To start with, let’s look at the quarterly results: Revenue, operating cash flow, net income and earnings per share increased 13%, 17%, 31% and 36%, respectively, in the third quarter (compared to last year’s results). Regardless, the stock was beaten down to a dip in sales in Windows & Windows Live Division. The average analyst estimate for 2011 EPS is $2.56, a nearly 22% increase in earnings from 2010; this is for a stock that is currently trading at 10x forward EPS and has roughly $40 billion in net cash on the balance sheet.
First, we need to clearly identify the bear argument. Here is what senior market analyst Joe Cusick of optionsXpress had to say on Friday: "Even though they had good earnings, the PC market is under scrutiny and there continues to be uncertainty on whether or not Microsoft can compete with the growing tablet and handheld devices from the likes of Samsung and Motorola (MOT).” One of the well articulated bear cases I have found was written in January by Adam Hartung of Forbes, who says that Microsoft “has almost no hope of moving beyond its lock-in to old products and markets which are declining.” Even Xbox and Kinect, which he calls “the only bright spot in Microsoft,” won’t live up to what it can because, “by all accounts Microsoft doesn’t realize what it has here.”
The bear case appears to have two separate pieces. The first stand alone piece is Microsoft’s “lock-in to old products and markets,” such as Windows and Office for PCs, which as noted by Mr. Hartung, are declining. The second part, which encompasses two separate issues, is an inability to compete in tablets and phones (collectively, new consumer markets), largely the result of incompetent management and a corporate bureaucracy that has stifled innovation.
First off, let’s look at the PC market for the quarter, as discussed in the 10-Q: “We estimate that sales of PCs to businesses grew approximately 9% this quarter and that sales of PCs to consumers declined approximately 8%. The decline in consumer PC sales included an approximately 40% decline in the sales of Netbooks. Taken together the total PC market declined an estimated 1% to 3%.”
Netbooks were on fire in the second half of 2009, growing more than 25% year over year in every month from July to December (booking 70% YOY growth in the last month). However, when Apple announced the iPad at the end of January 2010, retail sales for notebooks started to fall. By August, year over year sales had turned negative, suggesting that tablets were starting to cannibalize netbook sales; the 40% decline in this quarter is a testament to the way that tablets have taken netbooks to the cleaners.
But what about computers as a whole, like the one I’m typing this article on right now? Are people ditching their desktops and laptops in exchange for a tablet? The overall decline in PC sales of roughly 3% suggests otherwise (complementary rather than a substitute), especially when accounting for the fact that sales in Japan, which is a big market for PCs, was significantly lower due to the earthquake and tsunami; an additional adjustment for people who are delaying PC purchases due to macroeconomic concerns (such as myself) might also be worth consideration.
In 2010, global PC sales reached 346.2 million units, up 13.6% year over year; this idea that people are ditching their personal computers appears to be in stark contrast to the numbers. Gartner has predicted (as recently as March 2011) that PC sales will grow “only” 10.5% in 2011; there is a big difference between double digit growth and the end of PCs as we know them.
What about Mr. Hartung’s belief that Microsoft “has almost no hope of moving beyond its lock-in to old products and markets which are declining?” Is this an accurate assessment?
The recently announced agreement with Nokia (NOK), the largest maker of cell phones in the world (global share of 29.2% in Q1 2011), might suggest otherwise. As noted by CFO Peter Klein, “The great thing about the Nokia deal is this in an incredibly perfect opportunity for both of us to build a really compelling, vibrant third ecosystem, if you think about the complementary set of assets that we all bring to it… Clearly, this is a broad strategic alliance, it's a long-term strategic alliance, and we're going to be working closely together. And we are each making investments together along those lines. And I think the important thing to think about is, as we sort of build that out in its success, it's going to be a great thing for both companies and for customers and for other partners in the ecosystem.” If these two companies can come together and become the third horse in the fight for mobile share, watch out.
Bing is another area where Microsoft is inching forward, ending the quarter with a market share of 13.9%, up 190 basis points from the end of Q2; online advertising revenue increasing 17% to $586 million. Again, the company is taking steps in the right direction to develop a business unit outside of PC Windows and Office.
The bears will certainly jump on this: Microsoft has been dominated by Apple (AAPL) and Google (GOOG) in phones, and Bing continues to bleed cash. Part of the bull thesis is the realization that despite massive capital investments into areas that have thus far proven unsuccessful (grabbing share from Google is a slow and difficult process), Microsoft has been able to drive strong cash flow expansion due to an unrivaled core business.
The point is that the stock is priced for nothing to work; unlike growth stocks, which have every optimistic assumption for the next decade cooked into their stock price (take a peek at Salesforce.com (CRM)), Microsoft is priced as if Bing, Windows Phone, Kinect, Office 365, and many other business lines will never develop into a material addition to the company’s success; this may prove to be a grave miscalculation. Just some food for thought: Operating income in the Entertainment and Devices Division and the Server and Tools Division has increased 64% and 21%, respectively, through the first nine months of the year.
Gurus like Whitney Tilson, Jeff Auxier, Donald Yacktman, and Jeremy Grantham continue to pile into Microsoft; personally, I’m right there with them, and see value in Microsoft shares at these levels.