Should Microsoft Investors Be Worried About the Bottom Line?

By Timothy

Shares of Microsoft took a dive after the company reported its quarterly earnings in late January. While revenue grew by 8% year-over-year, earnings per share slumped, continuing a trend that has now persisted for four straight quarters. So what is driving these earnings declines? And, more importantly, should Microsoft investors be worried?

A changing companyThe worst-performing segments for Microsoft during its fiscal second quarter were its bread-and-butter licensing businesses. Revenue from the Devices and Consumer Licensing segment fell by a whopping 24% year-over-year, while Commercial Licensing fell 2% after posting robust growth in previous quarters.

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These licensing segments also carry the highest gross margins, so any revenue declines are bad news for the bottom line. However, total gross margin actually grew during the quarter, thanks to the addition of the phone business and a vast improvement in the profitability of the cloud segments. The Commercial Other segment, which includes Azure and Office 365 for businesses, grew revenue by 46% year-over-year, while gross profit more than doubled.

These cloud businesses are still small relevant to the licensing segments, but it is clear that the dynamic is shifting at the software giant. One thing to note, though: If it were not for the phone business Microsoft acquired in 2014, both revenue and gross margin would have declined for the quarter.

Shrinking by the day?Why is Microsoft having trouble growing revenue and profits? One reason is the end of Windows XP support, which helped drive sales of new PCs and upgrades for old ones, has fully run its course. Microsoft ended official support for Windows XP last April. In the lead-up to that date and afterwards, businesses scrambled to move to newer versions of the operating system, boosting the commercial licensing business. A subsequent decline from that level of demand should not be all that surprising.

Another reason is likely the upcoming launch of Windows 10. Consumers could be holding off on new PC purchases, waiting for the new OS to free them from Windows 8, which has had a public perception problem since it first launched. Microsoft recently announced free upgrades to Windows 10.

The shift from traditional Office to Office 365 is also a culprit. While Office sales weakened, subscription revenue from Office 365 soared, both in the consumer and commercial segments. In total, the commercial side of the business actually grew, with improvements in the cloud business, as well as server products, making up for weakness elsewhere.

Should investors be worried?Nothing mentioned above spells doom for the company. The results appear worse than they really are simply due to the fact results from the prior period were especially strong.

There are two other issues that drove down earnings as well, and both reinforce this idea. Microsoft took a $243 million restructuring charge in the second quarter related to previously announced layoffs, reducing the EPS by $0.02. Microsoft also had a far higher tax rate during the quarter, 25% versus 17% in the same quarter last year. This was mostly due to a tax charge from an IRS audit adjustment, which further reduced EPS by $0.04.

These are both one-time items, and adjusting for them reduces the EPS decline from $0.07 to just $0.01 year-over-year. Operating income actually grew year-over-year, backing out the restructuring charges, and since the phone business is unlikely to be generating much, if any, operating profit, this is the number investors should be focusing on.

The market seems to have overreacted to the earnings report. The stock is now down just over 15% from its 52-week high in November, but nothing has really changed at the company. According to data from S&P Capital IQ,Microsoft now trades at a cash-adjusted P/E ratio of about 13 times, not a bad deal for a dominant brand like Microsoft.

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Timothy Green has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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