Can Microsoft Survive Digital Darwinism?

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Software giant Microsoft (Nasdaq: MSFT  ) came in strong this week, reporting third-quarter earnings that beat analysts' estimates. Shares traded higher on the news. However, the company's core business is under attack, with smartphone and tablet devices threatening to replace personal computers. It's easy to look at an iconic company like Microsoft and assume it will get by on its good name alone. But that isn't always the case.

A window to profits 
Led by Apple's (Nasdaq: AAPL  ) iPhones and iPads, the shift to mobile devices is taking a toll on Microsoft. Nearly a year and a half after its release, the company's Windows Phone continues to scream "Pick me!" to no avail. Microsoft teamed up with Finnish cell-phone maker Nokia (NYSE: NOK  ) in a seemingly desperate attempt to get its mobile platform to market. However, the success of that partnership was recently challenged when Nokia's new Windows-based phone launched in the U.S. with a major glitch.

The Lumia 900 smartphone had a problem with suddenly dropping high-speed data connections. Not a good first impression, guys. To remedy the problem, Nokia is offering a full refund to all customers before today. While Microsoft won't divulge sales figures for its mobile platform, Nokia said sales of the new Lumia had been "mixed," according to The New York Times.

Anything less than stellar is bad news for Microsoft as it struggles to gain share of the booming smartphone and tablet market. If you squint and look closely, you may be able to see Microsoft's microscopic 4% piece of the mobile pie. Meanwhile, Apple and Google (Nasdaq: GOOG  ) steal the show -- together commanding more than 80% of the U.S. smartphone market, according to comScore.

Let the games begin
Microsoft has to get mobile right if it wants to see outperformance in the future. The company's gaming business has also fallen victim to this digital culture shift, with more people downloading games to their mobile devices instead of to the Xbox. In its latest quarter, Microsoft's entertainment segment declined 16%, to $1.62 billion. Even more alarming was the number of Xbox consoles sold for the quarter, which fell 48% from the year prior.

Nevertheless, I see Microsoft improving performance in the gaming business in the quarters ahead. The launch of products like the Kinect offer proof that the company has a process for innovation in gaming, which should help them keep up with competitors like Zynga and Facebook that rule the mobile space. It's also important to point out that Microsoft's gaming division is one of its lower-margin businesses. The company is showing tremendous strength where it counts -- in its server and enterprise segments. Microsoft Business rose 9%, ringing in $5.8 billion for the third quarter, while Server and Tools grabbed a cool $4.5 billion for a gain of 14% in the period.  

Taking score
Shares of Microsoft are up 25% this year regardless of ongoing changes in the technology sector. Microsoft's revenue increased 6% from a year ago, despite declining PC sales in the United States. Earnings excluding items came in at $0.60 per share on revenue of $17.4 billion, which were ahead of analysts' expectations for just $0.57 a share. Sales of the Windows operating system further impressed by posting a 4% gain in the period. Meanwhile, worldwide PC sales grew a modest 1.9%, according to Gartner. This was a surprise, especially considering Apple's iPad continued to poach would-be customers of low-end laptop computers.

The company pulled off a spectacular quarter without notice of an unfriendly PC environment -- I'm impressed. Clearly, there are some serious issues that Microsoft needs to address going forward in terms of the mobile and gaming segments. However, this is an extremely well-run business that's getting ready to roll out new products later this year, including Windows 8 PCs and tablets. More importantly, Microsoft's stock is not expensive.

The company generates strong free cash flow, trades at a price-to-earnings multiple of 11, and offers a dividend yield of more than 2%. True, the company needs to get its mobile strategy on track, although I think the stock has room to run. I expect strong earnings from Microsoft in the future as it embraces new industry trends. For that reason, I'm giving the stock a three-year outperform rating on my profile in Motley Fool CAPS. While Microsoft still faces challenges in this post-PC era, there's another stock that's already cashing in on shifts in the tech industry. Get The Motley Fool's free report titled "The Only Stock You Need to Profit From the NEW Technology Revolution."

Fool contributor Tamara Rutter owns shares of Apple. Follow her on Twitter, where she uses the handle @TamaraRutter, for more Foolish insight and investing advice. The Motley Fool owns shares of Microsoft, Apple, and Google. Motley Fool newsletter services have recommended buying shares of Apple, Google, Microsoft, and Nokia and creating bull call spread positions in Microsoft and Apple. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (2) | Recommend This Article (6)

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  • Report this Comment On April 22, 2012, at 3:14 PM, dastaub22 wrote:

    MSFT's goal is to have their phones competitive by the time Windows 8 is released.

  • Report this Comment On April 22, 2012, at 7:34 PM, techy46 wrote:

    Microsoft is using Nokia to test the WP7 Metro interface prior to the release of Windows 8 and Windows Phone 8. AT&T is selling a lot of Nokia's Lumia 900 is to great reviews with the cyan color out of stock and the white modle now shipping. Microsoft is transforming the XBOX 360 gaming device into the XBOX 720 multimedia device. Microsoft needs to buy Coinstar (RedBox) and 100 Radio Shack mall locations turning them into Microsoft retail outlets for devices and media. Nokia needs to bring out their Nokia Fluid phones and tablets running WP8 after announcing a new low end Lumia 510c for China and India.

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Tamara Walsh

I've been an analytical writer for The Motley Fool since 2011. I cover the sectors of Consumer Goods, Technology, and Industrials. Connect with me on Twitter using the handle, @TamaraRutter -- I'd love to hear from you!

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