What if Microsoft was turning things around right as its longtime CEO was heading toward the door?
Steve Ballmer isn’t going to win any CEO of the decades awards. He himself regrets Vista and getting into mobile too late. Microsoft became splintered under his leadership. The stock has basically moved sideways since he took over. For years, Ballmer weathered criticism and calls from investors to step down. Instead, he quietly plowed ahead.
But an interesting thing happened when Microsoft reported its most recent earnings. The company beat revenue expectations in nearly every division. Overall revenue rose 16% to $18.5 billion, topping analyst estimates of $17.8 billion. Earnings per share grew 17% to 62 cents a share, blowing past the 54-cents consensus estimate.
That sent the stock up 6% last Friday on two-and-a-half times the average volume. On Monday, Microsoft shares rose as high as $35.73, its highest level since November 2007, and it’s since held onto most of those recent gains. But when Microsoft’s stock was rallying six years ago, it was something of an aberration, reaching $37.50 on the back of, again, surprisingly strong earnings. Within three months, however, Microsoft gave up those gains as it pursued an ill-starred takeover of Yahoo.
Looking at Microsoft’s stock price over the past 13 years, the stock’s recent gains look even more encouraging. Outside of that three-month period in late 2007 and early 2008, Microsoft’s shares have been largely bound inside a range between $22 and $35. Investors have received substantial returns in the form of regular dividends since 2005. Even so, that kind of price stagnation is unusual especially considering the company has bought back more than $100 billion worth of stock over the past decade.
Now Microsoft is not far from breaking out of that range and heading higher. The big question is whether it can continue to post strong revenue and profit growth in coming quarters, or whether this is another short-term rally that will fade in a few months. If it’s the former, it would let Ballmer exit the CEO suite on a strong note, handing control over to a new chief executive just as the company’s turnaround stopped muddling along and started to slowly, finally begin to click into place.
On this question, Wall Street seems divided. Everyone is agreed that Microsoft is in a tough spot, having to navigate growth when its core market of software for laptops and desktops is locked in decline. No one expects Microsoft to grow like Facebook or Google are growing. The debate is how big of a player it can become in key growth areas like mobile devices, cloud computing and entertainment.
Some analysts were encouraged that Microsoft was showing improvement in several areas where it’s been struggling. Surface brought in revenue of $400 million. Revenue from commercial cloud services like Azure and Office 360 rose 103% over the year-ago figure. Nokia’s handset division, which Microsoft plans to buy, saw unit sales rise 19% and revenue rise 6%, thanks to Lumia handsets.
Many analysts raised price targets to $40 a share or above, but even these took a cautios tone. Oppenheimer analyst Shaul Eyal noted that “results exceeded Street estimates on almost every metric which was further supported by a solid outlook.” Credit Suisse’s Philip Winslow said “Microsoft can return to double-digit EPS growth” but added this may require some cost cutting or divesting of underperforming businesses by the new CEO.
Stil others were more skeptical. Nomura analyst Rick Sherlund, noting that the Street had set a low bar for Microsoft (expecting another lackluster earnings report), termed it “not a great quarter.” Yes, revenue was growing in hardware – Surface, Xbox and Nokia devices – but these are areas that will drag down profit margins as they grow further.
Kash Rangan of Bank of America went into more detail, noting that operating margins in the current quarter “are now projected to go below 30% for the first time in seven years. With Nokia thrown into the mix, we are concerned that operating margin could slip to 25-27% as hardware rises to above 25% of revenues and consumer rises to 50% of revenues.”
In short, Microsoft is on the path it needs to travel to move away from a PC industry in decline. But it is also a path to lower margins, which could limit profit growth the further the company pushes into its turnaround. As Goldman Sachs’s Heather Bellini, who has a sell rating on Microsoft put it, “EPS estimates will move lower as the company transforms its business.”
The good news is the new, improved Microsoft investors have long clamored for is finally gaining some traction, just as Ballmer is preparing to step down. The bad news for investors is that they’re getting what they asked for: a Microsoft with lower profit margins than they may be used to. Consider it Ballmer’s parting gift to the investors who have been calling for his head.