Is the PC Holding Back Microsoft?

Back in April, Apple (Nasdaq: AAPL  ) rose to take the top spot among techies in terms of market capitalization. Cries of irony erupted as once-dominant Microsoft (Nasdaq: MSFT  ) -- the company that literally helped Apple stave off bankruptcy years before -- fell to second place behind its rival.

Ah, April. Those were the good old days, eh?

Yesterday, IBM (NYSE: IBM  ) briefly also surpassed Mr. Softy in terms of market cap. An above-average selloff has reset the order today, but it seems inevitable that Big Blue will permanently bypass its old PC partner. All of which leads to the question: Is Microsoft backsliding because of its longstanding commitment to the PC?

I know; that's a loaded question. But it also can't be a coincidence that CEO Sam Palmisano's decision to sell the PC business to China's Lenovo in 2005 has ushered in an era of outperformance for Big Blue, can it? Consider:

  • Adjusted earnings are up 13.5% annually over the past five years. Microsoft has enjoyed a 7.5% annual gain over the same period.
  • IBM's gross margin is up more than 6 percentage points since 2005. Microsoft's gross margin is down 7 percentage points over the same period.
  • And while both companies have enjoyed gains in return on capital, Big Blue has nearly doubled ROC from 13.5% to 26%. Mr. Softy has rallied from 17.2% to 28%, but that's down from a 2008 high from 44.7%. IBM, by contrast, has enjoyed steady improvement.

I should admit a bias here; I've owned shares of IBM for years. I like Palmisano's style and strongly agree with his emphasis on crafting services and software bundles to address industry problems. Meanwhile, the R&D group keeps churning out innovations that result in more than $1 billion in high-margin royalty revenue. Big Blue never needed the PC to prove it was an innovator.

Microsoft isn't as lucky. To me, the comparative metrics from above paint the picture of a business that's suffered from exactly the sort of pricing pressure Palmisano feared when he sold to Lenovo.

To be fair, Mr. Softy has dealt with the changes better than most. The company still throws off billions in annual cash flow and sports high ROC. Yet the story doesn't end there. Microsoft also spends on ill-fated exploratory projects to overcome the limitations of dominating a market that's facing pricing pressure not just from pinched PC making customers, but also from consumers who've become accustomed to free alternatives to its Office suite of software. (Exhibit A: Paying $8.5 billion for Skype.)

Microsoft isn't going anywhere. It has too much cash and too many customers to simply disappear. But it also isn't going anywhere. It has too much competition and too many customers who expect more for less to grow as it once did.

IBM had that problem once, too -- when it still sold PCs. Those days are long over, and as its bulging market cap attests, shareholders are better off for it.

Do you agree? Disagree? Please weigh in using the comments box below. You can also keep track of the computing industry by adding any of these stocks to your Foolish watchlist.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Apple and IBM at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.

The Motley Fool owns shares of Microsoft, IBM, and Apple. Motley Fool newsletter serviceshave recommended buying shares of Microsoft and Apple and creating bull call spread positions in Apple and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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