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.
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.
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.