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Wall Street finally starts to appreciate Microsoft's difficulties

AP Microsoft CEO Satya Nadella Is Microsoft’s stock a good buy right now, hovering at about $41? Or is it overpriced, with another drop looming when management fails to meet consensus revenue and profit targets? In new research note, Wells Fargo thinks it’s a good buy. The team, lead by senior analyst Jason Maynard, just upgraded the stock to “outperform,” with a target of $46-50. Those prices would put the stock at or near 15-year highs, and within spitting distance of its all-time split-adjusted price of $53.98 in 1999 just before the Internet bubble burst. Maynard and team completely contradicted a research note issued by Goldman Sachs last week that advised investors to sell. The GS team believed the Street didn’t fully understand all the headwinds that are hurting Microsoft’s major businesses. Pshaw, is the general answer from Wells Fargo’s Maynard and team. While Maynard did agree with Goldman that the Street’s consensus estimates were too high and “clearly need to come down,” he notes that the “shares are down over 12% in 2015.” That means the stock has already corrected for its previous high, from the boost Microsoft got when businesses rushed to upgrade from XP. He writes: In our view, management is making sound moves that should benefit the business in the intermediate and long term. We think the strategic position has improved with the new cloud/mobile product introductions, the “software anywhere” cross-platform approach, and disciplined cost controls. … We like the new Microsoft. He’s bullish on Microsoft’s clouds. This includes, Azure, the one that competes with Amazon and Google and Microsoft Office which now spans the Windows PC, the cloud as well as iOS and Android. He likes Microsoft’s general message that it is “reclaiming worker productivity” and fending off Google Apps in the process. He also thinks general “sentiment and perception” of the company “has improved substantially over the last year.” That said, he does see a few rough spots. Windows is a “work in progress,” he writes, agreeing with Goldman that Windows 10 probably won’t have much of an impact on financials for a while. (Microsoft hasn’t yet discussed how its going to account for the free upgrade and potential deferred revenue on its books.) Meanwhile, Microsoft is experimenting with new revenue models to make up for free Windows 10, everything from its new Surface PCs to its app store. He also predicts more layoffs could be coming. Actually, both of these analysts indicated that Microsoft may not have cut costs deep enough to fend off the hit from its transformation and the rough foreign exchange plaguing US multi-national companies. Goldman believes that Microsoft will not cut more people, needing to compete in the tech talent wars. But Maynard predicts: “We believe that there is one more round of estimate cuts needed to reflect market conditions and a tougher FX environment.” We’ll see. Last week, Microsoft laid off a few hundred more people, mostly from its IT group, and said this was the last of the big cuts from its largest layoff in history, the 18,000 people it cut since last summer after it swallowed Nokia. But overall, Maynard sees a “reinvigorated” company “under CEO Nadella’s regime.” They are open to new approaches more than ever, and are embracing, not fighting, the disruption brought by mobility. The harsh reality is that every 15 years or so the technology industry undergoes a platform shift brought on by new innovation. … It’s hard to disrupt your own cash cow franchise, as its always easier being the hunter instead of the hunted. But now it’s fair to say that Microsoft has made that leap. Which of these opposing points of view is right? We’ll find out on April 23, when Microsoft releases its next earnings report. NOW WATCH: This is what happens to your brain and body when you check your phone before bed Please enable Javascript to watch this video Read more stories on Business Insider, Malaysian edition of the world’s fastest-growing business and technology news website.

Microsoft's (MSFT) stock tumbled Tuesday, as Wall Street finally started to realize that the whole PC-to-cloud transition was going to be a lot more difficult than they’d anticipated.

The software giant reported its holiday quarter results after the close on Monday and even an East Coast blizzard couldn’t obscure the problems. Revenue and profit for the quarter were mostly as expected, though sales of Windows and Office licenses fell short, but guidance for the beginning of 2015 shocked analysts. CFO Amy Hood said Microsoft expects sales of $20.6 billion to $21.4 billion for the fiscal third quarter versus a Street consensus of $24 billion.

Microsoft’s stock price dropped 8.5% in afternoon trading on Tuesday to $43.01, erasing almost six months of gains. Already, at least four Wall Street firms have downgraded the stock and more are likely to follow, as the bad news sinks in. Some of the shortfall is due to the stronger dollar depressing revenues from abroad, but larger issues loom.

As I’ve been warning for a while now, Microsoft and other "old tech" companies got a one-time boost from businesses upgrading from Windows XP last year but that juice has totally dried up. Now comes the really hard part, as they try to compete in a market where customers are relying less and less on old-school Windows PCs and using far more mobile devices and cloud services.

"Last year you had the migration from the older version of Windows, you had this benefit that’s now dissipating. No one was sure how much a benefit that was," Nomura analyst and longtime Microsoft watcher Rick Sherlund explained in a CNBC interview on Tuesday. "When you look under the covers of the December quarter, Windows was down 13%, it kinda took your breath away and the really tough comparisons are coming up in March and June."

As that realization sinks in, investors are selling other past beneficiaries of the XP upgrade cycle. Hewlett Packard (HPQ), Intel (INTC) and Western Digital (WDC) are all off 3%. Seagate (STX) is off 4% after falling 10% on Monday thanks its own weak outlook for 2015.

Microsoft is growing fast in the cloud and lagging terribly on mobile, but even if it was succeeding in both, it’s still unlikely the company will ever be able to capture anywhere near the same amount of revenue and profit in the new world. As just one example, CEO Satya Nadella bragged on Monday's analyst call that Microsoft's cloud business has reached an annual revenue “run rate” of $5.5 billion, but that’s only 6% of the company’s total revenue over the past year.

At the simplest level of analysis, if you just subtract the $2.3 billion of revenue added from the acquisition of Nokia’s phone business, the entire rest of Microsoft’s revenue grew only 1%.

Dig deeper, as appropriate every quarter, and compare what’s happening in Microsoft’s biggest and most profitable Windows-related units to its higher profile, faster growing new units.

Sales in the units that include consumer and corporate licenses for Windows and Office totaled $14.8 billion, down 10%, while sales of all the rest of the company hit $11.6 billion, up 4%. Growth isn’t coming fast enough and, again, virtually all of it came via the Nokia acquisition, which doesn’t look like a long-term winner.

Gross profit at the older businesses dropped 8% to $13.8 billion. All of the other businesses had a gross profit of $2.5 billion, more than double a year ago but still less than one-fifth what the older units brought in.
The gross margin in the new businesses combined is improving, hitting 22% from 14% a year ago, but it’s still a fraction of the 93% margin in the old-school businesses.

And gross profit likely overstates the contribution of the new businesses to Microsoft’s ultimate net income. The company doesn’t disclose actual operating profit of each business. Old businesses like software are almost pure profit beyond the gross expenses while new businesses, facing steep competition from the likes of Amazon (AMZN), Apple (AAPL) and others, have higher marketing and R&D costs.

Among all the new initiatives, hardware devices – one of former CEO Steve Ballmer’s top priorities – had to be the most disappointing of all. Sales of the Surface tablet hit $1.1 billion, barely growing from the previous quarter and likely to be one-tenth or less Apple’s iPad revenue. Sales of Lumia smartphones also barely grew from the previous quarter. Not only will Apple have sold six-or-seven times as many units, but Apple’s average selling price is also likely to be three to four times higher. Even the once-proud Xbox division is faltering a bit, as Sony captured the majority of holiday sales.

Last year, Microsoft was one of the best-performing large cap stocks. Looks like 2015 is going to be considerably less kind.

(Updated at 2:50 p.m. on January 27, with additional commentary from Rick Sherlund)

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