Following the second quarter 2012 earnings announcement on January 19, more than half the analysts covering Microsoft Corp. (NasdaqGS:MSFT - News) have made downward revisions to their estimates. The reason for the downward movement can be traced to the negative affect on the PC supply chain due to hard-disk drive (:HDD) shortages and macroeconomic uncertainties that are expected to continue well into 2012.
Last Quarter Synopsis
Microsoft’s second quarter results were a couple of cents higher than the Zacks Consensus Estimate. However, the client PC business was impacted by the Thai floods, although all the other areas of the business saw good growth.
Microsoft’s revenue was up sequentially as well as from the year-ago quarter at $20.89 billion, led by a triple-digit growth in the Entertainment & Devices segment and all other segments except Windows growing strong double digits. The Windows segment was impacted by HDD supply shortage and macro economic uncertainty, according to management.
The decline was due to weakness on the consumer side of the business, particularly netbooks, where Microsoft saw strong competition from Apple’s (NasdaqGS:AAPL - News) iPad, which cannibalized netbook sales.
Gross margins also declined sequentially to 73.0% due to an unfavorable product mix and higher royalty costs due to higher transactional sales on Xbox Live. The search agreement with Yahoo (NasdaqGS:YHOO - News) is also raising online services and traffic acquisition costs, thus impacting margins.
Agreement of Analysts
Estimate revisions for the upcoming quarter indicate declining sentiments, with 19 out of 27 analysts making downward revisions in the last 30 days. Also, for fiscal 2012, 23 out of 30 analysts made downward revisions, with only 3 analysts moving upward in the last 30 days.
Analysts, by and large, continue to believe that the ongoing weakness in the PC market and weak consumer sales in mature markets will likely lead to weak Windows revenue growth in the coming quarters. They believe that the weakening Windows business pressured by tablet devices like iPad and a lackluster enterprise PC refresh cycle will not allow gross margins to return to the historical level of 80%.
Despite a strong second quarter, analysts are of the opinion that both revenue and margins will likely remain under pressure over the next several quarters, given the macro headwinds and the Thailand flooding that led to greater-than-anticipated disruptions in the PC supply chain.
However, a handful of analysts believe that continued momentum in the non-PC enterprise businesses, growth in data centers and cloud computing should enable mid-to-high single-digit revenue growth even in a weak PC market.
The analysts contend that Windows 8, which is expected to be released in 2012, will do well in the enterprise market. Additionally, the early adoption of Office 365 can also open up new revenue opportunities going forward.
Impact on Estimates
For the third quarter, though Microsoft did not provide any specific revenue guidance, it expects revenue to continue to be impacted by market dynamics. However, management did not comment on margins but lowered its fiscal 2012 operating expense guidance to $28.5–$28.9 billion.
As may be expected, the negative bias of the majority of analysts decreased estimates over the past 30 and 90 days.
Accordingly, over the 30 day period, the Zacks Consensus Estimate fell 3 cents for the upcoming quarter to 58 cents and 5 cents for fiscal 2012 to $2.68. In the past 90 days, the Zacks Consensus Estimate fell 4 cents for the upcoming quarter and 9 cents for fiscal 2012.
The decline clearly indicates the uncertainties in the IT hardware sector, echoing the general pessimism for the PC market in 2012.
However, longer term, we believe Microsoft will be a major beneficiary of cloud computing adoption. New product cycles are also expected to drive growth going forward.
Conclusion
We believe that Microsoft remains one of the best-positioned software vendors, given its wide range of products, strength in emerging markets, continued technology deployment at data centers and growth in cloud computing.
Windows 8, which is expected to be released in 2012 and supports both the x86 and ARM chip architectures, could be the next big catalyst for Microsoft.We believe that the availability of Windows’ applications on a tablet form could make the Windows 8 tablet a good alternative to iPad and Google’s (NasdaqGS:GOOG - News) Android tablets, leading to significant traction in the demand for Windows thereafter.
Microsoft’s entertainment division is also expected to benefit from pre-holiday builds and new products (Mango). Additionally, management’s cost control measures are expected to yield solid margin expansion over time.
However, the weakness in the PC market and increasing competition from Android and Apple’s iOS could further pressure earnings in the near term. Therefore, Microsoft shares currently carry a Zacks #3 Rank, implying a Hold recommendation for the short term (1–3 months).
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