Ready to Run?

By Callum Turcan - August 7, 2012 | Tickers: AMZN, AAPL, BKS, IBM, MSFT, NOK | 0 Comments

• Email
• Print

Double Standard

Is Microsoft Corp (NASDAQ: MSFT) ready to break out of the $25-$32 rut it has been in for over a decade? Well, let's see. The PE for this year's estimates is 9.5, which is far lower the International Business Machines' (NYSE: IBM) expected PE of 12.85. This is very surprising considering that both IBM and Microsoft are expected to grow their EPS by 13% this year. So why is Microsoft trading at a lower PE? Both IBM and Microsoft are also slated to grow their EPS by 10-11% over the next few years based on analyst projections, so why is Microsoft trading at a discount even though Wall Street is expecting very similar things from both companies.

PC Market

IBM got itself out of the PC manufacturing business in 2005, which was a great move as the PC market remains very weak, with every manufacturer racing to the bottom on pricing. Microsoft can't say the same. Microsoft needs a strong PC market so it can sell more of its cash cow products: the Office Suite and its operating system Windows. Gartner (a research firm) revised its PC sales forecast down from 10.5% to 4.4% this year based on "PCs will face more competition as we see new media tablets based on operating systems from Android and Microsoft, as well the new iPad," which simply means tablet sales are hurting PC sales. Where tablets really hurt the PC market is in the lower-end notebook and desktop market, where you could buy a tablet for anywhere from $200-$600, just as you could a lower-end desktop or notebook.

There is some good news though, as Gartner expects PC sales to increase by 8.7% next year as emerging markets will continue to increase their share of the global PC market from 50% to 70% by 2016. Emerging market PC sales grew at 11.6% in 2011 (versus 2010) but the mature (Europe, US, Canada, Japan) markets saw an 8.8% decline (versus 2010). IDC also expects strong growth from emerging markets in 2012 and going forward, and thinks that in 2012 they will see an 7% rise in PC sales.

One problem for Microsoft is that in the emerging markets laptops are selling very well (19% growth) versus just 3.5% growth for desktops. But, Microsoft makes less money off of laptops (unless they are ultra-books) than desktops. Within the PC sector, there are some bright spots, particularly in the emerging markets, but in the mature markets, PC sales will continue to grow at a slow pace (IDC expects 2.3% growth in 2012 for mature markets). The biggest thing to take away from this is that the global PC market is starting to pick up slowly, and by 2013 should be doing pretty well. Microsoft's stock looks to be priced for zero growth, when it should be trading at a higher PE because it is growing both its top and bottom line and the PC market is also growing.

Tablet Competition

Tablet sales are hurting PC sales and will continue to do so for what will probably be forever, until the next new gadget comes out. This is why Microsoft is going to make its own tablet (Windows Surface), so it can get into a market slated to grow 350% by 2015. There is no way for a PC maker to counter the tablet revolution, so lower-end desktops and laptop sales will increasingly be competing with tablets for consumers dollars. The iPad from Apple Inc (NASDAQ: AAPL) remains a big challenge for Microsoft as Microsoft will have to compete with the top selling (the iPad is slated to hold 75% of the tablet market for a while) The iPad, which saw sales growth of 84% last quarter, took away from PC sales. Also, Amazon.com Inc's (NASDAQ: AMZN) Kindle Fire and the upcoming Kindle Fire 2 will pose a big problem for PC sales and Microsoft because of its low price. If the Kindle Fire 2 does come out at $149, then lower-end PCs will have to compete with something that is very cheap (cheaper than a laptop or desktop). But, for higher-end computers, tablets pose no real threat as they don't have the tools or the facilities to offer what consumers looking for those higher-end PCs want.

The MAC attack

Apple's PC operating system has been steadily gaining market share. In 2010, Apple had 9.0% of the market. By 2011, that had grown to 11.6%. This is hurting Microsoft, especially as PC sales continue to be weak. In order for Microsoft to keep Apple at bay, they need to have a stellar performance with Windows 8. Apple will continue be a thorn in Microsoft's side for a long time.

Windows 8

Windows 8 is projected to come out on October 26, 2012. This is one of the big catalysts for Microsoft, as Windows is its biggest cash cow. If Windows beats expectations, expect great things from this stock. The big thing about this version of Windows is that is will run on tablets. Tablets, as I said before, were eating up PC sales. But, if Microsoft can get into the booming tablet market, it can more than make up for the loss. While it is still too early to tell if this will be a big hit or not, Microsoft's PE is making it look like investors aren't expecting much, so any good news would be great news.

While some call Microsoft's foray into the tablet market a joke, others say it is Microsoft's big break. According to a PC Mag poll on Windows 8, 17% said they want the first tablet that ships, 14% said they would download Windows 8 as soon as possible, 9% said they would try out the beta first, 39% they would stay put, 15% said they would take not part in Microsoft's OS ever, and 6% fall in the other category. So there is some demand for the tablet which is a good sign. I think that Windows 8 will attract the more die-hard Windows fans and those who feel that Apple has the monopoly and want to have something else. Also, because the tablet will run Office, many professionals might turn to Microsoft as they need their Windows 8 tablet to do a presentation at work. The ability to do some work at a computer that runs Windows, then put that work onto your tablet to do your presentation might be a great selling point. I think Microsoft will make some headway into the tablet market because it isn't as established as something like the smartphone market. iPad may dominate 75% of the market share, but Microsoft's Windows and Amazon's Kindle Fire will definitely chip away at Apple's dominance. Plus, Microsoft's partnership with Barnes & Noble Inc (NYSE: BKS) will also give it some headway. The Nook could help Microsoft compete with Amazon in the "low end" of pricing in the tablet market, while Windows takes on the iPad.

Wildcards

While the success of Microsoft in the tablet market remains a wildcard, another is the smartphone market. Nokia Corp's (NYSE: NOK) partnership with Microsoft has gone okay, with Lumia sales not being stellar but still doing alright. In Nokia’s latest quarter it said it sold 4 million Lumia phones running on Windows Mobile, better than what analysts expected which sent Nokia's stock up, but still relatively low for industry standards. It just wasn't as bad as expected, which is never that appealing to hear. In the fourth quarter Nokia is expected to release the Windows 8 Mobile phones, which could be a huge catalyst for both Nokia and Microsoft. If Microsoft can make headway into the smartphone market, which has seen tremendous growth and will continue to do so, then it can be the "disruptive force" Nokia wants the Lumia phones to be.

Other Divisions

The Xbox continues to be the best selling console device out there, and with more and more people buying Xbox’s, then the more Xbox Live subscriptions are sold. While this is just a small part of Microsoft, it helps its bottom line. NPD Group's research says that the Xbox currently makes up 47% of all console sales. Plus, the more Xbox Live members there are, the more money is spent in Xbox's Marketplace, where gamers can buy Microsoft points to buy DLCs (Downloadable Content) for their games and avatar customizations for their profile. Also Microsoft's SQL Server and Enterprise Tools division continues to do well, with 12% this quarter and 14% growth last quarter (both year over year). The SQL & ET division remains a big growth area for Microsoft as more and more people go into the Cloud. Also, the purchase of Yammer for $1.2 billion can be integrated into Microsoft's Enterprise Tools division to offer social networking to other companies. Microsoft's attempts to rebrand its web search offering has paid off very well, with Bing's global market share rising from 2.9% in 2009 to 4% in 2011. Trefis (an investing research website) predicts that by 2016, not only will Bing have 5% of the global market share in web search but will also have a positive operating margin. Bing is still losing Microsoft a lot of money, but over the years that amount has come down, which is always a bullish sign. 

Final Thoughts

Microsoft seems to be priced for no growth, even though it is growing its earnings by 10% annually and pays out a nice 2.7% dividend. I think Microsoft would be a great investment, as there is limited downside; it has strong cash flow and a rock solid balance sheet. While there is a weak PC market and lots of competition in the markets Microsoft wants to expand into, using its large balance sheet and numerous partnerships, Microsoft will gain some market share in both the smartphone and the tablet markets. There still are some obstacles Microsoft will have to push through, such as sluggish PC sales and lots of competition. I am bullish on Microsoft, and think we will see its stock move past the $40 point within 12 months.

• Email
• Print
• Feedback