Microsoft - Can The Sleeping Giant Write A Turnaround Story?

Microsoft (NASDAQ:MSFT) is the 3rd most valuable technology company in the world, having recently lost its crown to Apple (AAPL) and Google (GOOG). The Seattle behemoth has been slow to adapt to fast changing technology trends, such as mobile and cloud computing. The company has stuck mostly to its Windows and Office software for generating revenues and profits. Its entry into newer technology lines has not been successful. The company's entry into smartphones proved to be a disaster, with the "Kin" being killed soon after its introduction. The company also failed miserably in the mobile O/S area, as Google and Apple have captured almost the entire market. Despite having a huge first mover advantage, MSFT let a golden opportunity slip through its hands. Google's Android has captured an almost unassailable lead in the mobile O/S market through its free Linux based O/S. MSFT has also been unsuccessful in Internet Search services, despite spending a huge amount of R&D dollars (Bing has not captured a meaningful market share). The company's Zune music players also never matched the iPod in sales and popularity.

Despite MSFT's many failures in the last few years, the company has still managed to generate massive cash flows thanks to the dominance of its Windows O/S and Office software. Open source substitutes have not managed to dent MSFT's monopoly in this space. While Google has started to gain traction through is cloud based solutions, MSFT will continue to generate billions of dollars in profits from these products in the foreseeable future.

What are the Biggest Concerns for Microsoft

1. PC and Laptop sales falling due to rapid tablet adoption - IDC and Gartner Inc. reported that worldwide PC shipments, in the third quarter of 2012, had contracted by the highest amount since at least 2001, compared to the same time a year ago. As a result, HP (HPQ) and Dell (DELL) have seen their stock prices diving to new lows. The other constituent of the WinIntel duopoly has also seen its stock price touch 52-week lows. Tablet sales are cannibalizing the sales of desktops and laptops, as most frequently used PC functions such as Internet browsing, email and games are available on tablets. This decline in PC sales has made a number of analysts bearish on MSFT.
2. Microsoft Windows 8 Sales have not been encouraging - Market reports about initial sales of MSFT's latest Windows 8 O/S have not been encouraging. Despite MSFT's claims about higher sales of Windows 8, skeptics have pointed out at lower ASP as a result of upgrades. Only a month has passed since Windows 8 went on sale, so it is too early to tell whether Windows 8 will be a winner or a loser.
3. Office is under threat from Google Apps - One of MSFT's biggest money spinners - Office - is seeing a strong competitive threat from Google Apps. By smartly putting this application on the cloud, Google has managed to circumvent the need for installing the software on MSFT's Windows O/S. There are reports that Google Apps is gaining increasing traction amongst enterprises, which are attracted by the lower pricing and other cloud advantages.
4. Emergence of bigger competitors - Microsoft has never faced competitors who could match its size and power in the recent past. It could manage to browbeat the competition by either selling its products for free, (Novell (NOVL), Netscape) or buy them out (Hotmail). But now MSFT cannot use the same strategy with Google or Apple. Ironically, Google is using some of the same strategies against MSFT, such as giving mobile O/S Android for free.

Microsoft Strengths and Catalysts

Microsoft stock has been hit in recent times because of the above mentioned concerns. However, there are some things which MSFT seems to be doing right. The company has massive resources (over $50 billion in cash) and generates massive amounts of FCF every year. MSFT is finally realizing that it cannot afford to be complacent anymore. The company is making a belated entry into the tablet and mobile markets. The company has also made its newest version of Windows 8 much more tablet and smartphone friendly. Instead of waiting for its OEM partners to introduce tablets based on Windows 8, the company has launched the Surface Tablet.

1. Tablet Entry is encouraging - MSFT has launched the Windows RT tablets which have received a mixed review from the market. The important thing to note here is that Surface is being favorably compared to iPad 4. The tablets by RIMM and HPQ were so far behind the iPad that they sank without a trace. The strongest advantage of MSFT lies in integrating Office with its tablets, which its competitors cannot do easily. MSFT does not have to become No.1 in the tablet market, even if it becomes a No.2 or No.3, then it is good enough.
2. Nokia provides unexpected good fortune - Microsoft has been left far behind in the mobile O/S market by Android and Apple. However, the company is trying to make a comeback by putting more resources into this segment. The company could win a big chunk of market share if Nokia (NOK) succeeds with its Lumia range of smartphones. Lumia has been receiving good reviews and has a good chance of being a blockbuster. Nokia has completely hitched itself to the MSFT bandwagon by abandoning its Symbian O/S and going for Windows O/S.
3. Xbox 720 - While MSFT has flopped with most of its hardware product launches, it has been quite successful in game consoles. Along with Nintendo and Sony (SNE), Microsoft has managed to capture the whole game console market. The company has managed to quietly add a huge number of captive customers to its Windows Live service. Sales of game titles are a big money generator, despite no new products having been introduced since Xbox 360 in 2005. There have been rumors that Microsoft will be coming out with a new generation console Xbox 720 in 2013. This will add buzz to the company's stock and could act as a big positive catalyst.
4. Cheap Valuation - MSFT stock has fallen by ~20% in the second half of 2012 due to concerns about falling PC sales. This has made the stock look more like a value stock than a technology growth stock. The company's forward P/E is now just 9x and its dividend yield is a very attractive ~3.5%. The company has become a very attractive substitute to low yielding bonds. The company trades at a big discount, compared to other big tech stocks like Google and Amazon (AMZN). The company has been raising its dividends sharply since 2008, as it looks to return cash to shareholders.
5. Financials have improved despite the bad stock performance - Despite increased competitive pressures, MSFT has managed to grow revenues at ~10% in the last few years, while maintaining its crazily high margins. The company managed to generate an eye popping $31 billion in OCF in its last fiscal year. It has got one of the strongest balance sheets with more than $50 billion in cash (source: Google Finance).

Stock Performance has not been great, but that has made the Stock Cheap

In the past 5 years, MSFT has badly underperformed the rest of the mega-cap technology sector. Like most of the players in the WinIntel ecosystem, MSFT has given a negative return in this period. In comparison, software behemoths like Oracle (ORCL) and IBM have given high double-digit returns, while Apple has been the star performer by far with a 167% return. MSFT has also performed quite poorly in the last year, compared to other tech stocks and Nasdaq. However, we think that this bad stock performance has set the stage for MSFT to potentially outperform in the next few years.

Summary

Microsoft has been giving the appearance of a tired old company for a long time now. Google and Apple have been running circles around the company. However, there are signs that the sleeping giant is finally awakening. It's not easy for a company long used to complete dominance to change its habits overnight. However, the management is realizing that the company could be faced with survival questions, unless it radically changes its strategy. The recent examples of RIMM, Nokia, Dell should serve as apt reminders to the management. It is not certain how successful MSFT will be with its recent product introductions. However, MSFT does not need to become No.1 in order to see its stock go up. It just needs to remain in the game.

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.