During the last years, Microsoft (MSFT 0.92%) observed competitors like Apple and Google progressively eroded its monopolistic control of personal computing. Microsoft stock endured a “lost decade”, as the success of initiatives in entertainment (Xbox) and cloud computing (Windows Azure, and now Office 365) was offset by massive losses associated with the Bing search engine and to the stagnation of Windows.
Microsoft stock price chart over 10 years, data by YCharts
Microsoft’s management has adapted to the changing market environment – albeit slowly – by trying to adopt some of the best features from competitors’ offerings. For example, Office 365 attempts to bring Microsoft Office into the world of Google Docs by offering cloud storage and collaboration tools. The new Windows 8 interface was designed to be “touch-based” and the Surface tablet was created to provide a Windows tablet-like experience.
However, Microsoft’s initiatives always seem to be “too little, too late”. With Microsoft stock recently hitting a multi-year high (after third-quarter earnings were better than expected), long-term earnings growth is likely to prove elusive. Even though Microsoft shares are trading at just 11.3 times forward earnings, investors should consider selling and taking profits now.
Windows isn’t what it used to be
The root of Microsoft’s problems is the decline of the Windows operating system. While the PC industry is not in imminent danger of extinction, the growth of tablets is cannibalizing the low end of the market. Netbook sales peaked at more than 32 million in 2010 – no coincidence, the year Apple released the iPad – but are expected to drop to zero by 2015, according to IHS iSuppli.
In addition, the growth of tablets may lengthen the refresh cycle of PCs, a phenomenon that is already taking shape. Since PC performance is not improving at the same rate as 10 or 15 years ago, most PC users can wait five or six years between PC upgrades.
Microsoft has tried to offset the impact of tablet cannibalization with a redesigned touchscreen Windows 8 interface. Microsoft shares rose last spring and summer in anticipation of the build of the new operating system. However, early sales of Windows 8 PCs were disappointing, and Microsoft was reportedly forced to cut OEM prices (at least for some versions of Windows).
The Windows 8 tablet concept initially seemed quite promising, as it would allow users to run legacy Windows apps in a tablet form factor. Such a feature sounded very appealing to businesses. (Consumers had already adopted the iPad in large numbers.) However, Microsoft was too late for the tablet party; Apple has repeatedly touted the iPad’s strong penetration into the business and education markets. Businesses that have adopted the iPad and created custom apps specific to the iPad are unlikely to move to Windows tablets in the future.
Potential carry-over effects
So far, Windows cannibalization hasn’t hurt Microsoft’s revenue too much. Year-to-date, Microsoft saw a slight decline in diluted EPS, from $2.05 in FY12 to $1.99 in FY13. Microsoft stock benefited from the perception that the worst is over and the company will return to earnings growth next year.
However, poor Windows performance is beginning to trickle down to the “Business Division”, which primarily houses Microsoft Office. Since customers typically buy a new Microsoft Office license when they buy a new PC, the drop in PC sales is hurting Microsoft in two ways.
In addition to this problem, many people find Google Drive’s free productivity tools to be “good enough” for their needs. Microsoft is trying to boost Office usage among students with a recent promotion giving students six months of free access to Office 365 (the company’s new cloud-based version of Office). After that, students can get four years of access for just $80.
Office remains a must have for businesses, and many consumers will also continue to use Office. However, rising competition from Google and other free productivity suites is forcing Microsoft to offer bigger discounts than before.
Insane result
If Windows and Office have both peaked, as I think they will, Microsoft stock is unlikely to rise over the next few years. The two divisions are still cash cows and generated more than $27 billion in operating revenue last year (excluding unallocated business expenses). However, if these companies’ revenues gradually decline due to poor PC sales trends and a continued shift to free productivity tools, Microsoft won’t be able to offset that with growth elsewhere.
Microsoft touted its progress in cloud services and in the “living room” to investors. On Tuesday, the company unveiled the next-generation Xbox One, which offers a number of improvements over the Xbox 360. Still, it’s unlikely to be the game changer investors are hoping for. The Xbox business is too small to drive company-wide earnings growth given the likely continued weakness in Windows and Office sales. As a result, investors may be advised to sell Microsoft shares as they near multi-year highs.
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