3 Takeaways From Microsoft’s Recent Earnings

Software, services, and devices, oh my!

May 7, 2014 at 1:05PM

Microsoft (NASDAQ:MSFT) is a company trying to transform itself from a software business to one that sells devices and services. Investors have become cautiously optimistic that the company is heading in the right direction, and the stock is up just less than 7% on the year, compared to an increase of less than 3% from the S&P 500 Index. The good news for investors is that there are at least three items in the company's recent earnings that suggest this outperformance will continue.

So crazy, it just might work
There might not have been a less expected product introduction by a company than when Microsoft first introduced the Surface tablet. Investors and analysts thought of the company as a software business, and the Surface seemed to come out of left field.

This bold move was designed to change the way people view Microsoft and usher in the company's device business. Though the Surface business is still relatively small compared to Apple's (NASDAQ:AAPL) iPad, the devices seem to be selling well. While Apple reported iPad unit sales fell 16% year over year, Microsoft's Surface revenue increased by 50%.

In addition, Microsoft's consumer devices and hardware division grew revenue by 40% on an annual basis. The first takeaway from Microsoft's earnings is that, due to Surface and Xbox sales, Microsoft is becoming more of a hardware company every day.

While the Surface currently isn't a huge threat to Apple's iPad sales, if its momentum continues, it will be a serious challenger at some point. According to IDC Research, sales of tablets, including 2-in-1s, are expected to increase 19% in 2014. In particular, the company said, "we expect Windows-based devices to capture more than a quarter of the market as its benefits become apparent thanks to growing adoption of 2-in-1s."

In addition, the growth of the Surface and Xbox businesses poses a threat to Google's (NASDAQ:GOOG) search dominance. The more Surface and Xbox units that are sold, the greater usage Bing should see. As proof, consider that six months ago, Bing grew revenue by 34%, compared to Google's 31% increase in paid clicks. In the current quarter, Bing's revenue increased 38%, compared to a 26% increase in Google's paid clicks.

As you can see, Microsoft is much more than an old, stodgy software company.

Software as a subscription is working
I was one of Microsoft's skeptics when the company introduced Office 365. The concern was whether consumers would willingly pay $99 a year to use Office when there were other options like Google Docs or Apple Pages that could be used for far less.

The second takeaway from Microsoft's earnings is that consumers will pay for a subscription to Office. Office 365 Home grew its users by 29% in the last three months and now boasts more than 4 million subscriptions. Though Google Docs is free and Apple Pages is either free or relatively cheap, depending on if you buy Apple hardware, neither of these is slowing Office 365 down.

On the commercial side, Office 365 was even more impressive, with a more than 100% reported revenue growth rate. It seems that customers are voting with their wallets, and though free is tempting, sometimes you get what you pay for.

$82 billion may be burning a hole in Microsoft's pocket
The third takeaway from Microsoft's earnings is somewhat speculation, but is based on past history. Microsoft has made significant acquisitions in the last few years designed to develop and improve its ecosystem of offerings. Skype in 2011 and Nokia's handset business in 2014 are two of the more significant investments.

The company plans on using the Nokia handset business to become an even more significant device manufacturer. The integration of Skype into both the Xbox and the Surface tablet has been a selling point for both devices. The company's next move could be more content- or social-based.

The two companies that come to mind immediately are Twitter and Netflix. Both companies have market caps of around $20 billion, so even a price of twice this much would only use half of Microsoft's cash and investments.

An investment in Twitter would give Microsoft a foothold in the social space where Google+ and Facebook reside. On the other hand, a deal for Netflix would give the company a valuable bargaining chip to bundle a Netflix service promotion to help sell more Surface tablets, Xbox consoles, and now Nokia handsets.

The Foolish bottom line
As you can see, Microsoft seems to be managing its transition to a devices and services company well. Investors who have been patiently waiting for the stock to regain its luster may be about to reap the benefits.

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Chad Henage owns shares of Apple and Microsoft. The Motley Fool recommends Apple and Google (C shares). The Motley Fool owns shares of Apple, Google (C shares), and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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