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3 Problems That Microsoft Needs To Solve

By Chad Henage – Feb 10, 2014 at 10:00PM

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Everyone knows PC sales are declining, but believe it or not becoming a devices and services company might be an even bigger problem.

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 (MSFT -2.03%) 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 (GOOGL -2.51%) 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 (AAPL -2.54%) 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.

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. 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.

Stocks Mentioned

Apple Stock Quote
$142.91 (-2.54%) $-3.72
Alphabet Stock Quote
$96.98 (-2.51%) $-2.50
Microsoft Stock Quote
$245.12 (-2.03%) $-5.08

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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