MSFT’s 3Q11: signs of Windows weakness

the results

After the close of the market in New York on Thursday April 28th, MSFT reported its 3Q11 (MSFT’s fiscal year ends in June) results.  The company earned $.56 per share for the three months (+24% year on year), on revenue of $16.4 billion (+13%).  A non-recurring tax benefit raised the final per share tally by $.05, to $.61.  This compares with the Wall Street consensus estimate of $.56.

MSFT shares dropped by 3% in Friday trading, in a flat market for IT.  INTC, the second member of the “Wintel alliance,” whose shares tend to  trade more or less in line with those of MSFT, rose, in contrast, by 1.5%.

the details

picky points (symptoms of analyst’s disease)

–MSFT continues to show impressive control of operating expenses.  Despite this, operating income for the quarter was up by only 10.3% year on year.  That’s less than the rate of increase in revenue–not what you’d expect from a software company.

–The company spent $10.3 billion, or a tad less than 60% of net income, over the first nine months of fiscal 2011 buying back its own stock.  That’s far above the $2.2 billion in new issuance (presumably from exercise of employee stock options) over the same period.  Outstanding shares are down by about 4% year on year–meaning around 4% of the advance in per share income comes, not from an increase in the bottom line, but from shrinkage of the denominator used in the calculation.

more important things

MSFT has five divisions, two big ones, one medium-sized and two that you can safely ignore if you just want a general picture of where growth is likely to come from.  In size order, giving the percent of operating income each represented in fiscal 2011 to date, and year on year growth for 3Q11, the divisions are:

Business (meaning MS Office and related productivity tools)      43.5% of operating earnings, 24.5% year on year growth in 3Q

Windows (the PC operating system)          38.7% of operating earnings, 10% year on year decline

Server and Tools          20% of operating income, 11.7% year on year growth

Entertainment + Devices (X-Box, cellphones…)          5.4% of operating income, 50% year on year growth

Online Services          -7.6% of operating income (a loss of $1.8 billion), a 10.% increase in the year on year loss.

the numbers need a bit of tweaking

Windows 7  launched in late October 2009.  So year-ago sales were flattered by the rush to buy the new product (and ditch Vista).  Office 2010 debuted in June 2010.  Anyone who bought Office 2007 in the runup to launch of the new version got a free upgrade.  Revenue was booked when the upgrade was redeemed, not when the sale was made–meaning that revenues in the Business segment during the year-ago quarter were unusually weak.

MSFT thinks the true rate of the Business segment revenue growth was 13%, not the 20% reported.  Conversely, it believes the decline in the PC market it saw in 3Q11 was 1%-3%, less than the 4.5% drop in sales it posted.

MSFT’s take on the PC market…

According to the company, netbook sales were down 40% year on year, business PCs were up 9% and consumer PCs were down 8%MSFT thinks that emerging markets represent “nearly half” of global PC shipments.

…vs. INTC’s

In simple terms, INTC (see my latest post on the company) is saying that the lion’s share of PC growth is coming in the emerging world, where consultants like Gartner or IDS, who are projecting lackluster growth in the PC market this year, have limited ability to collect data.  The two consultants are mistakenly extrapolating the present weakness in the US and Europe to include the developing world.  As a result their unit sales projections are too low.  INTC, which does over half its business in developing countries, says it has a much better look at demand through its warehouse and sales staffs–and business is better than the consultants think.

In a nutshell, MSFT sees the same picture the consultants do.

my thoughts

I don’t think netbooks are an important factor.  If they comprised 5% of the total PC market a year ago and that’s been cut in half, the resulting unit volume decline is 2.5%.  But they use low-cost Atom processors and Windows 7 Starter, which does little more than start the machine.  So they’re not a commensurate revenue loss.  Also,  to some degree buyers have switched to low-end laptops, which carry higher revenue and profits for both MSFT and INTC.

Macs are a factor, but not the key one, in my opinion.  Macs are growing much faster than the overall PC industry.  They use INTC chips but the AAPL operating system.  However, although Macs represent over 10% of the PCs sold in the US, they’re less than 4% of the world’s unit purchases.  Yes, they’ve been gaining half a point to a point of market share per year, but that probably means less than a 1% unit volume increase for INTC.

The MSFT management didn’t respond to an analyst’s question about piracy, which, in my experience, is rampant in the Pacific.  My guess is that non-branded “white box” computers with unauthorized copies of Windows software are a big part of the difference between MSFT’s experience and INTC’s.  There’s no way of knowing for sure, though, so MSFT’s judgment not to broach the topic is probably its best tack.

One other interesting MSFT management comment about INTC:  The MSFT CFO suggested that maybe the biggest reason for INTC’s good results was its ability to raise prices.  Although he didn’t say this, what seemed to me to be implied is that INTC can raise prices in a way MSFT can’t.  In other words, through constant innovation in chip size, speed, power consumption, INTC has a better value proposition for customers than MSFT does.  I think that’s right, but it’s funny to hear it from the lips of MSFT.

the stock

MSFT is guiding to a 4Q11 about in line with results from 3Q11.  This would bring full-year results to about $2.60 a share.  I think we’ve already seen the crest of the current product cycle with the launches of Windows 7 and Office 2010.  So fiscal 2012 will likely show eps growth at a much slower pace than the likely 24% gain this year.  Let’s pencil in 12%.

If so, the stock is trading at about 9X forward earnings, has net cash of around $4.50 a share, generates free cash flow and yields about 2.5%.  That looks cheap to me.  It’s hard to figure where the upside is going to come from, though.  Certainly, there are isolated interesting products, but I’m not sure there’s anything big or dramatic enough to move the needle for a giant like MSFT and engage investors’ imaginations. So value-oriented investors, the prime potential buyers of MSFT, may well worry that the stock will remain the “value trap” it has been for the last decade.

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