MicrosoftWhat's wrong with this picture?

Microsoft (MSFT) delivers blowout earnings, and shares open lower the following morning.

If you spotted the fact that the reaction to the event is exactly the opposite of what's expected, congratulations. You're well on your way to a perfect score on the English section of the SAT, if you ever decide to retake high school.

It's not that Microsoft is off a tremendous amount; its shares actually turned higher in early trading. However, it's a sign of a larger trend in technology earnings -- companies continuing to beat high expectations and their share prices subsequently flat lining, or worse, falling off a cliff.

Stodgy old tech titans like Microsoft and Intel (INTC) have been counted out as dinosaurs by many investors, yet each managed to easily surpass earnings estimates. The reaction: The market greeted them with a shrug the next day.

But before you dismiss Wall Street's muted reaction, consider this: Microsoft's shares aren't getting any love today because Wall Street has finally caught on to the company's game.

Microsoft Earnings Smoke and Mirrors

Here are the specific figures on Microsoft's earnings. Revenue hit $17.4 billion, an 8% jump over the previous year. Earnings were a whole different story; they bested the previous year's showing by a whopping 30%.

Great figures, right? Well, don't get ahead of yourself. For one thing, while Microsoft's earnings looked great, there's a component of smoke and mirrors involved. Namely, its operating income (calculated before interest and taxes) only increased 4% year-over-year. To Wall Street's credit, it's finally catching on to a game that's played by technology companies around the world.

Hey, That's a Nifty Tax Trick

The game is this: Make money overseas in areas with lower tax rates, and then avoid bringing the cash home to the United States. By bringing profits home, these companies would be subject to U.S. taxes that reach 35%. It's a nifty game because these companies get to report higher profits and get the double bonus of touting their huge cash piles. Don't you love a two-for-one deal?!

However, this is also a dangerous game. For one, many investors immediately give these companies credit for full cash on their books. However, since the companies don't want to trigger the huge taxes associated with bringing the cash home, it can't easily be used to do things that benefit shareholders, like pay dividends.

It isn't just Microsoft that's working overtime to avoid taxes; a raft of other U.S. companies are playing the same game. Intel's earnings also benefited tremendously from -- you guessed it -- a much lower tax rate.

Secondly, while this issue gets into very complex tax issues, it's extremely difficult to use the cash to make acquisitions in the United States without having to pay heavy taxes in the process. The end result is that companies are more inclined to make acquisitions abroad, where they're not subject to additional taxation.

Did you notice the fine print in Microsoft's recent $8.5 billion nonsensical acquisition of Skype? Microsoft managed to save billions of dollars by using foreign profits to buy Skype, which has its corporate headquarters in Luxembourg.

Microsoft made this bone-headed deal not because it was the best fit available for the company. They made the deal because it was a tax-efficient shot in the arm. If you're a Microsoft investor, this should scare you.

The Bottom Line

I don't begrudge these international titans for working within our tax system to reduce their payments. However, as an investor, I also don't give them credit for huge profit growth when their actual operating profits before taxes are showing anemic growth rates.

As ridiculous as the muted reaction to Microsoft's blowout quarter might look, it makes complete sense.


Motley Fool analyst Eric Bleeker owns shares of no companies listed above. The Motley Fool owns shares of Microsoft and owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel and Microsoft, as well as creating a diagonal call position in Intel.


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