By MARTIN PEERS
Microsoft confirmed Thursday its Windows cash machine is under threat. So what else is new?
Uncertainty about the PC market's growth prospects, and what that means for Windows in particular, arguably has been baked into Microsoft's stock price for years. From 2001 to 2010, Microsoft's net income rose 155% on 147% higher revenue. Yet as of Thursday's close of $26.71, Microsoft shares over the past decade had generated a total return, including dividends, of negative 0.2%, according to FactSet Research Systems.
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After Friday's selloff, Microsoft is trading at 7.1 times expected fiscal 2012 earnings, excluding cash. That isn't a whole lot better than Research In Motion, which after dropping Friday on lowered expectations, is trading at the equivalent multiple of 6.4. And it doesn't make much sense.
Microsoft is a much more diversified company than the BlackBerry maker. Even as Windows' profit growth has flattened, Microsoft Office continues to power ahead. With revenue rising 21% in the quarter, Office contributed 55% of operating income. That it sells on Macs, and Office products are available in some way on some tablets, insulates Office somewhat from what happens in the PC market.
Microsoft's server business, meanwhile, has emerged as a significant contributor to profits. And with the success of the Xbox Kinect product, the entertainment and devices division is even showing increasing profits albeit at much lower margins than the software businesses. Microsoft's partnership with Nokia means Windows Phone will gain significant market share, although the revenue potential remains uncertain.
Quantifying the threat to Windows is the big uncertainty. Microsoft's estimate that the PC market declined 1%-3% in the March quarter was the latest sign that tablet sales are eating into PC sales. As Windows-powered tablets are yet to make much of an impression, that is hurting Windows sales. Indeed, Windows' revenue fell 4.4% and operating profit 10%.
Still, it is easy to overstate the threat. While some consumers and even enterprise customers may opt for a tablet instead of a netbook or laptop, tablets' limited functions will cap how much cannibalization can occur.
Moreover, tablets are arguably more a threat in mature markets, whose growth rate has been at least half that of emerging markets since at least 2007, estimates Gartner. Admittedly, Microsoft sells more basic versions of Windows in emerging markets that generate lower revenue, notes Gartner analyst Michael Silver. And piracy remains a factor in emerging markets.
There also is the threat from Google: Laptops running the search firm's Chrome operating system are expected to hit the market midyear. Assuming Microsoft can limit the speed of such incursions, it would have a better chance of changing investor sentiment if the company was managed in a more disciplined way.
Spending 14%-15% of revenue on research and development, which Microsoft has done for years, looks extravagant given Microsoft's new product history. Apple, for example, spends less than 3%. Not only has it been beaten by rivals on many of the digital world's new developments in recent years, some of its new products, like Windows Vista or the Zune music player, have been duds.
Then there is its history of share buybacks. CT Capital President Kenneth Hackel points out that Microsoft has spent a net amount of $83.6 billion on share buybacks in the past decade. That was to no avail when it comes to the stock price.
Chief Executive Steve Ballmer has in the past couple of years been able to replace most of the senior management. But it may not be possible to change sentiment without a change at the top. With Microsoft looking so cheap, there would be plenty of opportunity for a new leader.
Write to Martin Peers at martin.peers@wsj.com
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