Microsoft’s Bad Quarter: Sign of Worse to Come?

This May Not Bode Well for Microsoft’s Future.

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Microsoft's Bad Quarter: Sign of Worse to Come?In the latest installment of Where’s Waldo?, Microsoft CEO Steve Ballmer opted not to participate in the company’s fourth-quarter conference call with Wall Street’s bean counters Thursday.

No surprise, as Ballmer never plays a role in these shindigs. A little cheeky, however, given that, just a week earlier, Ballmer had announced a major reorganization that shifts the responsibility accorded to top executives and that aims to make Microsoft (ticker: MSFT) a “devices and services company,” whatever that is.

Surely, these earnings calls, in which stock analysts drone on with piddly questions about minutiae, are a tedious drag. Humoring them is one of the unfortunate obligations of being a $266 billion company. But given the momentous nature of the re-org, one wonders, would it have killed Ballmer to join the proceedings just this once?

In the breach, the new chief financial officer, Amy Hood, did a credible job, even if some of the answers she provided were the equivalent of “You want fries with that?” — perfunctory and less than edifying.

All this came as Microsoft missed revenue and profit estimates by a sizable margin, in what Citigroup analyst Walter Pritchard termed its “sloppiest quarter in memory.”

Revenue in the Windows division, which sells operating systems for personal computers, fell 6%, year over year, when one excludes amounts booked in prior quarters but not recorded on the income statement until last quarter.

Microsoft also took a $900 million write-down for cutting the price of its Surface tablet to $349 from $499. Surface has struggled to gain a foothold in a market dominated by Apple’s (AAPL) iPad and by devices using Google’s (GOOG) Android operating system.

Even Microsoft’s Business Division, a relatively healthy part of the company’s story, quarter after quarter, saw its sales crimped by consumers who put off purchases of new personal computers and thus of Microsoft Office, too.

Hood warned that results will continue to be pressured by slumping consumer PC sales this quarter, further postponing the rebound in that market that Microsoft and Intel (INTC) repeatedly have predicted is just around the corner.

I said last week that investors were generally giving Microsoft a pass on the rotten PC market, but I was clearly wrong about that. Friday they brought their disappointment front and center, driving the stock down more than 11.4%, to $31.40. One reason for the selloff: With the shares up 33% for the year going into Thursday’s call, the bulls took some profits. If that’s the case, then I expect some people to shrug off this latest disappointment and quickly return to the stock.

It’s also possible that the messy quarter is prompting investors to ask where the reorganization is taking the company. Hood said that the full story of how it will affect the company will come in late September, when Microsoft holds its annual meeting with analysts.

In the meantime, here’s something to chew on. The new direction could imply a serious threat to earnings at an organization that long has enjoyed gross profit near 80% of sales, and operating profit of 30% or better. Remember, the motto of this reorganization is “devices and services.” If Microsoft wishes to dig deeper into the hardware business, in which the Xbox has been a hit, but Surface has been a flop, that will increase its cost of goods sold. And if it wishes to build more data centers to support its “Azure” cloud-computing service, that also will boost its product costs, capital-investment needs, and depreciation.

Indeed, cost of goods, Hood said last week, is expected to rise 20% this quarter.

IN CUTTING HIS RATING on the shares Friday, to the equivalent of Hold from Buy, Cowen’s Gregg Moskowitz warned that “gross margins are likely to come under increasing pressure going forward, as Microsoft focuses on building out its data centers to provide services such as Azure and Office 365,” the online version of its Office productivity suite.

The operating profit for the Windows division, estimates Moskowitz, was 45% last quarter. That’s worrisome because it’s generally higher than the company average, at 50% to 60%. The analyst thinks the overall corporate operating margin will decline to 33.6% this fiscal year from the adjusted 36% in the year just ended.

Again, we don’t know for certain if such concern is warranted, and we won’t know until we hear from Waldo, sometime in September.

We can’t know, in other words, if the fundamentals are about to get better or worse for Microsoft, so we’ll have to wait and see if sentiment, suddenly so terribly dark, will again brighten for the software giant.

IN CONTRAST TO MICROSOFT’S terrible week, SanDisk, a maker of the flash-memory drives that are replacing conventional hard drives, continues to shine.

Thursday, the company reported its fifth quarter in a row of beating revenue expectations and projected that the year’s results would be higher as well.

The stock (SNDK) ended the week up almost 3%, at $62.71. On the year, it’s up 44% and, over 12 months, nearly 79%. The company is benefiting from selling components for the exploding mobile-device market and for mission-critical enterprise gear.

Four months ago, I wrote that SanDisk seemed to be the memory stock most likely to have outperformance past June, based on its historical trading patterns (“Memory Stocks Are Booming, but Don’t Expect It to Last,” March 18). Further gains seem likely, given that the bear case for SanDisk’s business is, at the moment, wishful thinking.

SanDisk, along with Micron Technology (MU), has been benefiting not only from high demand for flash memory, but also from supply constraints that have driven up prices for the entire industry.

The bears are waiting for the manufacturing pendulum to swing back, and for new investments to boost supply and clobber prices.

So far, there seems little evidence of that. In fact, some contend that a structural shift is under way in the memory-chip business, with the most advanced parts being so expensive to manufacture that supply will be constrained for some time to come.

That’s not certain, but until there’s some sign of the bump-up in supply that the bears hypothesize, the stock is likely to continue to work.

Article by Tiernan Ray, Barron’s