Tech Giants' Dwindling Margins Spur Real Change

By Peter Pham - October 28, 2012 | Tickers: AAPL, BBRY, GOOG, MSFT, NOK | 0 Comments

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Two of the world’s leading technology firms, Google (NASDAQ: GOOG) and Microsoft (NASDAQ: MSFT), posted disappointing results for their most recent quarters, pulling down the Nasdaq by 2.2% that day. On Thursday, Oct. 18, Google released its quarterly results and by Friday, when markets closed, its shares had slumped by 9.76%. Google’s financials were leaked accidentally during trading hours, which caused no end of dislocation that day. The confusion that followed saw its shares plummeting by 8% within minutes until trading was halted temporarily from 12:50pm until 3:20pm; but by that time the company had lost the $700 per share benchmark it had reached in mid-September.  One has to wonder if that wasn’t our October Surprise for 2012, as the markets have not recovered their footing since that mistaken release took place. 

Google’s revenues jumped by 45% year on year to $14.1 billion but its profits fell by 20% to $2.17 billion. As the world shifts towards smartphones and tablets and the number of PC sales drops, Google is finding it more difficult to operate in the lower-margin mobile environment with its much lower cost-per-click rates as compared to desktop.  The total number of paid clicks has increased by almost one-third, but the revenue Google generated from advertisers slumped by 15%, its fourth consecutive fall. Google’s profit margin now, at 15.4%, is nearly half of what it was in this quarter last year at 28%.`

Meanwhile, Microsoft is also having similar problems with falling margins which, dipped by 5 percentage points over the year to 28%. The one time massive slump in June 2012, which saw Microsoft recording its first ever quarterly loss of $492 million, was entirely due to the single $6.2 billion write-off of aQuantive’s goodwill treated as an unusual expense. 

In its most recent quarterly filings, Microsoft recorded a 22.2% fall in profits year-on-year to $4.47 billion, which caused its shares to slide by 2.6%. Unlike Google, Microsoft’s revenues have also fallen by 7.8% to $16 billion. The plunge in profits is attributed to similar reasons as Google’s: a drop in PC sales and a move towards mobile where Microsoft will only now begin in earnest to penetrate.  This is in contrast to Apple's (NASDAQ: AAPL) stock performance, which crossed the $700 per share benchmark prior to the release of iPhone 5 but has since fallen by 12.7%.

However, Apple’s was a classic case of “buy on the rumor and sell on the news” (i.e.  buy on the promise of the iPhone 5 but sell on the fact that it’s a 4S with an LTE modem and not that distinguished from its competition).  The move into the 4^th quarter has not helped things either, as it is obvious many institutions are booking profits early in anticipation of a market correction.

Meanwhile, the changing market dynamics have sent alarm bells ringing for both Microsoft and Google. This change has its roots back into 2010, when PC sales stood at 85 million while smartphone sales touched 55 million in the first quarter of that year. Industry experts had predicted that smartphones will overtake PCs in the next two years. However, in the final quarter of 2010, PC sales increased to 94 million but smartphone numbers nearly doubled to 100 million.  So, while technology spending was increasing, it masked the actual trend changes happening within the industry.  The last two quarters, however, have begun to be an exclamation point on this trend, especially when one factors in chip sales and wafer orders. That was the beginning of the end of the PC dominance and it happened nearly two years ago.

Currently, there are around 1.3 billion PCs in the world running Windows against 1 billion smartphones. While smartphones are growing, PC sales are shrinking. In 2011, the global PC market shrunk by 8% and the U.S domestic market witnessed a 14% decline. On the contrary, according to market research firm IDC, smartphone sales are expected to increase by 39% in 2012 to 686 million.

Microsoft’s main revenue stream has been Windows and Office; both products currently rely on PC sales. In the mobile environment, Microsoft is now selling the licenses of its core products with its ARM-variation on Windows 8, Windows RT, with those tablets. This is not the case, however, for x86-based tablets, like Lenovo’s ThinkPad 2, where the Office license is a separate line item adding to the licensing cost of the device, pushing it near Ultrabook pricing.  This may be the poison pill that destroys Intel’s ability to fully leverage into the mobile arena unless it is content to build devices to run Android.  The recent quarterly filings showed the net income from the Windows division falling by 50%. This is significant, although some of the drop can be attributed to the anticipation of Windows 8.

For Microsoft, the PC is never going to regain its former glory, and to make matters worse, Apple owns the tablets space while Android dominates the smartphones. Microsoft rules the desktop and the console market, but it is looking to change the tablet and smartphone trend in favor of Windows OS. Furthermore, with the markets still expanding, offering tremendous opportunities for growth, there is even more reason to believe that its dynamics are going to change in the future. Currently, Microsoft has smaller global share than even the struggling Research In Motion's (NASDAQ: BBRY) BlackBerry OS.

However, there are still incredible growth opportunities in the mobile market. Smartphone’s total global mobile share is just 20%, while the rest use feature phones, which Nokia (NYSE: NOK) is doing its best to blur the line between with its Asha line of touch-enabled phones selling like mad in places like India. This area will therefore continue to grow for years to come, particularly in Brazil, China, Germany and Italy where smartphone penetration is just 14%, 33%, 29% and 28% respectively. The smartphone market share will most likely change in the next couple of years. According to recent estimates by IDC, by 2016 Android will still dominate with a 53% share (which would represent an 8 percentage point decline), but Windows will emerge as the second biggest player with more than 19% global share offering consumers a credible alternative to Apple.

Google on the other hand, is looking towards Samsung’s latest Chromebook to help expand its presence.  So far, Chromebooks have been about as successful as netbooks were.  That said, however, on Oct. 23 its Wi-Fi version managed to beat 13.3 inch Apple’s MacBook Pro for the top spot in Amazon’s best selling laptops list; the 3G version secured the third spot, behind MacBook Pro and ahead of MacBook Air. This is a significant achievement, but it remains to be seen whether Google could sustain this in the long run.

Google and Microsoft are both attempting with their latest products to push into the consumer device space currently dominated by Apple.  The early success of the Google Nexus 7 and the early reviews/pre-orders for Microsoft’s Surface make a strong case that they are beginning to truly get it. 

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