Is Microsoft Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Microsoft (NASDAQ: MSFT  ) fit the bill? Let's take a look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell Microsoft's story, a story we'll be grading in several ways:

  • Growth: Are profits, margins, and free cash flow all increasing?
  • Valuation: Is share price growing in line with earnings per share?
  • Opportunities: Is return on equity increasing while debt to equity declines?
  • Dividends: are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's take a look at Microsoft's key statistics:

MSFT Total Return Price Chart

MSFT Total Return Price data by YCharts.

Criteria

3-Year* Change

Grade

Revenue growth > 30%

24.6%

Fail

Improving profit margin

(6.5%)

Fail

Free cash flow growth > Net income growth

11.2% vs. 16.5%

Fail

Improving EPS

23.6%

Pass

Stock growth (+ 15%) < EPS growth

65.9% vs. 23.6%

Fail

Source: YCharts. *Period begins at end of Q2 2010.

MSFT Return on Equity Chart

MSFT Return on Equity data by YCharts.

Criteria

3-Year* Change

Grade

Improving return on equity

(30.4%)

Fail

Declining debt to equity

53.7%

Fail

Dividend growth > 25%

76.9%

Pass

Free cash flow payout ratio < 50%

30.3%

Pass

Source: YCharts. *Period begins at end of Q2 2010.

How we got here and where we're going
We first looked at Microsoft last year. It has lost two passing grades in its second assessment, falling to a mere three out of nine passing grades today. A $900 million writedown on its Surface tablet inventory earlier this year severely dented its profitability, and the unsold inventory also crimped its cash flow. Competition has been fierce in mobile, and the PC industry has shown incontrovertible signs of decline, hindering Microsoft's progress on two fronts. Despite these weaknesses, shares have grown faster than they have in years -- so fast, in fact, that earnings haven't kept up. How might Microsoft overcome its many challenges and justify renewed long-term optimism? Let's dig a little deeper to find out.

Slowing demand in the PC business has made Microsoft's entry into the tablet market imperative, and the Surface has thus far been a complete flop. As mentioned earlier, the company took a massive writedown on its unsold inventory earlier this year. However, the company hasn't given up its tablet strategy yet -- it recently announced a premium tablet targeting business customers. Fool contributor Tim Beyers notes that the company may lose enormous opportunities in consumer media by focusing on business users. Other companies may help pick up the slack, though -- Samsung unveiled the ATIV Q, a convertible Windows 8 tablet that also runs on Google's (NASDAQ: GOOGL  ) Android OS. Unfortunately, patent-related issues are rumored to have caused unnecessary delays in its launch.

Microsoft is also doing everything in its power to hold onto PC users, and recently released Windows 8.1 to smooth over the harsh criticism that followed its previous operating system since its botched launch.

After finally surging into the lead in the video game console wars, Microsoft now plans to launch the Xbox One within the next few weeks. Fool contributor Rick Munarriz notes that Sony's PS4 may pose a significant threat to Microsoft's Xbox One, since it will be available at a lower price and has thus far benefited from the blowback of an atrocious rollout from Microsoft. Fool contributor Keith Noonan notes that the Xbox One will be launched with the Machinima app, which capitalizes on a growing user interest in recording, editing, and watching others' gaming sessions. Microsoft and Time Warner Cable also teamed up to launch an app for TV content on the Xbox console.

Microsoft is also poised to benefit from its subscription model for Office 365, a cloud-based office productivity suite which offers functionality advantages over Google Docs. Google, of course, has a vested interest in closing that gap, and Apple's (NASDAQ: AAPL  ) launch of iWork for iCloud shows that the productivity software space is no longer the free ride on which Microsoft has long relied. This is an obvious problem for Microsoft, which has barely penetrated mobile yet -- in the second quarter, Google's Android controlled 63% of the tablet market, while Apple held 33%. That's a two-way race, and it's a similar picture in smartphones, where Android controls 52% of the U.S. market and Apple holds 41%. With PCs in decline, Microsoft needs to find a way to penetrate this segment quickly before it's locked out completely. Nokia, whose handset business was recently acquired by Microsoft for $7.2 billion, recently announced several new products, including a phablet, at its annual Nokia World event this month. The Windows Phone OS was also recently updated to run on devices with screens of up to 6 inches. That's a start, but it's probably not enough.

Putting the pieces together
Today, Microsoft has few of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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