Sell Microsoft Until $40 Amid Nokia Problems

| About: Microsoft Corporation (MSFT)
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Microsoft delivered underwhelming quarterly earnings as weakness at Nokia weighed down strong performance at its commercial unit.

Nokia lost $0.08 this quarter, and sales will be weak next quarter as well. It will be at least a year before this unit can be profitable.

Commercial remains strong thanks to solid enterprise PC demand and strong cloud execution while consumer was mildly positive.

Still with problems at NOK, 13.6x forward earnings is not very attractive, and investors should be sellers here.

After the bell on Tuesday, Microsoft (NASDAQ:MSFT) delivered its quarterly results, and this quarter included the acquisition of Nokia's (NYSE:NOK) phone unit. It was also Satya Nadella's second quarter as the CEO of Microsoft, and it was not as impressive as his first report. In fact, it now makes more sense that he decided to cut 18,000 employees last week, which was more than the 6,000-8,000 I was looking for. Surprisingly, MSFT was trading slightly higher after the bell on Tuesday, and I would recommend investors rotate into other tech firms like Intel (NASDAQ:INTC), Apple (NASDAQ:AAPL), or Qualcomm (NASDAQ:QCOM), which are offering more consistent performance and attractive valuations.

In the company's fiscal fourth quarter, it earned $0.55 on revenue of $23.4 billion compared to expectations of $0.61 on revenue of $23.1 billion (financial and operating data available here). The purchase of Nokia is a significant drag on performance. While it generated $1.99 billion in revenue, it lost $692 million, cutting EPS by $0.08. This acquisition was the brainchild of former CEO Steve Ballmer, and I am unconvinced Nokia's hardware business fits with Nadella's focus on the cloud, services, and mobile software, which may explain why he is cutting more jobs than thought. Nokia will likely be a drag on financial results for at least 12 months and probably longer.

While Nokia was bad in its two months this quarter, guidance was truly atrocious with revenue seen at $1.9-$2.3 billion next quarter, compared to year ago revenue of nearly $4 billion. Lumia sales are also weak and increasingly centered around the low end of the smartphone market, which delivers lower margins and does not fit with Microsoft's focus on premium software. The Nokia acquisition makes less sense every day and will continue to drag on results, weighing down stronger numbers in other segments.

In particular, commercial revenue trends continue to be robust as Microsoft is the clear leader in enterprise. Commercial revenue jumped 11% thanks to an 11% increase in Windows licensing, and it accounted for 65% of gross profits. Last week, we saw strong results out of Intel (more here) that showed the PC wasn't dead because enterprise still needs its functionality. Microsoft confirmed that trend, and the headwind from PCs has clearly been overstated. Cloud is the real stand-out performer with revenue jumping 147%. Its annual revenue run rate stands at $4.4 billion, and it should do over $6 billion in fiscal 2015. In the cloud, Microsoft continue to take share and grow revenue by triple digits. Commercial should be strong again in 2015 as overall unearned revenue reached $25.2 billion, up 12% from last year.

Window's consumer operations offered solid results but were clearly not as strong as commercial. Windows OEM revenue was only up 3%, which is indicative of weaker consumer PC demand than commercial demand. Office 365 is gaining some traction, adding 1 million subscribers, bringing the total to 5.6 million. While that is a high growth rate of 20%, it comes off of a low base and is seeing limited market-wide traction. Bing continues to be a solid ancillary business with share of 19.2% thanks to problems at Yahoo (NASDAQ:YHOO), but Google (NASDAQ:GOOG) continue to be the clear search leader. With the holiday season behind us, Xbox is in its seasonal lull, though 1.1 million unit sales is relatively strong. Still, it is unclear when Microsoft's consumer hardware business will be able to consistently turn a profit.

Microsoft is really a tale of three cities. Enterprise is doing really well, consumer is mildly strong, but Nokia and mobile hardware is terrible. I would feel much better about Microsoft if it were a pure play on enterprise, but this unit will now need to subsidize Nokia's losses, bringing down overall earnings power. Unless it can somehow build an unparalleled product, it is hard to see Nokia regaining share at the high end of the smart phone market, and the low end does not have the margins to generate profits with its sales rate. First quarter guidance of $21.2-$22.3 billion is well below consensus of $23.1 billion, which can be explained by the horrendous Nokia guidance.

Frankly, I believe Nadella would be better off saying Ballmer screwed up and spinning out Nokia to focus exclusively on software, the cloud, and enterprise. Nokia is an unnecessary and loss-making distraction. Unlike Xbox, which at least is a segment leader, Nokia is a market also-ran with limited prospects of market share gains. On the positive side, Microsoft carries $85.7 billion in cash against $20.6 billion in long term debt, though its abundance of riches could allow it to excessively subsidize losses at Nokia.

While commercial growth is solid led by the cloud, Nokia and consumer hardware will continue to drag on results. As a consequence, I expect Microsoft to earn about $2.75 in fiscal 2015. After accounting for its net cash hoard, MSFT is trading 13.65x 2015 earnings. This is not particularly expensive but is not cheaper than competitors like QCOM and AAPL that don't have its headaches. On a relative value basis, Microsoft is expensive until it can show how Nokia will be a positive, or at least stop being a drag. I would wait for shares to trade back to $40 before considering buying the stock. At $45, the good at enterprise is fully priced in while investors are discounting the problems at Nokia. Investors should look elsewhere for value.

Disclosure: The author is long QCOM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.