Making Sense of Microsoft

Making sense of tech giant Microsoft (NASDAQ: MSFT  ) presents a unique challenge to the investor. A truly global company with over a billion users and a product range that spans the full gamut of computing, it's difficult to pin Microsoft down. The past year has complicated things further: Microsoft released its own tablet, acquired Nokia's handset division, and saw CEO Steve Ballmer announce his retirement with no confirmed successor.

With so much to consider, you’d be forgiven for wanting to dismiss the company altogether. Recent headlines are hardly encouraging: PC sales are falling, Surface tablets aren't shifting, and Microsoft is losing ground to Google and Apple as smartphone computing replaces traditional computing methods. But Microsoft should not be written off without some careful thought. If the widespread pessimism proves unfounded, investors could see their resilience rewarded for years to come.

One Microsoft
Microsoft has seen a number of important changes recently. In October 2012 the company released the Surface RT followed by the Surface Pro in February this year. These tablet-PC hybrids are Microsoft's challenge to the iPad, and comprise part of a broader strategy to transition Microsoft from a software company to an integrated "devices and services company," a strategy outlined in CEO Steve Ballmer's "One Microsoft" memo in July.

The Surface has so far proved to be a commercial disaster, however, with Microsoft taking a $900 million writedown in July when the products' prices were slashed in a bid to boost demand. Despite calls from some investors to stick to the tried-and-tested software-based business model, Microsoft has not wavered in its pursuit of a share in the growing market for smaller computing devices, purchasing Nokia's handset business for $7.2 billion in September.

Are things really so bad?
It's easy to feel pessimistic about Microsoft, but the past year's events need to be put into context. Microsoft has $3.8 billion in cash and $73.2 billion in net assets. Spending $1 billion marketing the Surface or risking $7.2 billion in purchasing Nokia may not be such a bad idea after all. A far riskier strategy would be for Microsoft to sit back and watch its dominant position fade as smartphones and tablets replace PCs.

The company's aggressive strategy to promote new products has resulted in some short-term embarrassments, but should not faze long-term investors. With phones and tablets replacing PCs even in Microsoft's core enterprise market, Microsoft needs a strong presence across what Ballmer calls the "many screens in our lives" if its core business is to survive major changes in computing habits.

After initial criticism, Microsoft appears to be refining its approach to becoming a "devices and services" company. September saw the second generation of Surface tablets released to critical acclaim. The outlook for Windows Phone is also improving, with new research from Kantar showing that Windows has for the first time achieved double-digit market share in France and Great Britain. This comes as Google's Android appears to have reached the limits of its expansion.

Microsoft v. Google
Microsoft's main competitor today is not Apple, as many might assume, but Google. Comparing the two as investment options, Microsoft appears to offer better value. Microsoft's price-earnings ratio of 13.12 suggests pessimism has already been priced in to the market. Compare this with Google's price-earnings ratio of 25.35. This high P/E reflects expectations of future growth, but with Google's market share already so high it's hard to see where this growth will come from.

In the notoriously unpredictable tech business Microsoft represents a fairly stable and dependable prospect. Microsoft also pays a dividend of 3.40%--not bad in a time of almost 0% interest rates. Google's investors have to rely on an ever-increasing stock price for returns, and could be hit hard when the current stock market rally inevitably ends.

The bottom line
As a brand Microsoft may not be as sexy as Apple or Google, but investors seeking value should not be put off by the company's "boring" image. Microsoft was caught napping when the smartphone and tablet emerged, but by drawing on the copious resources built up over decades of market dominance it shouldn't be long before Microsoft has a serious and profitable position in these new computing markets.

With the release of the second-generation Surface and growth in the uptake of Windows Phone we are seeing promising developments in Microsoft's reorientation as a "devices and services" company. Microsoft looks set to successfully reinvent itself while remaining a dominant player in the tech industry.


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