Over the past five years, the rise of mobile computing took the world by storm, and Microsoft (MSFT -1.25%) failed to capitalize on massive profits that came along with the ride. As a result, shares have been stuck in a range-bound rut, forcing the question of whether this sleeping giant will ever wake up. For investors searching for answers, Microsoft has been working to unify the Windows experience across the PC and mobile spectrum between the release of Windows 8, Windows RT, and Windows Phone 8.
The optimistic view is that Microsoft will be better equipped to compete in today's ecosystem-driven world, making a compelling case for its future. The pessimists view Microsoft as a too little, too late kind of company, and these efforts will be met with more failure, ultimately continuing the "lost decade" for Microsoft investors.
By next Christmas, investors will have a better understanding about how these efforts have fared. But until Santa comes back to town, what should you do with Microsoft's shares?
The value view
Microsoft shares aren't trading at any deep discount relative to their earnings growth rate. Shares are currently trading at 8.4 times forward earnings, and analysts expect Microsoft will grow earnings by an average of 8.9% over the next five years. On this basis, they are trading a 6% discount to Microsoft's long-term expected growth rate. However, if we look historically, shares become overvalued. Over the past five years, Microsoft grew its earnings by an average 7% per year, making shares overvalued by 16.7% above forward earnings.
Based on this PEG ratio analysis, shares are overvalued on a historical basis, and undervalued when you examine future expectations. I prefer historical figures over estimates, because actual results may vary greatly from expectations. History gives you the facts and a good sense of a company's ability to grow earnings, leading me to believe that Microsoft shares are a touch overvalued.
Cash and ambition
Valuation aside, it's hard to refute that Microsoft has tremendous investment potential for investors. It's sitting on nearly $66.1 billion in cash, pays a healthy 3.4% dividend, and still maintains a stronghold in terms of PC market share. On the mobile front, Microsoft has partnered with Nokia (NOK 2.32%) to drive Windows Phone 8 to become a top three ecosystem. Strategically, Nokia faces challenges to return to profitability and grow revenues, and Microsoft is seeking to reclaim lost opportunity. Together the partnership shares the same end goal, all hinging on the success of Windows Phone 8.
This puts Research in Motion (BB -0.90%) in a difficult position because it currently holds the No. 3 spot in mobile OS market share. The BlackBerry maker faces enough challenges without the threat of having Microsoft breathe down its neck. Undoubtedly, BlackBerry 10, slated for release at the end of January, is crucial to the long-term viability of the company. The way I'll be gauging immediate success is if RIM's subscriber base continues to expand after the release of BlackBerry 10. This will indicate that users are initially satisfied with the newest iteration of the BlackBerry ecosystem.
In terms of resources, Microsoft is more of a problem for RIM than RIM is a problem for Microsoft. Microsoft is sitting on nine times more cash than RIM's market cap and has plenty ambition to make Windows Phone 8 successful. In other words, Microsoft's rise through the ranks will likely come at the expense of RIM's market share.
A bear named Google
Google (GOOGL -1.59%) Apps product manager Clay Bavor, went on record saying that Google has "no plans to build out Windows apps" and elaborated that "we are very careful about where we invest and will go where the users are, but they are not on Windows Phone or Windows 8." For the time being, Google will only offer Google Search as a native Windows Phone 8 app.
A lack of Google interest is a blow to Microsoft's efforts. On the PC side, this isn't as important, because Google services typically live in the browser -- something users are already accustomed with. But for Windows Phone 8, this is problematic. Can you really have a successful ecosystem without native YouTube, Gmail, Google Drive, Chrome, Google Earth, Google Translate, Google Calendar, or Google Voice apps?
On a platform with a small form factor like Windows Phone 8, mobile apps are essential to the experience because instead of queuing up a search engine, users rely on selecting an app that directly meets their needs. Going back to the browser approach on a mobile ecosystem will feel like a compromise, especially for users who are already use native Google apps. Given that there are more than 425 million Gmail subscribers alone, the potential affected user group is quite large.
You could even argue that Google helped make Apple's (AAPL -1.14%) iOS successful, especially with Google Maps. When first released, iOS came standard with Google Maps and YouTube. Take those two apps out of the equation, and how does iOS fare? If the Maps fiasco was any indication, not well.
For Microsoft, Windows Phone 8 without Google integration is like having a paintbrush without any primer. It lacks stickiness.
Click in and do more
The Surface tablet has become another area for investors to watch. How it fares will give insight into Microsoft's ability to build a market base from a late-mover position. According to research firm Parks Associates, 21% of consumers plan to buy the Surface tablet this holiday season. While this may not sound like a ton of interest, it was substantially more interest than the 12% who planned on buying a Google Nexus tablet. This survey was taken between October and November -- before Microsoft expanded distribution for the Surface. During this time, there were only 67 Microsoft retail locations for consumers to see the tablet across the U.S. and Canada. Given the small retail footprint available for consumers, these results are quite encouraging.
Microsoft plans to make the Surface available at additional retailers in the U.S. and Australia by mid-December. For those keeping track at home, the Surface is currently available online in seven countries. Investors and consumers alike can expect this number to rise after the first of the year, when the Surface will be made available in more countries worldwide.
The road ahead
Smart devices remain a key interest area for Microsoft in the coming years. It will inevitably come down to how consumers adopt Windows Phone 8 and the Surface fares against rivals. As it currently stands, Windows Phone commands a 2.4% market share worldwide, and it's unclear how the Surface is faring beyond early indications. We will have to wait and see how the uptake of Windows Phone 8 continues given the lack of Google interest for the ecosystem. Granted, Microsoft does offer alternatives to Google products and is even willing to build its own versions if necessary. Microsoft's YouTube app is its first attempt at filling in for Google, and it earned three out of five stars from more than 5,800 users.
Investors should understand that the Microsoft-Google conundrum is like a chicken-and-egg argument. Google has said it's willing to develop for Microsoft's ecosystems as long as the user base is large enough to justify the investment. But is it possible for Microsoft gain enough market share without Google's help? Given Google's influence on the Web and how its products integrate with millions of users on a daily basis, the answer remains inconclusive.
Between the valuation and the high degree of uncertainty surrounding Microsoft's future growth trajectory, I don't believe there is enough compelling information to initiate a new position today. With that being said, I currently rate Microsoft shares as a hold and would consider buying after the next earnings report in January if more positive developments are unearthed. In the end, perceptions hold a strong influence over an investment, and I don't believe there is enough evidence to suggest that perceptions of Microsoft are about to change anytime soon.
