Microsoft Stock Rides on Digital Fumes

Computers have infiltrated every facet of our lives, from our toothbrushes to the parking meter. The one company to get in early and become the standard bearer of software, Microsoft (NASDAQ: MSFT  ) made out like a bandit with its network effects: Your office uses Office? We'll use Office, too. With that momentum, the products sold themselves every upgraded version -- you didn't want to send files in the old, incompatible, unstylish format.

That momentum, though, is fading. Competition and industry dynamics are combining to unseat the default software choice, and Microsoft is struggling to deliver products to keep it relevant. The market has yet to realize just how quickly Microsoft can find itself without much of a future.

A breakdown
The following charts list out Microsoft's revenue and operating profits by division. Note that online services, which includes Bing and MSN, have run at a loss for the past three years.

Profits from Windows fell 6% from 2011 to 2012. Windows 8 is supposed to buoy those numbers; however, while its official sales numbers remain a mystery, reports of a 14% drop in PC sales don't suggest a hit piece of software. Sure, PC sales don't include tablets, what Windows 8 was truly created for, but even sales of Microsoft's Surface have reportedly been slow, with an estimated and unofficial 1.5 million sold versus an order of 3 million. About 130 million tablets overall were sold in 2012.

Online services, Microsoft's effort in online advertising, lost about $2.5 billion in 2010 and 2011, and then $8.5 billion in 2012 after writing off $6 billion in goodwill.

The entertainment division, made up of Xbox and Windows Phone, barely contributed to profits in 2012, with $364 million.

The real drivers in Microsoft's income are its business-oriented profits in servers and Office. Taken together, they contributed $23 billion in operating income, helping fund the losing business segments, as total operating income for Microsoft was $21.7 billion. While Microsoft seemingly has a large consumer presence based on its expansive advertising, it is dependent mostly on business sales and should be valued as such. But even business sales could change rapidly for the worse.

More mobile, less Office
Microsoft is following the industry toward online offerings, including its juggernaut Office. Such a move makes sense, but it takes Office and puts it against free offerings such as Google (NASDAQ: GOOGL  ) Drive. It also highlights the trend away from single workstations and toward mobile devices that depend more on accessing items through a browser instead of through an application running on an traditional operating system. Google's (NASDAQ: GOOGL  ) Chrome OS exemplifies this as well, as an entire operating system built specifically geared toward Web-based applications. And Google, of course, dominates competitors such as Microsoft when it comes to online advertising, which contribute to 95% of Google's revenues.

It makes sense that Microsoft has thrown all that it can at the mobile market through Windows Phone and the Surface. It needs to be a part of that growing tech sector. Even the weight of Microsoft, however, doesn't guarantee successful products. The company can fund a failing product for a long time -- maybe even long enough for some general adoption -- but significant profits may never follow. For example, the Xbox was able to gain a following in a market that Microsoft never previously touched, but it still fails to significantly contribute to earnings.

For now, Microsoft continues to milk Office. But with mobile devices that don't need such software, based much more on Web-centric applications, the future is hazy. Even if its server business remains untouched and grows with its industry, there's little to look forward to in Microsoft's future.

It's been a frustrating path for Microsoft investors, who've watched the company fail to capitalize on the incredible growth in mobile over the past decade. However, with the release of its own tablet, along with the widely anticipated Windows 8 operating system, the company is looking to make a splash in this booming market. In this brand-new premium report on Microsoft, our analyst explains that while the opportunity is huge, the challenges are many. He's also providing regular updates as key events occur, so make sure to claim a copy of this report now by clicking here.


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