What a Difference a Decade Makes
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It's amazing in the technology industry what a difference a 10-year period can make. I remember back in 2002, when owning Microsoft (NASDAQ: MSFT) seemed like the most obvious investment anyone could make. However, after the “lost decade” that investors have suffered by owning the shares, it seems now it's just as likely that you'll hear reasons not to buy the company. Well-financed competitors such as Apple (NASDAQ: AAPL) and Google (NASDAQ: GOOG) have become issues in just the last few years. Considering that 10 years ago, most people didn't know who Google was and many had given up on Apple altogether, this just goes to show that current dominance does not necessarily mean future relevance.
In Microsoft's most recent earnings report, we see the huge difference in growth that the company experiences today versus years ago. Ten to 15 years ago, it wasn't unusual for Microsoft to report earnings up 20% to 30% or more. Today, earnings per share increasing by 6% is considered a good result. In the current quarter, revenue increased just 7%, but many would argue that Microsoft is about to begin growing like the old days. With upcoming releases of new versions of Windows, Office, server, and mobile operating systems, the company has a lot on the line in the next year or so. One thing that has not changed much over time is that Microsoft relies primarily on Windows and Microsoft Office to make the majority of their money.
In particular, without the growth in their Business and Server division, it's questionable if the company would have increased earnings at all. The Server and Tools business showed revenue up 13%, and income up 24.3%. The company mentioned that more businesses were relying on Microsoft to create their own private cloud infrastructure through the company's server product. Microsoft also said that it's excited about the next release in September called Windows server 2012.
In the Business division, revenue increased 7%, which led to net income up 9%. For Microsoft, it's a good thing that businesses rely so heavily on Microsoft Office. In the last quarter, business revenue increased 9%, while consumer revenue decreased 4%. However, business revenue is much more significant in total dollars. An impressive statistic is the fact that Microsoft Office is now installed on more than 1 billion PCs around the world. As you can see, even upcoming versions of Microsoft Office and Windows Server did not slow down these two divisions. However, that was not the case when it came to the traditional Windows operating system.
Much has been written about Microsoft's hopes for the Windows 8 operating system. The company's plan is that developers will be attracted to Windows 8 because it will be able to run on smart phones, tablets, desktops and laptops. While according to the company, “more than 50% of desktops run Windows 7,” it appears customers are delaying their purchases in anticipation of Windows 8. This is proven by the fact that revenue decreased 13% and income was down 17.6% during the quarter. With Windows 8 not fully available until Oct. 26, it could be a challenging upcoming quarter for the company as well.
If Windows 8 is able to deliver on the company's hopes, it could be a game-changing operating system. This is a rare case where Microsoft's ambition is something that its competition is looking to match. With the recent introduction of Mountain Lion by Apple, this company is beginning to integrate its mobile operating system and desktop operating systems. Google has always pushed cloud computing as the wave of the future. This allows Google to develop the Internet as an operating system, with the theory being that it's more efficient to go online and use web-based applications.
While in this case Microsoft is leading the way, newer divisions of the company are simply not producing profits though they are touted as part of Microsoft's growth drivers going forward. For instance, the company's Online Services division showed improvement with revenues up 8%. However, income was still negative and Bing powered U.S. search market share was actually down 1% year-over-year.
Where this division showed slight improvement, the Entertainment and Devices division seemed to take a step backward. Though Skype was an interesting acquisition; it remains to be seen if the company can turn this into additional profits. The company was also quick to tout that the Xbox remained the top-selling console for the last 18 months. This sounds like good news, but it contributed virtually nothing to the bottom line.
Speaking of the bottom line, the company's two most impressive numbers were cash and investments and operating cash flow. Operating cash flow increased over 29%, and this drove cash and investments up by 19.5%. If there's one number on Microsoft's balance sheet that I honestly don't understand, it's the $10.7 billion worth of long-term debt. Considering the company now has over $63 billion in cash and investments, it's highly unlikely that these funds are earning more in interest than the company is paying for their long-term debt. It seems a simple maneuver would be to use part of this cash and investments to pay off their long-term debt and eliminate the interest expense.
Does Microsoft represent a good buying opportunity at this point? For those looking for yield, Microsoft's 2.7% dividend is more attractive than Apple's new dividend, and certainly better than nothing, which is what Google offers. The company's P/E ratio of just 9.5 is cheap relative to the company's two biggest competitors. Where Microsoft is being left behind is in earnings growth. With an expected growth rate of just 9%, versus 16% at Google, and over 22% at Apple, the company needs its newest versions of software to be major hits. Windows 8 being a success is particularly important. If the software works properly (which is a big if) this may attract developers that would otherwise choose to develop for either Android or iOS.
All this being said, most businesses still consider Microsoft products to be their default operating systems and this does not appear likely to change in the near future. The company is generating tremendous cash flow, has tons of cash on the balance sheet, and if able to execute, could be a decent investment.
MHenage owns shares of Apple. The Motley Fool owns shares of Apple, Google, and Microsoft. Motley Fool newsletter services recommend 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. If you have questions about this post or the Fool’s blog network, click here for information.