Just when you think you've found a fool-proof business, a better fool evolves to mess things up. I've long thought that Microsoft (Nasdaq:MSFT) shares seemed much too cheap, but held off on buying for fear that ongoing operational shortcomings would obscure that value. With a fiscal fourth quarter that was weak across almost every metric, it looks like that has come home to roost.
 
Although I think the base Windows, Office, and server/tools businesses are still valuable, it's increasingly difficult to trust management to adequately execute or communicate their plan. So while I still think these shares are too cheap on a cash flow basis, it's likely going to take something more dramatic than another reorganization or stabilization in the PC business to get these shares closer to fair value.

SEE: A Primer On Investing In The Tech Industry
 
Disappointing Results Down The Line
Microsoft accomplished something relatively rare among tech companies with multiple lines of reporting segments – the company missed everywhere. The misses weren't particularly large (at least among the revenue lines), but it's hard to come away from these earnings feeling good unless you believe it's just a transitional period for the company.
 
Revenue rose 6% on a GAAP basis, and the 4% miss relative to the average sell-side estimate wasn't all that bad. Windows revenue was up 7%, and about 8% shy of expectations, and was even worse on an adjusted non-GAAP basis (down 6%). Server/Tools revenue rose 8%, as did Entertainment revenue, and Online was up a similar 9%. Microsoft's Business division once again saved the day with nearly 15% growth, but this was about 3% shy of estimates.
 
With the company discounting Windows for tablets, seeing significant COGS pressure in devices, and aggressively building out Azure, a price had to be paid in the margins. Gross margin fell five points on a GAAP basis, missing expectations by about four and a half points. Operating income was down 5% on an adjusted GAAP basis, and the company was about seven points short on operating margin.

SEE: Analyzing Operating Margins
 
Will A Restructuring/Reorganization Really Solve The Problems?
Not too long before these earnings, Microsoft laid out its intentions for a reorganization of the business. The company is looking to refocus around the core concepts of Windows (OS), Apps, Cloud, and Devices.
 
That all sounds fine, but the reality is that reorganizations are usually the final step in tacitly acknowledging that a company's operating approach isn't working, and I'm not sure Microsoft is really aiming towards the right solutions. Although the company has a lot of ideas here and there that could work – Skype, the Windows Phone partnership with Nokia (NYSE:NOK), growing middleware offerings – I don't have a lot of confidence about the ability to execute.
 
As it is, Office is still a strong and lucrative business. Likewise, the company's Windows/SQL Server, Azure, and Hyper-V are likely underrated by the market – Azure, for instance, has a market share lead on Amazon's (Nasdaq:AMZN) much-discussed AWS. And though I don't think Microsoft is going to unseat IBM (NYSE:IBM) or Oracle (Nasdaq:ORCL) in middleware, they're stronger in business intelligence and analystics than Wall Street typically wants to acknowledge.
 
But for all of the good, there is at least one bad. Management still hasn't done much with Skype, and Google (Nasdaq:GOOG) continues to kick them around in markets ranging from online advertising/search to mobile operating systems to cloud apps. And don't forget the Surface – maybe this tablet was just a way of getting more attention for Windows on tablets, but it has hardly gone well for the company.
 
The Bottom Line
Even though there's ample criticism and skepticism regarding Microsoft, I'm actually surprised there hasn't been more investor activism in the pursuit of bigger changes (like a new CEO). There's value here, and I don't think the current management has done anything to deserve the benefit of the doubt regarding their ability to realize that value.
 
I'm still expecting Microsoft to grow its free cash flow at a 3% to 4% rate. With that, the fair value for the shares is well into the $40s. Even if the company were to generate 0% free cash flow growth, fair value would still come in around $37, and fair value net of cash and investments would come in around $28 to $29. Consequently, I think there's already a huge amount of skepticism at work in the stock, though performances like this suggest that such skepticism is coming from a pretty reasonable place.

Related Articles
  1. Investing

    5 Up and Coming Social Media Startups

    Although the days of Facebook's dominance aren't close to being over, here are some new creative platforms gaining traction on the worldwide web.
  2. Investing News

    Public Vs. Private Tech Valuations: What's Driving the Divide?

    The gross valuations over the past five years are more indicative of the market than the true value of the company itself.
  3. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  4. Stock Analysis

    Domo Inc: An IPO Candidate in 2016?

    Learn about key information on Utah-based technology startup Domo Inc. and how the Domo dashboard differentiates itself in the world of business intelligence.
  5. Stock Analysis

    Top 5 Companies Owned By Microsoft (MSFT)

    Find out about Microsoft's most newsworthy acquisitions. Microsoft acquired Skype in 2011 to expand its footprint in the online telecommunications sector.
  6. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  7. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  8. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  9. Investing

    How Digital Payments Will Change Commerce in 2016

    The way we transfer and spend money is constantly evolving, and 2016 is poised to expand digital payments like we've never seen before.
  10. Entrepreneurship

    Digital Nomads in the Modern Economy

    Digital nomads compose a growing portion of the modern economy.
RELATED FAQS
  1. Is Apple Pay safe and free?

    Apple Pay is a mobile payment system created by Apple to reduce the number of times shoppers and buyers have to pay for goods ... Read Full Answer >>
  2. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  3. What is the formula for calculating weighted average cost of capital (WACC) in Excel?

    When analyzing different financing options, companies need to look at how much it will cost to fund operations. There are ... Read Full Answer >>
  4. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  5. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  6. How has Google's operations strayed from its original mission statement?

    Google's (GOOG) mission statement has been the same since its inception in 1998: "Organize the world's information and make ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center