Tuesday, August 27, 2013

Tablet Wars: Changing Industry Dynamics Catch up With Microsoft

One of the world’s leading tech companies, Microsoft (NASDAQ: MSFT), recently released quarterly results that disappointed investors. The company missed both top- and bottom-line estimates on the back of weakness in the global PC market and poor sales of its flagship tablet computer. The PC market has been in recession for more than a couple of years, but Microsoft was too late to react. It is now trying to make some room for itself in a market dominated by Apple’s (NASDAQ: AAPL) iPads and Google’s (NASDAQ: GOOG) Android.
Earnings miss
Microsoft reported income of $0.59 per share, as opposed to a loss of $0.06 per share in the same quarter last year, which came on the back of a $6 billion write-down. During this period, its revenue rose 10% to $19.9 billion. This meant that the company ended up missing Wall Street’s expectations for a profit of $0.75 per share coming from revenue of $20.7 billion. 

According to Gartner, the relevant quarter witnessed a 10.9% drop in PC shipments. The industry is going through a major shift from PCs to tablets. The current reorganization at Microsoft is also aimed at making the business pro-mobile.
Microsoft’s shareholders also took a $900-million hit, which was written off as unsold Surface RT inventories. This dragged earnings by $0.07 per share.
On the other hand, despite the explosive growth of Android on tablets (discussed later), Google continues to struggle with mobile. In its quarterly results announced a few weeks ago, Google's cost-per-click dropped 2% sequentially and 6% year-over-year in Q2. The search-engine giant reported a 20.6% year-over-year increase in net revenue to $11.1 billion, while net income rose 15.8% to $3.2 billion, or $9.56 per share, excluding stock-option costs. The results were below analysts’ expectations for net revenue of $11.3 billion and a profit of $10.78 per share. 
However, Google is now doing a major overhaul of AdWords through enhanced campaigns, which could cause the much-needed increase in mobile-ad prices. Therefore, the slowdown in ad-network is a short-term problem, and the company should start making more money from mobile-ads in the long term.
Surface numbers
Interestingly, Microsoft has decided to keep the sales numbers of its Surface tablets to itself, but the 26th page of its latest 10-K filing (download here) has revealed that the company has sold $853 million of Surface tablets since the launch through the end of June – a period of eight months. The business is now selling its products at steep discounts to lure buyers--the Surface RT now sells for $349, while Surface Pro goes for $799.
Based on the total Surface revenue of $853 million for FY 2013 and assuming an average price of $450 to $550, we can assume that Microsoft has sold between 1.5 million and 1.9 million Surface tablets so far. For a three-month quarter, based on my calculations, this number comes down to a mid-point of just around 646,000 tablets.
Tablets represent a booming market in which millions of iOS and Android-based devices are being sold every month. According to the research firm IDC, Android is gaining market share, eating a big slice out of Apple’s pie.
In Q2 2013, Android was able to increase its market share to 62.6% due a 162.9% year-over-year increase in shipments to 28.2 million units. On the other hand, Apple’s iPad shipments fell by 14.1% to 14.6 million units, as the California-based tech giant was dethroned as the OS leader of tablets. Its market share dropped from 60.3% in Q2 2012 to 32.5% in Q2 2013.
While it is true that Apple is still the largest tablet maker of the world, Samsung is quickly catching up. Where Apple registered a drop in tablet volume, Samsung saw phenomenal year-over-year growth of 277% to 8.1 million units as its market share more than doubled from 7.6% in Q2 2012 to 18% in Q2 2013.
However, rumors abound that Apple could unveil the next iPhone, possibly a 5S, on Sept. 10. This was revealed by AllThingsD – which accurately predicted iPad Mini’s launch last year -- in an article published on Saturday. Apple's stock was up more than 2% by noon on Monday. Markets are also eagerly awaiting the arrival of iOS-7 with some major UI changes. Its stock is also not expensive at the moment; trading at 11.3 times the company's earnings; therefore, with new product launches and an attractive valuation, Apple at $466 is looking like a good investment at the moment.
However, the tablet market is still growing, so everyone’s position is under threat. According to NPD DisplaySearch, tablet shipments are expected to touch 364 million by 2014 and 589 million by 2017. While it is true that Microsoft was the late entrant to the party and its numbers haven’t been impressive, it is still too early to call it a “flop” based on just eight months of data.
So far, Microsoft has successfully maneuvered itself in this tough business environment (e.g. through long-term software contracts with corporate clients) but the softness in its core market is finally catching up with it. The company is simply not that big a player in the tablets industry (yet), which is set to dominate the future.
With the failure of Windows 8 and nothing to boast on the mobile front, its performance has not been satisfactory. But then again, Microsoft is a company in transition operating in an industry in transition.
In the past 52 weeks, its shares have lagged the market and are up by 8% when the S&P-500 ETF (SPY) has seen growth of 20%. As a result, its stock is not expensive at the moment and is trading at just 12.6 times earnings when the industry’s average is 39.2 times. But I believe that long-term investors should wait for things to become clearer before putting any money in this stock. 
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Disclosure: I, Sarfaraz A. Khan, have no position in any stocks mentioned and no plans to initiate any within the next 72 hours of this publication. I have no business relationship with any company mentioned in this article. 
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