Saturday, January 26, 2013

Microsoft's Q2 2013 Was a Mixed Bag

We've had a few recent posts about Microsoft, and we were certainly more positive about the initial launch of Surface RT, and a bit more cautious about Windows 8.  Listening to Microsoft's conference call was about as revealing as a White House press briefing.  Since they publish all their numbers laid out for the user  in Excel, the story is right there, including historical data.

The company wouldn't comment on how many Surface RT tablets were sold in the second quarter, but Credit Suisse analyst Phillip Winslow estimates the unit sales at 700,000 in the December quarter, which is nothing to sneeze at.  The company referred to the February 9, 2013 launch of Surface with Windows 8 Pro, which is supposed to have a broader retail channel launch than Surface RT that was available only through Microsoft pop-up stores.

The change towards selling devices will, over time, blend the gross margin rate down some, but ceteris paribus, it will be coming down from levels like 73.5% in the second quarter.  The CFO, who has also led some business units in his career, made repeated reference to "what we (Microsoft) learned in the quarter."

I believe that one thing they learned is the conversion of the user base, particularly corporate users, to Windows 8 is going to take more time and more support dollars than planned. Many large corporate users haven't really finished their implementations of Windows 7 yet.  In certain industries, like healthcare, IT managers are focused on compliance with HIPAA and on determining how many actual network attachment points they currently have on their system.  Dollars for a Windows 8 implementation are not a sensible use of funds for corporate executives in an uncertain 2013.

The core Windows business in the quarter had sales increase 24 percent to $5,881 million, with operating income increasing 14 percent to $3,296 million; adjusting for revenue deferrals, the revenue gain was 11%. So, even though consumers may have been confused between Windows 8 RT and the full Windows 8, it wasn't a bad quarter.

Servers and Tools revenues increased 9 percent y-o-y to $5,186 million with operating income increasing 9 percent to $2,121 million.

Microsoft Business Division saw revenues decline by 9 percent to $5,691 million,  but adjusting for deferred revenue the decline was 3 percent. Operating income declined to $3,565 million from $4,188 million in the prior year period.  Healthy indicators in this business include a higher mix of multi-year licensing cited by the CFO and a 12 percent increase in revenue from the Microsoft Dynamics ERP.  Operating margins in this business, though down y-o-y, are robust.

Online Service and the Entertainment Services Division remain works in progress.  The Bing search engine increased its market share in the quarter by 120 basis points y-o-y, and online advertising increased, while display ad revenue declined.  Revenue per search increased.  Windows phone revenue increased by $546 million.

Cash flow from operations was $4,780 million and capital expenditures were $930 million--substantially above the prior year.  Free cash flow from operations was $3,850 million. Of this, $1,658 million went to share repurchases and $1,933 million to dividends.

There wasn't one question on the conference call about the proposed participation in the Dell LBO.  It certainly makes sense that Microsoft support one of its biggest, loyal partners in rolling out Windows 8.  It also makes sense as Microsoft accesses Dell's manufacturing and supply chain management capabilities for chips, boards and component assemblies. Microsoft enjoys a low effective tax rate, and some observers have suggested that participation in a Dell LBO could be done in way that would allow Microsoft to access overseas cash without paying taxes on repatriated balances.  That would be an additional financial engineering benefit, but let's see.

The bulls on the stock suggest a significant opportunity for operating margin expansion in the coming quarters and years, starting with the next quarter due to a surge from Windows 8 on the consumer side.  The problem, as we have written about before, is the unanswered question, "Is this a value stock or a value trap?"

Traditional value-oriented mutual fund investors like Tweedy Browne dipped their toes in the stock in the 2008 down draft, but they subsequently sold out of it.  The relative valuation metrics always look cheap, as they do now.  Aside from index investors, and small positions held by Vanguard Wellington, this stock is not at all widely owned by growth or value investors.

Were the company to significantly raise its dividend to get its yield into line with value stock yields,  and cut back on its share repurchases, this would help.  It will need continuing investment in its online and entertainment businesses, as well as to support its consumer device businesses.  Share repurchases don't earn the management any kudos with the stock flat over five years.

The other question is the management.  Managing distinct enterprise-oriented businesses with hardware, software and services and consumer businesses that will depend on access to content, new product launches and hardware is exceedingly difficult under the current organization.  Who is in charge of these distinct efforts?  The Street is clearly not enamored of CEO Ballmer.  It might be time to launch Windows 8, declare victory, restructure the company, and allow CEO Ballmer to retire on a win.

I don't think there is any chance that will happen given the cultural legacy of Microsoft. If Microsoft is going to drive the financial strength of the balance sheet engine to deliver significant value, then the corporate organization and leadership needs a major refresh.  Hopefully, it won't be another five years of the share price going sideways.

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