In just a few days, investors will get a chance to see what is going on behind the scenes at Microsoft (NASDAQ:MSFT). In the last three months, it looked like the company had turned the corner. The stock made a new 52-week high, and with revenue and earnings up in the teens, many investors expected great things in the future. However, there are three key issues investors need to watch when Microsoft reports earnings, and the company's conversion from a software company to a device and services company may not be as easy as some would hope.
The most important division could have a problem
Microsoft's most important division is its commercial licensing business. The company's server and Office sales represent 52% of revenue, and this business is facing multiple challenges. The first question investors will be asking is, can Microsoft maintain positive momentum in this business?
One issue is the increasing importance of Google (NASDAQ:GOOGL) Android devices and the millions of Apple (NASDAQ:AAPL) devices being sold. The simple fact is, Microsoft has a major hole in its Office business. The company makes Office available for iPhone, Android, and Windows Phone, but Microsoft's solution for tablet users is to use the company's Office Web Apps.
The problem is, Web Apps are limited versions of the full Office suite. If corporate users want to use a tablet to edit documents, they could simply use Google Docs, a free version of Office-compatible software. In addition, Apple is now giving Pages, Numbers, and Keynote with all new iPads and Macs. Obviously Apple's productivity suite lags far behind Office, but it's free, and it's often difficult to justify paying for something if you don't have to.
The bottom line is, Microsoft investors need to watch for weakness in the company's commercial licensing business. Last quarter, this business reported 7% revenue growth and a huge 90%+ gross margin. If these numbers begin to slip, the stock could be in trouble.
Speaking of margins
One of Microsoft's greatest strengths is the company's huge margins, which produce significant free cash flow. The second question investors need to answer is, will Microsoft's push toward devices have a negative effect on margins?
For example, Microsoft's consumer business reported a blended gross margin of 60% last quarter, compared to the company's commercial business, which carried a blended gross margin over 80%. For comparison, Google's main business, search and sites, carries a margin of roughly 60%. The company's Motorola business, which is device-focused, has a gross margin of less than 20%.
To take this further, consider that Apple is the epitome of a device and services company. Given that Apple's gross margin has dropped from over 40% to near 37%, it's difficult to imagine that Microsoft won't experience some margin compression.
Last quarter, Microsoft reported an overall gross margin of 72%. Even if that margin compressed by just 2% (to 70%), that 2% decline would have cut about 8% from net income. This hypothetical 2% margin decline would have caused diluted EPS to increase by just 5.7%, compared to the 17% increase the company reported.
If devices and services are Microsoft's future, this future might include lower margins and slower earnings growth.
The X factor?
The third question is, will the strength of the Xbox One and the Surface 2 live up to expectations? Last quarter, Microsoft reported that devices and consumer hardware (Xbox and Surface) reported a 37% increase in revenue. With the release of the Xbox One and continued strength of the Xbox 360 system, Microsoft investors are hoping for a huge holiday quarter.
According to Microsoft, over 900,000 Xbox One systems and over 640,000 Xbox 360 systems were sold in December alone. The Surface lineup generated 2.3% of tablet Internet traffic post-Christmas, versus just 0.9% last year. Based on these figures, investors might expect a lot from the company in the current quarter.
However, keep in mind that this division also reported a relatively weak 14% gross margin last quarter, so it will take a lot of sales to generate significant earnings.
In the end, Microsoft still generates massive free cash flow (nearly $5 billion last quarter), but faces serious questions about its future. In theory, it would be great if Microsoft could become a device and services company, but if investors aren't satisfied with the answers to these questions, the stock could suffer.
Chad Henage owns shares of Apple and Microsoft. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple, Google, 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.