cannot be sustained and the "new" competition is based upon constantly introducing new products or new updates of products. This competitive environment is so fierce that high profit margins are extremely tough to achieve.
The consequence of this is that Microsoft cannot expect to earn anywhere near the profit margins that it had achieved in the past.
The software and service business, primarily the commercial business, is a part of the "old" regime of information goods and these generate high profit margins. Microsoft achieved its competitive advantage in this space a long time ago and continues to feast upon the funds that are generated here. However, this business now suffers from the "what have you done for me lately" syndrome. The competitive advantage earned here with an almost monopoly position in the market was gained quite a few years ago and investors incorporated it in the stock price at that time. Microsoft has maintained its market position here but has not really brought the investment company anything in recent years that would cause an upward adjustment in the price of its stock.
As a consequence, Microsoft, simplistically put, is made up of the "old" line of products in which it has a competitive advantage that generates lots and lots of cash with the high gross profit margins it achieves, and the "new" line of products, where they don't have any perceptible competitive advantage, and where they face relatively narrow gross profit margins.
And, on the hardware side, Microsoft is about to add Nokia's (NYSE:NOK) handset business to its portfolio, which is also not a high grow profit margin product. Furthermore, Nokia just released information that its smartphone sales declined by 7 percent in the past year.
So, Ballmer's planned transformation seems to be working. It's just that it doesn't mean a whole lot in terms of the longer-term performance of Microsoft's stock. And, anyhow, Ballmer is history … the future depends upon who is chosen to replace him … something that we are still waiting to hear about.
Disclosure: I am long MSFT. 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.