Is This Company Stuck on a Sinking PC Ship?

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

Microsoft's (NASDAQ: MSFT) shares recently fell over 10% after the company reported a terrible quarter, missing earnings estimates by a large margin. Microsoft took a $900 million charge related to Surface RT inventory adjustments, indicating that one of its big bets on mobile had "flopped" severely. To make matters worse, Microsoft also acknowledged that the PC market contracted by 9% during its fiscal year. But even as those sales decline, Microsoft is much more than just PCs and Windows 8.

A pillar of financial strength...

Let's examine the company's current situation first:

MSFT Cash and ST Investments data by YCharts

More cash and short-term investments than total liabilities, a very low debt-to-equity ratio, and a high current ratio (indicating high liquidity), illustrate why Microsoft is one of the only companies left in the world with a AAA-rated balance sheet. The company also pays out a rock-solid, increasing dividend yielding around 2.80%-- supported by a low and sustainable payout ratio of only around 34%. 

Establishing the company's financial strength is one thing, but will Microsoft remain strong long-term? Or will competitors like Google (NASDAQ: GOOG) cripple it with their dominance in mobile?

Turning Android lemons into patented lemonade...

Google's Android operating system boosted its global smartphone market share from around 69% to around 80% in its recent quarter, according to data released by IDC. 

Android's dominance is impressive, but it isn't exactly a money-maker -- at least not directly. More than  90% of Google's overall revenue comes from advertising. This is why Google gives things like Android and its Chrome OS away for free-- because more people using its products means more potential advertising revenues and profits. 

Manufacturers like Samsung (NASDAQOTH: SSNLF) make money from Android directly, by selling hardware equipped with the OS. This leads to another unlikely company with its hand in the Android profit pie: Microsoft. Samsung, just as one example, pays Microsoft royalty payments on every Android device it produces, apparently deciding that it's easier to pay Microsoft to go away than to fight it. 

Geekwire has gone so far as to call Android "Microsoft's new billion-dollar business," because of the patent agreements that allow Microsoft to siphon "free money" from various Android manufacturers such as Samsung and HTC. It also recently said that " ...80% of Android smartphones sold in the U.S. and a majority of those sold worldwide are covered under agreements with Microsoft." This increase comes after recent big Android-related patent agreements between Microsoft and the likes of China-based Foxconn, which manufacturers around 40% of the world's smartphones; it's now Microsoft's largest patent licensee.

A flaw in Google's Android strategy?

Samsung controls roughly 19% of China's $80 billion smartphone market (the largest in the world), according to IDC. Android is largely responsible for Samsung's success, helping it sell 12.5 million handsets in China in the first quarter of 2013.

Google ironically makes almost nothing from Android's dominance in China, because the country doesn't allow Google search-- which means no ad revenue. Microsoft, however, sits back and collects royalties.

Microsoft doesn't break out its patent revenue numbers. But if Geekwire's estimates are correct, less than $400 million of the $1.2 billion increase in "Windows Phone revenues" actually came from Windows Phones, since only an estimated 26 million units (bringing in an estimated $15 in licensing fees each) shipped. This leaves more than $800 million of these revenues attributable to Android patent licensing, which gets lumped together with Windows Phone revenues when Microsoft reports its numbers.

The PC ship might be sinking, but it seems Microsoft is riding on an Android life raft while also maybe even profiting more from patents than its own Windows Phone sales. These same patents allow it to monetize Android where Google can't. 

What about organic growth?

Besides patent revenues, Microsoft has numerous other $1 billion businesses. These include Office 365, Azure (its cloud service), and thanks to three consecutive quarters with growth of around 30%, Microsoft Lync (an instant messaging client for businesses), which reached $1 billion in revenues for the full 2013 fiscal year. 

Why are Office, Azure, and Lync so important? TechCrunch points out that these growing businesses are fundamental for the future of Microsoft and its strategy to become more of a services company, because all three are subscription-based and offer continual income. They aren't doomed businesses if the PC dies off, either. 

A well-balanced portfolio

Microsoft is highly diversified in its revenue streams, especially when compared to Google, who's dependent on revenues from advertising almost exclusively. Apple is a hardware maker, and a darn good one at that, but it is also almost entirely dependent on the success of its iPhones and iPads. Microsoft is a different story.

Here is a breakdown of its revenues by segment:

Source: Microsoft investor relations.

Windows Division makes up 25% of revenues, Server and tools (which includes Azure) is around 26%, Online Services Division (including the Bing search engine) accounts for only 4%. Microsoft Business Division (the most important division, including Office) makes up 32%, and lastly, Entertainment and Devices (home of the Xbox) contributes 13% of overall revenues.

In short, Microsoft is far from a PC-dependent, one-trick pony.

The bottom line

Declining PC sales may be troubling in the short term for Microsoft, but the company is growing new businesses and revenue streams to prepare for the future. It is also receiving revenues from Android-related patent agreements in the meantime. Microsoft dying off with the PC just doesn't seem likely.

The company is also incredibly strong financially and pays a safe, income-generating dividend. Microsoft is a compelling value play trading at just under 13 times earnings (as opposed to Google's P/E of over 25), and thanks to its diverse revenue sources, its future could prove sturdier than most investors think.


Joseph Harry owns shares of 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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