Buy Microsoft on Short Term Weakness

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Microsoft (NASDAQ: MSFT) reported a fairly dismal quarter, and the outlook wasn’t exactly hot either. On July 18, the company reported weakness in some of its core businesses. The negative impact from declining PC shipments has finally had an impact on the company’s financial performance.

Qualitative earnings discussion

For the fourth quarter, the company reported a 24% year-over-year decline in earnings (adjusted basis). From a cash-flow standpoint, that was a fairly reasonable representation. This is because the company excluded the losses from the previously purchased intangibles, then included the cost of the Microsoft Office upgrade offers in both years to make it a fairer representation.

The company on an adjusted basis also reported a 5% year-over-year decline in operating income for the full year. This is well below the 6.2% average growth that I was anticipating for the full fiscal year.

Segment performance

The company reported a 15% decline in Windows OEM (other equipment manufacturer) licenses. The 15% decline in the x86 PC market is likely to persist going into the next quarter. Microsoft believes that the segment should see mid-teen year-over-year declines in the next quarter.

The company reported that the servers and tools segment was able to grow by 9% year over year. The growth in revenue was driven by data center and data platforms. Partnership with Oracle is helping to contribute to the company’s growth. Microsoft provided guidance that – in the next quarter – this segment should grow in the high-single digits.

This makes sense because the demand for servers is likely to trend higher despite the shift to virtualization. Downstream suppliers like IBM (NYSE: IBM) and Oracle are being hit with falling demand for systems and technology. Beneficiaries of virtualization (cloud) will be companies like Microsoft and Salesforce.com.

The business revenue was up by 7% year over year in the quarter. The growth in revenue was modest relative to other quarters. This is driven by the transition to Office 365 (subscription based Office suite). Over the short term, the subscription model will not generate any significant revenue growth, but when given enough time, the revenue from this segment should be able to improve. Microsoft expects growth from this segment to be modest over the short term (mid-single-digit growth in the next quarter).

The low rates of revenue growth will eventually pick up as the company has offered Office 365 to Mac users. Currently, Office 365 has more than a million subscribers. However, I believe that the total addressable market for Office 365 is substantially larger than this. Eventually, Office 365 will have more of a favorable impact on the company’s consolidated earnings.

Online services (Bing) and entertainment and devices (Xbox One, Windows 8 Mobile) reported 9%, and 8% year-over-year revenue growth, respectively. The growth in these two business segments is likely to be sustained over the long term.

Microsoft believes that online services will continue to sustain low-double-digit growth in the next quarter. Entertainment is expected to report a low-single-digit year-over-year decline in the next quarter. The growth in the segment will improve during the holiday shopping season, which will be in two quarters. The growth in entertainment will be driven by the release of Xbox One.

Mixed news for the rest of the industry

It seems that demand for servers is likely to be sustained going into the next quarter. This should have somewhat of a favorable impact on IBM, which recently reported earnings. IBM is transitioning away from hardware and instead is more actively involved in the selling of hardware and software. The transition is helping to keep IBM less exposed to companies like Amazon, which offers storage as a service.

Despite IBM's attempt at shifting its operations to software and services. The company is having difficulty identifying scalable opportunities in the space. There is still pent-up growth potential, but all of that growth may not necessarily be realized by IBM. The company reported a 1% year-over-year decline on its revenues in the most recent quarter, which implies that IBM's business is starting to stabilize. The contribution from software and services is outweighing the losses from its systems and technology segment.

The video-gaming companies are likely to be hit in the current and next quarter. Short-term measures of performance indicate that there will be pent-up demand for gaming in the holiday season. However, companies like Electronic Arts (NASDAQ: EA) may not grow revenue by much in the second and third quarter of 2013. Analysts on a consensus basis anticipate the company to report a 7.6% decline in revenue for the current quarter, and a 9.5% decline for the next quarter. This is because the next generation consoles are expected to be released in the fourth quarter of 2013.

Electronic Arts has a really strong lineup of games heading into the fourth quarter of 2013. Despite this fact, almost every major studio plans on a blockbuster title release for the fourth quarter of 2013. So competition will become fierce. Another negative for game studios are the strained budgets of video gamers, as they have already spent $400 to $500 on a console system. These factors have resulted in a more modest forecast, and as a result, analysts are anticipating the industry to grow by 17.8% for the full year.

Conclusion

Microsoft had a tough earnings release. For the most part, the company’s performance fell because of weakening PC shipments along with weaknesses in its Windows business segment. Both Microsoft and Electronic Arts are likely to exhibit some significant growth from gaming in the holiday season. I also anticipate demand for PCs to stabilize when support for Windows XP ends in the second quarter of 2014. On the system side of the server market, it seems that demand will continue to decline, but IBM is still able to recover because of its software and service offerings.

It's incredible to think just how much of our digital and technological lives are almost entirely shaped and molded by just a handful of companies. Find out "Who Will Win the War Between the 5 Biggest Tech Stocks?" in The Motley Fool's latest free report, which details the knock-down, drag-out battle being waged by the five kings of tech. Click here to keep reading.


Alexander Cho has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus