Higher Profit Margins Will Reward Investors In 2013

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

In the throes of Microsoft's (NASDAQ: MSFT) biggest ever product shift in its consumer division, earnings are tumbling.

Overall, it was a “good news, bad news” quarter for Microsoft. Just ahead of the October 26 Windows 8 launch, sales and profits disappointed. Revenues were down 7.8% from $16.01 billion from last year’s period. Net income fell 22% to $4.47 billion. The enterprise business did well while the consumer and business divisions that revolve around Windows and Microsoft Office sales underperformed. Server and Tools sales were up 8% backed by strong sales of SQL servers, and a boost in advertising sales led to a 9% revenue increase for online services. It is Microsoft's smart execution on the enterprise side - namely cloud, social and mobile integration - that will help kick-start sales on Windows 8 and Surface tablets.

Microsoft shares slipped slightly (2%) on news of missed earnings numbers, indicating that the market has faith in the prospects for the new Windows 8 platform. And here's why. Windows sales revenues fell 33% in the third quarter, but the results do not include Windows 8 pre-sales and Windows 7 editions eligible for upgrade to Windows 8 for $15. Pre-orders for Windows 8 are already 40% higher than those for Windows 7, at about $800 million.

In 2013, Microsoft will benefit from two strong demand drivers for Windows 8 and its Surface tablet - the demand for a full MS Office experience on a tablet and an enterprise business retooled for the cloud and driving the need for mobile devices. I have never bought into the theory that the PC giant was too deft and weighty to turn itself around as slim, more elegant tablets with equally slim but less powerful operating systems started to take market share. So far, only Microsoft has been able to deliver the full PC operating system on a tablet, but this has come at a high price, although more options in the $1,000 range are being introduced such as the new Sony (SNE) hybrid ultrabook at $1,100. Microsoft's Surface tablet provides a slimmer device competitive on price with the iPad and Android devices, at $499.

Microsoft's timing of Windows 8 tablets is too opportune to be happenstance. Tablet users have been trying out and buying and selling tablets to figure out what they need and miss in their personal computing experience. For many, what they miss is Microsoft Office. The greatest shortcoming of tablets has been an inability to reproduce the Microsoft Office experience in terms of functionality and standardization. Track changes and split windows are some of the functions missed. Online hosts of the MS Office suite are a welcome option but are too sluggish to offer a comparable user experience. And many have a fee-based model. Microsoft Office 2013 will drive Surface sales. It is just too convenient to be able to instantaneously call up a work document on the subway or in line at Starbucks (SBUX) and edit it with track changes.

Here is where Windows 8 and Surface sales forecasts get fuzzy. MS Office 2013 is also coming to Androids and iPads in 2013. With 94% of the office suite market share, Microsoft can make more money selling a portable MS Office to the world than it can selling Surface tablets. But you should by no means count out Surface tablet sales. Windows 8 and Surface tablets will get an important push from Microsoft's enterprise business. The migration of business to the cloud is making it more important that the enterprise and personal and mobile computing operate well together. Microsoft has retooled its enterprise and consumer offerings for tight integration.

Microsoft's Windows and Surface launches coincide with upgrades to its enterprise management system. As enterprises integrate cloud services and social media, more mobile computing users - including tablet-enabled users - are connecting through enterprise systems. With more devices and data streaming in from more locations, any integration improvements Microsoft can provide between tablets and the enterprise will add market value to the Surface.

Microsoft has announced a lot of smart moves in recent weeks to support this integration. Updates to its Microsoft Dynamics CRM Online software will add Skype and Yammer integration. Microsoft has announced it is replacing MSN Messenger with Skype. In 2013, a mobile CRM application will be introduced that runs on Windows 8 and iPad devices. It has just given Yammer, its enterprise social networking (ESN) application, a major overhaul, adding new features and functionality to turn it into an enterprise-level social media tool, including improved security. With these changes, Microsoft is helping enterprises extract more value from social media and cloud services over mobile devices, including the tablet.

For consumers, Microsoft's tablet pricing may be an issue. The Windows Surface tablet is retailing at $499. Consumers and analysts were hoping for a lower price. Apple similarly disappointed on its iPad mini pricing at $329. Microsoft needs to add value to justify a price higher than the lower end Android tablets to consumers. But for Microsoft, the Surface consumer play is more about the business market, and pricing is in line with other tablets for business use. If employees are using Surface at work, they are more apt to use it at home.

The iPad does have an advantage over the Surface tablet on perceived security. Security is a key selling point for IT managers. This gap may simply require education to close. For now, though, surveys find that IT managers are worried about security over Surface tablets. Apple's more insular ecosystem is considered safer while there are concerns that Windows may be more vulnerable to malware.

The best good news story about the Surface is the RT version promises more attractive profit margins than the iPad. The total cost to build the $599 Surface is estimated to be $284, according to IHS iSupply. The highest cost component at $101 is the 1366-by-768 high resolution screen, which the Surface needs to compete with iPad's stunning optics. In comparison, IHS estimates a cost of $325.60 to build the iPad 2 selling for $500 and $188 to build the iPad mini retailing for $329, both are 16 GB + Wi-Fi versions.

Windows 8 and Surface can give Microsoft's profit margins the boost they require. The weaker profitability in the PC business was weighing down more heavily on margins. Just last quarter, Microsoft enjoyed healthier operating margins at 36% than Apple (NASDAQ: AAPL), at 35%, and Google (NASDAQ: GOOG), at 28%. Profit margins have fallen to 31.7% in the third quarter. With the help of healthy iPad profit margins, Apple posted record profits of $8.8 billion in the third quarter, and higher operating margins of 36.6%. While iPhone and Mac sales were up, it received a strong revenue and profit boost from iPads, whose sales jumped 84% year-over-year. Apple's iPad and Google's Android will give up some market share but remain formidable tablet vendors. In somewhat of a Pyrrhic victory, greater market share loss is likely to be felt by Samsung's (SSNLF) Galaxy and ASUS' Transformer, the PC makers who were not too keen on making a tablet for Windows 8.

With more attractive profit margins, as per IHS iSupply, and Microsoft's own enterprise business well-positioned to drive demand for Windows 8 and Surface tablets, Microsoft's major Windows overhaul is in the throes of bringing the operating system back to profitability.

StockCroc1 has no positions in the stocks mentioned above. 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.

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