3 Problems That Microsoft Needs To Solve

When your company is mentioned fairly consistently with a "lost decade" of returns, you know that drastic changes may be needed to sway investors. Microsoft (NASDAQ: MSFT  ) has a new strategy and wants to become a devices and services company. The good news is, that is exactly what's happening, the bad news is, these changes are not all positive. In fact, if Microsoft can't answer three important questions, we might be in the middle of another lost decade for the stock.

Which is worse? The devil you know?
It's no secret that Microsoft is suffering when it comes to licensing its popular Windows operating system. In the company's current quarter, Device & Consumer Licensing revenue fell by nearly 6%. To make things worse, the overall PC market witnessed the steepest decline in sales in history with a 10% decline last year. Somehow Microsoft needs to find a way to solve this problem and fast.

The causes are known and aren't going away anytime soon. Google (NASDAQ: GOOGL  ) is taking a piece of Microsoft's pie by offering Chromebooks, a computer that just connects to the Internet. Between streaming video, music, and multiple photo services offering huge online storage, saving your own files just isn't as important as it used to be.

On Chromebooks and Android devices, services like YouTube, Google Docs, Google Music and more are making customers question why they need a PC.

In addition, Apple (NASDAQ: AAPL  ) is shipping millions of iPads and Macs and Microsoft makes nothing off of these sales. Whether it's Chromebooks, Macs, iPads, or Android tablets, Microsoft is finding out what happens when customers have multiple choices that can do what their computer used to do.

Or the devil you don't?
Many investors expect that the future of Microsoft is its push into devices and services. This sounds great, but devices aren't nearly as profitable as software licensing.

Google learned this lesson and decided to jettison the money-losing Motorola Mobile business by selling it to Lenovo. Motorola carried roughly 20% gross margins versus better than 60% gross margins at Google's search and sites business. It appears that the company didn't want to continue dragging its other business down with continued investment in Motorola.

A good picture of what a devices and services company looks like is Apple. However, Apple's gross margin has been under pressure and in the current quarter the company's gross margin came in just under 38%.

The challenge for Microsoft is the company's push toward devices is going very well, but at the expense of margins. In the current quarter, Microsoft witnessed a 68% increase in its Devices and Consumer Hardware business. This would seem to be great news, but with a gross margin of just 8.7%, investors need to hold their applause.

In fact, gross margin pressure from this business is probably just getting started. The company's highly successful device sales (Surface and Xbox) over the holiday season are at least partially to blame for Microsoft's overall gross margin, compressing from over 70% last quarter to just over 66% in the current quarter.

With lower margins it will be harder for Microsoft to generate significant earnings growth even with better sales. If you want proof, consider that current quarter revenue jumped 14% but EPS increased less than 3%.

An investing thesis is dying right before our eyes
One reason many investors own Microsoft is the company's huge cash-generating capabilities. However, the company's thinner margins are hurting the company's cash flow as well.

In the last six months, Microsoft's net cash and investments was essentially unchanged. By comparison, Google grew its net cash and investments by 25% year-over-year, and Apple generated better than 9% net cash growth in just the last three months.

The bottom line is, if Microsoft is going to continue on its current path, investors need to realize this new company won't be like the old Microsoft. While the company's devices may sell very well, the company's huge margins are at risk. This quarter was likely a preview of what is in Microsoft's future. Better revenue growth, but anemic earnings growth because of lower and lower margins. This sounds like a recipe for another lost decade.

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  • Report this Comment On February 10, 2014, at 11:59 PM, StephenPAdams wrote:

    This is an interesting article and one that is generally spot on.

    But I think the biggest thing to remember here (and you're omitting it) is Microsoft's absolute dominance when it comes to commercial business. In that regard, they are actually welcoming the cloud. Office 365, Azure, their servers and development tools, etc. are all very...very...very profitable.

    Now, if you're talking the consumer space, I think that's largely correct in regards to their gross margins. I think the one thing to keep in mind with MSFT is that they went from doing terrible in regards to judging demand (first gen Surface) by over producing the original Surface RT to the tune of a $900 write-off in FY2013 Q4 (MSFT's) to actually being too pessimistic with their next generation Surface (both Surface 2 and Pro 2 were sold out for months from various retailers).

    The biggest thing Microsoft needs to learn going into 2014 is properly estimating demand. I think they'll do a much better job with a year under their belts. They'll also be able to price appropriately with multiple generations available to sell.

    What they also need to do is learn to expand. Properly. Look at the number of markets the PS4 is available in (well over 50 at this point) versus the Xbox One (was in the teens last I checked). Same goes for Surface. They have the same issue.

    Look at the Apple Stores vs. Microsoft Stores. As of May 2013, Apple has ~11 times as many stores as Microsoft does. That's huge. Their distribution chain is also much more widely available. Microsoft needs to help bridge that gap.

    I think a ~9% gross margin is way too low. I expect that to increase as the shelf life of the Xbox One increases and overall availability of their products increases.

  • Report this Comment On February 11, 2014, at 12:51 PM, VegasSmitty wrote:

    Lets see, MS has problems? The MF like BGR is nothing more then a shill for Apple products. MS has over 80% of the worlds computers running their OS. I'd say they are doing pretty good.

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