Can Win8 And Surface Change The Tone On Microsoft?

By Stephen D. Simpson, CFA | October 19, 2012 AAA

In some respects, Microsoft (Nasdaq:MSFT) is just like any and every other lower-growth tech story - nobody cares about the value of the cash flow, because the years of market-defining growth are long past. Perhaps it's even worse in the case of Microsoft, as moves towards mobile computing devices, software as service/cloud, and so on threaten the very core of that cash flow. Therefore, while the stock continues to look cheap on the basis of even vestigial growth, new products like Win8 and the Surface tablet really have to work if any of that potential value is going to become real.

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A Disappointing Quarter...but Not That Bad
This was certainly not the right kind of quarter for Microsoft to post in a market that is already twitchy and inclined to a "shoot first" mentality. That said, I don't think it was any sort of disaster as the company looks to some significant product launches. Revenue fell 8% as reported, and if investors are willing to accept the company's non-GAAP adjustment to account for various revenue deferrals, then it was more or less flat with the prior year. Windows plunged 33%, while business and entertainment were down 2% and 1%, respectively. Online revenue rose 9%, with server/tools up 8%. In summation, Microsoft's three biggest revenue lines all missed sell-side expectations, while the estimate-beaters amount to less than 17% of total revenue.

Profits were likewise weak. Gross margin was soft, falling about 430 basis points, while reported operating income dropped more than 25%. Microsoft's miss vis-a-vis published estimates were worse than they looked, as about three cents of extra earnings came from below the line. But I suspect some of these estimates were a little stale given recent reports regarding the PC market.

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A Deeper Dive Shows Slightly Better Trends
One of the most dangerous things any investor can do is focus so much on looking for a bright side that they ignore real danger signs. That said, I do think there were some details that soften the blow a bit for Microsoft this quarter. The company doesn't offer as much detail about Windows as it used to, but the company did say that presales of Win8 are about 40% over those of Win7 at similar points in the cycle. In the server/tool business, a transition to a multi-year subscription model is cannibalizing some near-term revenue; multi-year licenses were up 19% and adjusted revenue here seems to stack up alright next to Oracle (Nasdaq:ORCL) and IBM (NYSE:IBM).

The New (Good) Vs. the New (Bad)
It's certainly fair to say that Microsoft is at a challenging point in its lifecycle. Apple (Nasdaq:AAPL) has led a rethinking of what phones and tablets can do, and has certainly altered the landscape for low-end PCs. Likewise, not only has Google (Nasdaq:GOOG) joined in the mobile computing fray, but the company (along with others such as Red Hat (NYSE:RHT), Oracle and Salesforce.com (NYSE:CRM)) have also started altering how consumers and businesses access software. If Microsoft does nothing, then it's fair to ask whether similar companies can maintain their current rich cash flow streams. However, Microsoft is not just surrendering the field.

The company's venture with Nokia (NYSE:NOK) has yet to shake up the mobile market, but the upcoming launches of Win8 and Surface are going to be closely-watched as bellwethers for the company's ability to adapt to changing times. Win8 purports to offer a more mobile-friendly set-up, while the launch of Surface will see whether the company can strike back on the hardware side. Certainly, there are obstacles for both, but expectations seem fairly moderate now and the company could surprise.

The Bottom Line
The market is not expecting much from Microsoft anymore. Just 2% forward free cash flow (FCF) growth can fuel a fair value close to $50 a share. In fact, assuming that Microsoft merits a slightly better discount rate than the average S&P 500 stock, today's price implies a perpetual 10% decline in free cash flows. Now I'll certainly grant that Microsoft is unlikely to follow such a path if it cannot stay relevant in the new mobile/cloud world (irrelevant tech companies don't fade away gently...), but it feels like valuation is more skewed toward risk than reward. If the launch of Win8 and Surface go well, 2013 could be a rebound year for this giant software company.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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