This Tech Giant Is Still Building a Competitive Ecosystem

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Microsoft (NASDAQ: MSFT) just cut prices on the Surface and wrote down nearly $1 billion worth of the tablet's inventory. Is this an admission that the Surface is a flop, or is it just this tech giant's way of gearing up for a long-term fight?

Copycat

There's little question that Microsoft has been late to the mobile party. It tried to break into the group with a mobile operating system, but it didn't take off. As it retooled, however, it took a close look at competitor Apple and decided it was best to start looking more like a winner.

One of Apple's big strengths is that it creates easy to use interfaces for its iPhone, iPad, and iPod products. Moreover, it has something of an ecosystem in which customers can comfortably live. With simple to use products that work out of the box, Apple's success over the last decade has been nothing short of extraordinary.

That “easy ecosystem” model has allowed Apple to grow its top line from around $6 billion a decade ago to about $156 billion in 2012. Earnings, meanwhile, have gone from a dime a share to over $44.00 a share. That said, it has pretty much saturated a mature market. That means market share is key and it is battling with fierce competitors like Samsung, Google, and increasingly Microsoft.

Investors have sent the shares down some 40% from their highs. The stock yields around 2.8% and has a price to earnings ratio of about 11, or so. The company faces challenges in finding new customers or enticing existing customers to buy more, but its industry leading position and still massive earnings should afford it plenty of time to solve these issues.

The takeaway

The takeaway for Microsoft was clearly that its products were too hard to use and didn't play well together. So, it has created a uniform appearance across its products with the introduction of Windows 8 and Windows Mobile. Now, customers can buy a phone, computer, and a tablet and easily switch between them.

That's a big thing, since, according to CFO Amy Hood, the company has “over 1.5 billion Windows users around the world...” Although every one of those customers may not like Windows, there's clearly enough users to create a real business if Microsoft can get them to buy into the ecosystem. It's just going to take time and commitment.

Like Apple, Microsoft makes plenty of money. It had $73 billion in revenue in 2012, with earnings of about $2.00 a share. In the just ended 2013 fiscal year, the company's earnings jumped to $2.58 a share. Granted Microsoft's top line is about half of Apple's and its bottom line isn't nearly as impressive (it has over eight times as many shares), the Window's giant has plenty of financial firepower to push its ecosystem approach. And with a mid-teens PE, it appears reasonably priced.

A little help from friends

A big part of the ecosystem that Microsoft is building is Windows Mobile. That will require phone companies to partner with the Windows giant. It paid struggling Nokia (NYSE: NOK) to use Windows Mobile as the also-ran cell phone maker tried to relaunch its smartphone line with the Lumia. The phone has been well received for looks and functionality, which is good. However, it hasn't sold particularly well.

That's a bad thing for Nokia, where revenue has been falling since 2007. Worse, it has lost money in each of the last two years, and the first two quarters of this year haven't reversed that trend. Moreover, as it focused on the Lumia launch, it let competitors gain ground in emerging markets -- the one area in which it remained a leader. Investors should avoid the company.

For Microsoft, however, the Lumia has been a huge win. It allowed the company to showcase Windows Mobile at exactly the same time as Google has become more combative with its mobile partners via the soon to be launched Moto X phone. Samsung is trying to use its own OS, dubbed Tizen, to limit its reliance on Google's Android, but other companies would probably rather partner with an existing mobile OS than build from scratch.

Not an easy turn

Microsoft isn't making an easy pivot. However, now is a good time to be making it. Although the mobile industry looks “mature,” it's really still in its infancy. With a huge customer base and a still highly profitable business, Microsoft's recent earnings induced price drop of over 10% looks like an overreaction. Investors should take a second look at the Windows ecosystem, looking at the Surface price drop not as a sign of weakness, but as a way to gain market share.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple 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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