Applause for Windows 7, cost-cutting, and an earnings surprise have stirred hope that Microsoft's stock will revive. Will businesses buy the upgrade?
A well-received debut for its newest operating system and fresh signs that businesses again want to spend on computers gave Microsoft investors reason to hope a more than yearlong sales decline is coming to an end. But it may take big spending by consumers to pop Microsoft stock out of its tight trading range.
Shares of Microsoft (MSFT) gained 1.43, or 5.4%, on Oct. 23 to close at 28.02. Before the market opened, the company reported fiscal first-quarter sales and profit that bested analysts' forecasts. Revenue fell 14% and profit dropped 18%, but Wall Street analysts had expected worse. "The fourth quarter of fiscal 2009 may well have been the bottom on the economic reset," Microsoft Chief Financial Officer Chris Liddell said during a conference call with analysts. He was harking back to remarks by other Microsoft officials, who have said that old demand patterns have been "reset" lower amid recession and a credit crunch.
As heartening as recent gains may be, Microsoft shares remain in the mid-20s range, where they've been mired for a couple of years. An investor who bought Microsoft shares in late October 2000 and held them would have realized a net gain of about 1%. The shares reached about 37 in November 2007, but then declined to about 27 by February 2008. They've barely budged since. Despite Microsoft's size and influence—the company reported $58.4 billion in sales last year—its stock has lagged the tech industry's highfliers.
Apple (AAPL) shares closed at an all-time high of 205.20 on Oct. 22 after the company reported a blowout 47% increase in quarterly profits on Oct. 19. Amazon.com (AMZN) shares reached a record high on Oct. 23, closing at 118.49, after it reported a 68% jump in third-quarter earnings a day earlier. And Google (GOOG) is trading at a lofty 554, although the stock is well off its high of 715 in late 2007.
PC Sales Stalled in First Quarter
Getting consumers to embrace Windows 7 and snap up more capable computers than the low-end mini-laptops that have accounted for the PC industry's meager growth will be key to Microsoft's earnings and stock performance, analysts say. The difficulty of forecasting consumers' fickle buying behavior is one reason Microsoft isn't releasing a specific sales or earnings target for the current quarter. "The financial impact of [Windows 7] will be driven by the consumer market, and that's very hard to predict," says Yun Kim, an analyst at Broadpoint AmTech (BPSG) who has a buy rating on Microsoft shares.
During the fiscal first quarter, sales of consumer PCs rose at a single-digit pace while those of PCs for businesses dropped at a double-digit rate, Liddell said.
Business demand will need to reverse course and consumer buying will have to accelerate. A "wildly successful" year of Windows 7 sales could propel the stock to 33 and put the company's price-to-earnings ratio on par with the rest of the tech industry, Kim says. That will likely only happen if Microsoft can increase sales and earnings by more than 10% a quarter. "If they can grow by double digits, there's a lot of room for this stock to go higher," Kim says. "There aren't many companies doing that anymore."
For the moment, analysts seem to think Microsoft can pull it off. After several quarters of decline, Microsoft is poised to start growing again. Before the first-quarter report, analysts expected Microsoft to generate $17.12 billion in sales for the second quarter—an increase of 14%—and earn 52¢ a share. The surprisingly strong first quarter will likely prompt Wall Street analysts to raise estimates even higher.
Business Users Ignored Vista, Kept XP
One potential roadblock for Microsoft is Apple, which has been grabbing market share in the U.S., and now accounts for 8.6% of PC sales there, according to market researcher IDC. Apple's computer shipments grew by 12% in the third quarter while the overall PC market grew at an anemic 2.5%. Worldwide PC sales increased 2.3%, IDC said.
What's more, Microsoft will need to overcome weakness in sales to businesses, which largely bypassed the Windows Vista operating system released in 2007, perceiving it as slow and lacking in compelling features. Instead, companies stood pat with older machines. Consumers, meanwhile, have been gravitating to low-priced netbooks that run a discounted version of an earlier operating system, Windows XP.
Windows 7 will likely help Microsoft on both fronts. The software has received positive reviews. Windows 7 helps PC users more easily manage files and it starts and shuts computers faster. It eliminates many of the annoyances that bothered Vista users. Windows 7 also gives Microsoft a better-performing—and higher-priced—operating system to sell on netbooks. "The end result may be that Microsoft sells more versions of Windows 7 at lower price points, but if Microsoft did not meet this emerging demand," rivals would, said Allan Krans, an analyst at consultant Technology Business Research, in an Oct. 23 report.
Microsoft has more than Windows 7 to rely on. Cost-cutting could boost shares by increasing operating margins. Microsoft's profit margins have been declining over the past seven years as the company entered expensive new businesses such as Internet search and video games. The operating margin in fiscal 2009 was 34.8%, down from 46.3% in fiscal 2001. "One of the biggest hangups investors have had about Microsoft the past few years is their spending on the online side of the business," says Jeff Gaggin, a vice-president at Avian Securities who rates Microsoft a buy.
An 8¢ Surprise, Aided by Xbox
To rein in expenses, Microsoft is cutting its staff and reducing marketing and other costs. Operating expenses fell 7% during the quarter ended Sept. 30.
Sales declined to $12.92 billion, and profit fell to $3.57 billion, or 40¢ a share, Microsoft said. Wall Street analysts expected Microsoft to earn 32¢ per share on revenue of $12.32 billion. A year ago, Microsoft earned $4.37 billion, or 48¢ per share, on sales of $15.06 billion. Surprisingly strong sales of Microsoft's Xbox video game console and royalties from games sold for the machine helped boost the results.
First-quarter sales were lower than they would have been had Microsoft not offered coupons for a free upgrade to Windows 7 to consumers who bought Vista in the months leading up to the Oct. 22 launch of the new software. The program resulted in $1.47 billion of revenues, which Microsoft deferred. It will recognize most of those sales in the current quarter.
Liddell didn't give investors guidance for Microsoft's second quarter ending in December, but said businesses were ready to buy new PCs loaded with copies of Windows and Office. Microsoft will continue to hold the line on expenses for at least the next year, he added. "The fiscal discipline that you have seen will continue," he said.