Microsoft may be facing increased competition from tablets, but its quarterly earnings show the company is doing fine.The iPad is killing Microsoft (MSFT), at least if you believe the meme that has been spreading in the stock market.

After Microsoft reported its second-quarter earnings last Thursday, the stock fell 4% despite stronger-than-expected financials and several analysts raising their price targets on the stock. But investors were taken in by the idea that Microsoft's future earnings are so much roadkill in the iPad Era.

Microsoft's quarterly revenue came in at $19.95 billion, above the $19.14 billion estimated by analysts, and its earnings of 77 cents a share beat the analysts' expectations of 68 cents per share. Revenue was especially strong in productivity software and gaming devices.

But the only thing investors seemed to focus on was the rise of the tablets and the decline of the netbooks.

It's true that tablets are eating into the market for netbooks and PCs in general. Gartner reckoned that PC shipments grew by 3.1% in the fourth quarter to 93.5 million units, a slower pace than the 4.8% it had estimated. But tablets are growing much, much faster: Strategy Analytics estimates sales of nearly 10 million tablets last quarter (77% of them iPads), up from virtually no tablet sales a year ago.

Don't Believe the Meme

But while memes are wonderful for culture, they may not be so great for financial markets. Microsoft may be a big, sprawling company, but it's hardly acting like a deer in the headlights facing a speeding Steve Jobs at the wheel. Given the decades-old and often bitter rivalry between Apple and Microsoft, that narrative is tempting. But a deeper look into Microsoft's report reveals a company that's surprisingly nimble for its size.

First of all, the idea that Microsoft can't create a phenomenon like the iPad anymore simply isn't true. The iPad sold 2 million units in its first 60 days. The Kinect sold four times as many, tapping mainstream interest much sooner. "Kinect is the fastest-selling consumer electronics device in history," Microsoft CFO Peter Klein said in a conference call with analysts.

What's especially interesting is that the Kinect sold so well despite the lack of buzz in the tech media. Comparing Google search and news trends for the word "Kinect" with that of "iPad," and you'll find that the iPad attracted much more of the public conversation. And yet the Kinect's 8 million sales in November and December surpassed the 7.3 million iPads that Apple sold in the entire fourth quarter.

True, the Kinect's $149 price tag is significantly less than the iPad's $499 starting price. But the Kinect's strong launch suggests that Microsoft hasn't lost its ability to produce innovative products that resonate with consumers.

Multifaceted Strength

In the fourth quarter, Microsoft also demonstrated its ability to maintain strong sales in a highly competitive market. Google (GOOG) has made it clear that, as its business customers grow more comfortable housing data and applications online (or "in the cloud," as it's colloquially called), it plans to go after Microsoft's business software. But Office 2010 sales were surprisingly strong, with license sales up more than 50% higher than the pace Office 2007 had at the same point after its launch.

Investors seemed put off by the 30% decline in revenue and the 40% drop in operating profit for Microsoft's Windows division, the segment that contains operating software for netbooks and PCs. The drop exacerbated concerns that Microsoft's core product was in decline.

But as Microsoft pointed out in its conference call, the 30% revenue drop was largely the result of deferred revenue that was recognized a year ago during the launch of Windows 7. Factoring out the effect of the Windows launch, Microsoft estimated growth around 3%, "in line with PC market growth." Again, 3% growth isn't terrific, but it's nowhere near as bad as the headline figure suggests.

Even if Microsoft's Windows revenue does start to slide in coming years, the company can weather the blow. Sure, Windows revenue makes up a quarter of Microsoft's total sales. But its business-software division -- including Office, as well as SharePoint and Exchange -- contributes 30% of its revenue, and that division expanded its profit by 35% last quarter.

Other divisions are seeing similarly strong profit growth. Microsoft's server and tools division, which makes up another 22% of revenue, saw its profit rise by 21%. And the entertainment group, which makes Xbox and Kinect and accounts for 19% of revenue, posted profit growth of a whopping 86%.

Is Microsoft Undervalued?

In spite of all this growth, Microsoft's price-to-earnings ratio lounges at 12 on a historical basis and a mere 10 based on estimated earnings for the current fiscal year. That's well below the average P/E ratio of 18 for the Standard & Poor's 500 Index. Such is the power of the meme in the minds of Microsoft investors.

None of this means to play down the challenges that Microsoft faces as tablets and smartphones become more integrated into consumers' lives. The company faces an uphill battle in those markets. Windows Phone 7 is good enough to compete with Android and iOS, but Microsoft waited too long to enter the smartphone race. The same seems to be happening with tablets, as early reviews of Windows Phone 7 tablets haven't been promising.

But we've been hearing for years that PCs are on the decline in an era of cloud computing. And in response, Microsoft has been positioning itself for a post-PC world for some time, building on areas of strength that could serve it in the future – especially business software and video games.

The threat of tablets to Microsoft is real and shouldn't be trivialized. But neither should Microsoft's ability to keep sales and profits growing in other areas of its broad-based businesses.


Increase your money and finance knowledge from home

Managing your Portfolio

Keeping your portfolio and financial life fit!

View Course »

Investment Strategies

What's your investing game plan?

View Course »

Add a Comment

*0 / 3000 Character Maximum

10 Comments

Filter by:
mmmk

apple is for hipsters who don't need a computer for actual work, but to carry it around as a fashion accessory im not a fan of microsoft but the gimicky crap apple makes has never been worth buying.

February 02 2011 at 8:53 PM Report abuse +1 rate up rate down Reply
fgt

I can't imagine that anyone with any brains at all would think that the Ipad would kill Microsoft. Microsoft has really messed up with Vista and making people pay to upgrade to Windows 7 but there is little if anything that will kill MS. I am no fan and have given up on them and will never own another Windows machine (I switched to Linux and my wife is using Mac) but it will be a very long time if/when MS is killed, and what will kill them the fastest is if the idiot MS management (like that insane moron Ballmer) keeps screwing their customers and I am sure they will. Many many people are moving to Macs and Linux in droves. and I couldn't be happier about this.

February 01 2011 at 9:16 PM Report abuse -1 rate up rate down Reply
Gumby

PC hardware is so god awful stupid in design!! Example! Take your hard drive enclosures that come with (gasp!) transformer unless the hard drive is 2.5 inch. Really, if your 3.5 inch hard drive enclosure can be plugged into your power supply in the case through external outlet.. NObody is adding this feature really boggles my mind!!!!! Another example.. WHY CANT WINDOWS MEDIA PLAYER RUN QUICKTIME FILE FORMATS LIKE .MOV FORMAT??????? i DONT CARE ABOUT WHAT APPLE SAY OR WHETHER MICROSOFT REFUSE TO PAY APPLE FOR RIGHT TO PLAY QUICKTIME FORMAT IN WINDOWS MEDIA PLAYER,, JUST DO IT. I FEEL LIKE DRILLING A INCH WIDE DRILL HOLE IN EITHER OF YOUR SKULLS!!

February 01 2011 at 5:52 PM Report abuse rate up rate down Reply
meliafc

As an investment, it has been diappointing over the last few yra

February 01 2011 at 5:45 PM Report abuse rate up rate down Reply
meliafc

explain meme

February 01 2011 at 5:43 PM Report abuse rate up rate down Reply
Sekinu2

Thing about Microsoft is they dont have a good marketing team. i mean they have been marketing the waste of time cloud like its the biggest thing but then they have the Zune which has the potental to kill ipods but I think i say 2 commercials in 3 years for the zune. Seems like they should fire thier marketing department and advertise more thier better products. Netbooks were dead before they started you had to be stupid to buy one but not as dumb as those who got raped for ipads that do nothing lol

February 01 2011 at 1:53 PM Report abuse rate up rate down Reply
gttdux

Yeah, sure - I've owned MSFT since 1997 - still waiting to make a capital gain so I can dump this pig.

February 01 2011 at 1:43 PM Report abuse rate up rate down Reply
3 replies to gttdux's comment