Forget about the copious amounts of cash flow that Microsoft (Nasdaq:MSFT) generates. With Windows and Office still responsible for the lion's share of the company's profitability, sales trends there drive the bus. Although Microsoft continues to look too cheap, Windows 8 adoption hasn't been great, and the stock may struggle to go anywhere fast in the meantime.
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Decent Enough Fiscal Second Quarter Results, but not Where It Really Matters to Investors
Although Microsoft had, on balance, a respectable second quarter, it's not likely to make anyone feel especially good about the stock. Microsoft is still critically dependent on the PC cycle, and more effective cash/capital deployment is still on the horizon.
Revenue rose 3% this quarter with quite a few moving parts. The Windows division reported 24% revenue growth, but the real growth rate (adjusting out deferrals, pre-sales and so on) was more like 11%. The Business division saw sales fall 9%, while Server/Tools rose 9%. Online Services posted nearly 12% growth, while Entertainment/Devices declined by a reported 11% but closer to 2% excluding deferrals tied to "Halo 4."
Microsoft did just OK relative to lowered revenue expectations, and it basically matched profit expectations. Gross margins were a little stronger than expected - 73.5% against an average estimate of 73%. But operating income declined 3%, and the company's operating margin matched expectations.
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Windows 8 Not so Great so Far
Many analysts took Microsoft estimates down back in December on fears that lower PC sales would weigh on Windows revenue, and it looks like those adjustments were prescient. So far, it looks like the availability of Windows 8 has not, in and of itself, been much of a driver in the PC market.
Maybe some of this is due to the limited supply of Win 8 touch-enabled tablets this Christmas (touch support is a big feature of Win 8). But the reality is that Microsoft is heavily dependent on Windows, and this launch has not been a barn burner just yet. Making matters a little worse, Microsoft management refused to talk in specifics about the success (or lack thereof) with Surface. Call me a cynic, but I suspect that a very successful performance would have been something that management would have highlighted, so I think it's reasonable to assume (for now, at least) that Surface has not made much impact against competitive offerings from Apple (Nasdaq:AAPL), Samsung (OTCBB:SSNLF) or Amazon (Nasdaq:AMZN).
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Enterprise Strong, but too Small
Microsoft's Server/Tools business did well this quarter, and the company is holding its own with the likes of IBM (NYSE:IBM), Oracle (Nasdaq:ORCL) and SAP (NYSE:SAP) in the enterprise market. Unfortunately, Microsoft hasn't been nearly as active in building this business relative to its peers, and it's just not big enough to drive the overall business forward.
Microsoft's SQL business is solid, and Hyper-V continues to gain share, but I feel like the company has missed out by not building up more middleware and analytics capabilities.
Still on the Outside in Online and Devices
Microsoft still clearly has work to do with its strategies in online and devices. The Online Services division saw revenue increase again by double digits, and online ad revenue was up 15%, but companies like Google (Nasdaq:GOOG) and Facebook (Nasdaq:FB) seem to be stretching their lead on Microsoft.
On the device side, there are still many unknowns. Management said that Windows Phone revenue was up over four times (which suggests revenue around $500 million to $600 million), but the company is still playing catch-up.
The Bottom Line
Value isn't the problem at Microsoft, nor has it been for awhile. This company generates huge free cash flow, but the trouble is that management has not deployed it particularly well in the past. Investors seem to be firmly in the "show us" camp regarding improvements in capital allocation, and I don't think that a simple "rinse and repeat" with Windows and Office will lead to better multiples for this stock.
If Microsoft can grow revenue at a 4 to 5% rate and cash flow at a 2% rate (which assumes declining margins into the future), these shares should trade into the high $40s. Even free cash flow contraction leaves value in the shares - free cash flow could shrink 5% a year indefinitely, and fair value would still be north of $30. I think that gives some context for how little confidence there is that Microsoft can continue to grow and/or effectively deploy its capital.
As a result, it's hard not to like Microsoft from a value perspective. Even still, investors need to realize that they could be in for a very long wait to see that value realized.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
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