Microsoft: 25% Gains Likely On Mobile Push

May.30.12 | About: Microsoft Corporation (MSFT)

While the Windows operating system is still a vital part of Microsoft's (NASDAQ:MSFT) businesses, it is nowhere near the whole story. The company's business portfolio now includes products like the Xbox 360, the Windows Phone operating system for mobile phones and tablet computers, Bing (Microsoft's computer search engine platform), Skype (a personal communication platform), and MSN (an Internet news and entertainment portal).

Microsoft currently has $58 billion in cash and equivalents and has used its cash to purchase or invest in businesses that could add to its portfolio or improve its balance sheet. In recent years, it has made numerous business acquisitions. For instance, in May 2011 Microsoft announced that it would acquire Skype Global for $8.5 billion. Skype connects people by offering free messaging, voice, and video services. For a fee, people can use Skype to call landlines and mobiles virtually anywhere in the world. Skype has recently introduced group video, allowing groups of more than two people to do things together whenever they're apart. At the time that the purchase was announced Skype had over 170 million users, and it is still growing.

Microsoft is also making inroads into the highly lucrative smartphone market. Microsoft has made patent licensing agreements with manufacturers of Android smartphones, and in September 2011 it inked a deal with Samsung -- the largest smartphone manufacturer with a 30.6% market share. Under the terms of the agreement, Microsoft will receive royalties for Samsung's mobile phones and tablets running the Android mobile platform. In addition, the companies agreed to cooperate in the development and marketing of Windows Phone. With the 500,000 daily Android activations that Google (NASDAQ:GOOG) recently reported, Microsoft could make $912 million in a year if it extracts $5 per activation on every Android Smartphone or tablet sold.

Microsoft has made a total of 10 licensing agreements with companies such as General Dynamics (NYSE:GD), Acer, and Apple (NASDAQ:AAPL). Horatio Gutierrez, a Microsoft corporate vice president and deputy general counsel, said that "together with our 10 previous agreements with Android and Chrome OS device manufacturers, including HTC, Samsung and Acer, this agreement with LG means that more than 70% of all Android smartphones sold in the U.S. are now receiving coverage under Microsoft's patent portfolio."

Microsoft, which is not willing to put all of its eggs in one basket, has negotiated a deal with Nokia (NYSE:NOK) -- the second largest mobile phone manufacturer in the world. Microsoft will pay Nokia at least $1 billion -- and probably much more -- to use the Windows Phone operating system on its smartphones. Microsoft expects to earn the money back from the royalties that it will receive on each smartphone Nokia sells. The deal was finalized on April 21, at which time Microsoft's CEO Steve Ballmer said: "Together, Nokia and Microsoft will innovate with greater speed, and provide enhanced opportunities for consumers and our partners to share in the success of our ecosystem." Nokia has said that it "hopes to transition 200 million current Symbian users to Windows Phone. If that works out, Microsoft would move from also-ran to become the No. 2 phone platform in the market -- some analysts have predicted it will overtake Apple by 2015."

Even though Microsoft is late getting into the fast-growing mobile communications market, it seems to be making a good effort to catch up. The company certainly needs this new business, because sales of personal computers are relatively flat and it needs the revenues that the mobile communications market can provide. Over the last three years, Microsoft's revenues have increased by 19.7%, and its net income has increased by 59%. On April 19, Microsoft reported earnings for the third quarter, which ended on March 31. During the third quarter, the company reported earnings per share of $0.61, which was roughly equal to earnings per share of $0.62 in the third quarter of 2011. Third-quarter revenues were $17.4 billion, which was a 6% increase from revenues of $16.4 billion in the third quarter of 2011. Third quarter net income was $5.1 billion, which was a 2% decrease from net income of $5.2 billion in the first quarter of 2011.

The good news that came out of the third-quarter earnings call was that Microsoft's Business Division had sales of $5.8 billion, which was a 9% increase from the third quarter of 2011. The increased sales of Microsoft Office was key to the Business Division's increased revenues. Microsoft's Windows Division also increased sales as "businesses continued to upgrade their hardware and software to Windows 7." The concern that I had about the earnings call was that despite Microsoft's push into the mobile communications business, no one asked about Microsoft's Windows Phone performance and Microsoft provided nothing of substance.

In the third quarter, the PC market grew by an anemic 2% to 4%. It seems obvious that Microsoft cannot rely on its computer software sells, and needs to make a breakthrough in the smartphone and tablet computing business in order to maintain its earnings growth and stock appreciation. It appears that the company has made a good start, and will reap big profits from its Android licensing deals, which could net it more in revenues than it will receive in royalties from its Windows Phone operating system.

Microsoft has made it known that more than half of all Android devices are now covered by the company's "cross-license agreement." In other words, manufacturers accounting for half of all Android devices produced now pay Microsoft a patent-related royalty. Microsoft also hopes to reap big profits from the royalties it receives from Nokia if the use of its Windows Phone operating system works out. I do not think that Microsoft's stock, which is relatively cheap (a price-to-earnings ratio of 10.6) and pays a solid dividend of $0.80 with a 2.7% yield, will explode higher. But it should surpass its 52-week high of $32.95. If Microsoft's move into the mobile communications market works out, I think the stock will move above $40.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.