Microsoft Is Further Behind than It Thinks

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Given the decades of dominance that Microsoft (NASDAQ: MSFT) has enjoyed over the PC market, it’s a bit hard to believe that the Surface tablet is one of the few products that are Microsoft in hardware and software. That’s because the PC market has always been a collection of hardware companies that run on Microsoft’s software, creating a competitive PC market while solidifying Microsoft’s hold on the industry. Now with the PC industry giving way to the tablet industry, Microsoft is trying to be both hardware and software to remain relevant.

So far, it’s not working out.

Not the leader anymore

Microsoft’s quarterly earnings confirmed that the slowdown of the PC industry is hurting the company in the eyes of its investors. It posted a 10% increase in sales to $19.9 billion, and a $0.66/share profit, missing expectations of $20.7 billion and$0.75/share profit. The reasons for this downturn are pretty straightforward: poor sales of the Surface tablets, which had to undergo a $900 million write down in inventory, a still-struggling Windows Phone, and uncompetitive pricing for these late entrants into a highly-competitive industry have caught Microsoft flatfooted.

According to industry analysts, PC shipments were down 11%, marking the fifth straight quarter of decline, hammering into Microsoft’s core business and setting the company back considerably. It is evident that Microsoft needs to make a bigger play in the mobile computer business if it wants to get on the right side of the balance sheet. Unfortunately for them, they are entering a hostile market that they are late to, unfamiliar territory for this long standing company.

A bitter rival putting Microsoft in the hole

Apple (NASDAQ: AAPL), Microsoft’s bitter rival, is expected to restructure the company a bit over the next quarter. The transition in question will involve both the release of the iPhone 5S, an upgrade from the very popular iPhone 5, as well as moving to decrease iPhone prices while lowering costs. The ability to sell iPhones for less demonstrates that Apple has turned a corner with its gadgets in the sense that the technology that goes into making them has gotten cheaper to develop, thus lowering prices.

Microsoft, meanwhile, is still developing tablets and its smartphones, which puts them at a huge disadvantage compared to Apple’s iPads and iPhones. The iPhone 5 costs as little as $199, while a phone like the Nokia Lumia 1020 can fetch up to $299 on contract and comes with a screen design that has been criticized as being too cluttered by some consumer websites. The iPhone hasn’t been dominating either, as Samsung’s Galaxy series helped the Korean company pass Apple in terms of market share (20% vs. 19% in 2012.) This just helps to show how far behind Microsoft is in terms of development in this new section of the tech industry.

Behind the curve in hardware as well

It’s not just software development that has kept Microsoft down for the last few years, hardware is getting hurt as well, thanks to chip-maker Qualcomm (NASDAQ: QCOM). According to its most recent earnings report, Qualcomm chips are in over 800 smartphone devices, with nearly 500 more on the way. As the only LTE chip maker in business, Qualcomm has the inside track with phones like the Samsung Galaxy S4 and the iPhone 5S when it is released. All of this is bolstered by over $1.8 billion in R&D investment, a 21% increase year-over-year. This has helped the company boost its yearly earnings estimate from $4.20-4.45/share, to $4.40-4.55/share, which goes nicely with the expected increase in chip shipments for the rest of the year.

This is bad for Microsoft because it highlights another area where the company was once king. Microsoft would dominate when PCs ruled the land, and an area that Microsoft should be doing better. Yet, they aren’t, and that’s what is keeping the company back even further.

Microsoft’s silver lining

Fortunately, there are ways Microsoft can rebound over the coming months. While Qualcomm has a fairly good earnings season, a drop in smartphone prices from companies like Apple and Samsung will put pressure on the company to streamline its chip-making capability. As the current monopoly on LTE manufacturing, it will also have competitors that can start from scratch rather than having to decrease existing costs, a disadvantage for Qualcomm.

Enter Microsoft, which has both the experience in the tech industry as well as a need to get back to competitive strength by driving investment in LTE. If Microsoft can make its own LTE chips, theoretically, it could sell them off or collect royalties. It would have the Microsoft stamp, which is still valuable as a sign of quality, so there would be a market for the chips. It would also provide a chance for the company to upgrade Windows Phone devices cheaply. This would make the phones more competitively priced, and would also give Microsoft a renewed edge in the tech industry. That is something that the company desperately needs right now.

The bottom line

Until Microsoft makes these shifts, which will probably take a few quarters to become profit-making, its stock is probably not a good bet right now. In fact, none of the PC companies seem like good bets because of the bearish market they inhabit. Qualcomm may be the best stock in the sector to own because it deals in chip manufacturing, allowing it to sell to a diverse range of clients and tablet makers.

With a forward price-to-earnings of 12.5 and a $60/share price tag, Qualcomm is a good buy if you want a stock that will either go up or stay flat for as long as it has the LTE monopoly. If Microsoft gets in on the act, or some other company looking to cash in on LTE chips, then watch how Qualcomm reacts to the competition and hedge your bets accordingly. Until then, the company is a good buy, and Microsoft won’t be until it can get its act together on smartphones and tablets.

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John McKenna has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple, Microsoft, and Qualcomm. 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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