By Joseph Hogue, CFA
Microsoft (MSFT) beat expectations by $0.02 last month for second quarter earnings of $0.78 per share though revenue came in a little light at $20.89 billion versus expectations of $20.94 billion. Despite the revenue miss, investors were happy and sent the shares up 5.7% on earnings. The stock has had a good run before and since earnings as well, outperforming the S&P500 in the three, six, and twelve month intervals. With the stock close to its 52-week high and trading around historical resistance levels, investors may need to keep an eye on the shares to avoid some losses.
While earnings have been generally strong and the stock is still trading at below its four-year average trailing price-to-earnings of 11.4 times (graph below), there are three risks that could limit the shares over the next year.
Headline and Implementation Risk to Windows 8
A lot is riding on the eventual rollout of Windows 8, to be released in beta next month. The operating system is said to include a tablet-friendly user interface, improved power consumption and instant-on. The system is expected to be available in the third or fourth quarter of this year.
Microsoft needs Windows 8 to be successful if it wants a piece of the growing mobile device market. Google's (GOOG) Android has a wide lead on Apple (AAPL) and Microsoft with about 48 percent of the U.S. smartphone market in the fourth quarter. Google recently announced that it would introduce a test version of its popular Chrome Web browser for mobile phones. Apple and Samsung (SSNLF.PK) have dominated advertising in the mobile arena while we have heard almost nothing from Microsoft. Even the behemoth from Redmond may not have enough cash to take market share if it doesn't start soon.
Steven Vaughan-Nichols at zdnet.com thinks there could be some big problems with the new operating system. He wrote on February 8th that, "the Metro interface will be a total failure on the desktop, but that 'Classic' Windows on a tablet or a smartphone will be even more of a design flop." He questions the readiness of Metro with a slew of developers leaving the company or the division recently.
Microsoft not only needs Windows 8 to grab market share in tablets and phones, but to generally reinvigorate their product cycle. With three years since the rollout of Windows 7, recent enthusiasm could be lost if the new OS does not come to market smoothly.
Continued Weakness in Core Segments and Earnings Growth
Windows revenue came in at $4.7 billion last quarter, well below expectations of $5.0 billion. The company estimated PC shipments decreased by 2-4% on a year-over-year basis and that OEM license units decreased by 6% over the year. Operating margins for its Windows division came down significantly over the quarter to 60.2% from 66.8% as well.
Much of the weakness was attributable to a decline in shipments of PCs and hard-disk drives. Executives warned recently that the decline in PC shipments would last through the spring due to flooding in Thailand.
While the company's business division did relatively well with a revenue increase of 4.1%, there are signs that the company may be neglecting one of its largest segments. Microsoft has been focusing much of its time on its Windows Phone 7 software but the lack of compatibility between the smartphone OS and older Windows Mobile apps may leave the door open for competitors to take share in the business space. Large enterprises have used primarily Windows to run business solutions but may be open to competitors if they cannot get support for the system on which they run applications. Revenue from the company's business division was the largest of the five divisions last quarter at $6.28 billion.
Lack of Innovation
This is something Terrence Ing, PIMCO analyst, talked about in a recent report after the Consumer Electronics Show (CES). Mr. Ing saw a trend in slowing innovation, cash trapped overseas, and higher levels of debt without commensurate earnings growth in many 'old' tech companies. Patent applications have been on a declining trend over the last eight years and R&D as a percentage of sales has come down to just 8% of sales.
While Microsoft has $51.7 billion in cash and short-term investments, much of it trapped overseas, it has increased long-term debt from zero in 2009 to $11.9 billion this year. The cash sits there earning relatively nothing, but cannot be repatriated without incurring a hefty tax bill. This is all happening while year-over-year earnings growth has been falling since the rebound in 2009.
Though Microsoft has had some success with growth in its entertainment division, it has generally had a hard time 're-inventing' itself compared to other 'old' tech companies. This is leading the company to depend on share buybacks and dividends to drive shareholder returns. This is the hallmark of a mature company and investors may need to re-evaluate future price multiples relative to historic benchmarks.
Thirty-dollars per share seems to be the Holy Grail for Microsoft. The stock has struggled below that point since 2002, only breaking above resistance a few times. A surge of 14.4% in the last three months and breaking the critical $30 reference, investors should watch for warning signs in performance. Some profit-taking, or use of hedging strategies, may be warranted.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.