Profiting From This Earnings Disappointment

Douglas 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) announced disappointing results last night, seeing quarterly earnings slide by 22% amid weak PC demand. Still, with a fall that dramatic, shares are only trading down 2.3% in Friday’s early session. This suggests that despite the significant decline in EPS, investors have high hopes that the October 26 release of Windows 8 and the Surface tablet will be a turning point for the company. As such, buying Microsoft shares into weakness and ahead of the big release date should yield a short-term pop and a solid longer-term entry point.

The Earnings

In Thursday’s earnings release, Microsoft reported earnings of $0.53 per share versus the consensus expectation of $0.56 per share. Revenue fell 8% to $16 billion, also missing expectations of $16.5 billion and dropping earnings to $4.47 billion – a year ago the company posted earnings of $5.7 billion. While the numbers are not pretty at initial consideration, there are some mitigating factors. First, the Server and Tool division is in the midst of a transition in its business model. Rather than collecting at the program level, the division is working on moving to more comprehensive multi-year deals. This type of transition tends to lower initial numbers while simultaneously setting the company up for better long-term success.

The second major factor that improves the stance of the earnings results is that over $1 billion in revenues was excluded prior to the official launch date of Windows 8. $783 million of licensing revenue was deferred on pre-sales of PCs that include the new Windows 8 operating system, and an additional $384 million was deferred on PCs that shipped with Windows 7 but will receive a free upgrade at launch. When this $1.1 billion is added back into the company’s numbers, the decline is far less precipitous. This may explain why traders have been fairly gentle on the stock despite the news.

The Way Forward

While the earnings results are hardly positive, they are far from catastrophic. Given the market’s recent penchant for drastic swings on the heels of negative news, the mild decline suggests a struggle is underway between those rushing for the exits and those who believe October 26 has the potential to be a date of rebirth for the company. I fall into the latter category because I believe the Surface tablet represents the industry-changing bridge between the PC and tablet that has been long needed.

The “death of the PC” has been blamed for the struggles on a wide range of market participants: PC makers, like Dell (NASDAQ: DELL) and Hewlett-Packard (NYSE: HPQ), chip makers, like Intel (NASDAQ: INTC) and of course Microsoft. The concept of the Surface is to provide notebook functionality in the tablet form factor. This represents the needed bridge because tablets available to date have not contained the productive power to replace the PC entirely. While fun to use, and useful for web browsing, books and video, users were not writing papers, building presentations or running high-level financial software on their tablets. The Surface may be the first tablet that changes that trend and with it, the industry.

Given the potential importance of this advance, the very future of the PC world may rest on the reception received on October 26. While Microsoft will likely lead the way with the Surface, Dell and H-P have already put hybrid PC-tablets into production; Intel chips are expected to be used. What this means for the industry is that whether one calls it the death of the PC, the new computing renaissance or some other catchy moniker, Microsoft has positioned itself in the right place.

Based on the potential strength of the new release, I would buy Microsoft shares on this weakness.

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Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of Intel and Microsoft. Motley Fool newsletter services recommend Dell, Intel, 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.If you have questions about this post or the Fool’s blog network, click here for information.

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