Things Aren't so Bad at Microsoft

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

Microsoft (NASDAQ: MSFT) fell 11.4% after the company issued its quarterly earnings report. Such a move is rare for a stock with capitalization over $260 billion. Clearly, the earnings report had disappointed investors. However, sometimes such moves are exaggerated and present a buying opportunity. Is this the case with Microsoft?

What’s bad

Let’s examine what scared investors. Microsoft has missed analysts’ estimates on both earnings and revenue. There were two main sources for the miss: the softness in Windows revenue and a $900 million charge related to Surface RT inventory adjustments.

Surface RT has looked dubious many observers. Now, it is clearer than ever that it looked dubious to potential customers, too. Microsoft has cut $150 from the price of Surface RT, resulting in a write-off from inventory. The company has ultimately realized that, at this price tag, it just can't compete with Apple (NASDAQ: AAPL) and Samsung.

The tablet field is getting crowded, especially considering the number of Chinese producers throwing Android-based devices at the market at low prices. This is not very important for the U.S., but it has a significant impact on emerging markets. The demand for higher-end products seems to have slowed down. Apple recently cut iPhone orders by 20% due to the slow demand in high-end smartphones. The company has updated neither the iPhone nor the iPad for a while, and this is weighing on the stock price. Despite the fact that Apple trades at a cheap 9.77 forward P/E, the shares remain in the downtrend. The stock is down 19% this year, and clearly needs a boost in the form of fresh products. However, those products are not going out until this fall. Many investors are sitting on the sidelines to see what happens when they hit the shelves.

The cut in the Surface RT price looks like a desperate move from Microsoft. The company has produced those tablets, but nobody is buying them. Surface RT write-offs had a $0.07 impact on earnings, eating more than 10%.

While the Surface RT issue is clearly unpleasant, it is not the core of Microsoft’s business. What’s much more important is the Windows segment. Windows was hit by the combination of weak PC sales and Windows 8. Microsoft execs could state that Windows 8 is the new experience, but unless customers agree with that, the train would not go further. Some even blame Windows 8 for weaker PC sales, but I think that's an exaggeration. Microsoft expects that consumer PC sales will drop by 20%, which is a huge number.

What’s good?

Microsoft is performing well on the enterprise front. Enterprise Services revenue was up 9%. SQL server revenue grew 16%. Microsoft established a partnership with Oracle (NYSE: ORCL) in order to gain more customers for its Windows Azure platform. Windows Azure has grown its enterprise customer base by 25%.

Microsoft offers solutions that are suitable for small and mid-sized businesses, which gives it an edge over Oracle, whose solutions are pricier. Global IT spending is muted due to unfavorable economic situations, and customers are trying to save every penny. Oracle’s earnings report in the second half of June showed major softness in hardware sales, as well as problems on the software front. The stock was punished and became attractive. Since then, it has rebounded, but is still down 4% year-to-date. The stock trades at 10.1 forward P/E, but lacks growth catalysts. The possible upside looks equal to the possible downside at current prices.

Office 365 is also gaining momentum. There are currently more than one million Office 365 Home Premium subscribers. I think that the subscription model could pay off, as it provides a more stable revenue stream and helps fight piracy.

Bottom line

If put on scales, do bad factors outweigh positive ones? I think that the sell-off was overdone. At current prices, Microsoft yields 2.93% and should attract income hunters. Surface RT is not a major part of the business. Perhaps, Microsoft would even say goodbye to tablets at some point. The enterprise segment is doing well. The subscription model is going to pay off in the future, although it pressures the bottom line in the near term.

Apple continues to be in a down trend. Only new products would be able to lift the stock again. Despite the fact that Apple yields 2.87%, I would not recommend it as an income source, as there could be significant volatility in the stock.

Oracle lacks momentum. The company continues to be pressured by the drop in hardware and worldwide cuts in IT spending. The stock seems fairly valued at the moment. 

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple, Microsoft, and Oracle.. 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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