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Rough Road Ahead for Microsoft (MSFT)

It's uncertain whether MSFT can transition to being a device company


Along with weakness in other PC and “old Internet” names, the king of the desktop, Microsoft (MSFT), reported its messiest quarter in memory Thursday.

It’s worth going into a little detail on Microsoft: Total revenue of $19.9 billion was almost $1 billion short of the consensus estimates, and it was driven by almost every part of the business, including its horrible tablet Surface and even its server and tools division, and Xbox.

The earnings miss was massive, as Microsoft reported EPS of 56 cents, which was well shy of the consensus expectation of 78 cents per share. Part of the reason was a $900 million inventory chart for the Surface tablet. Overall, the 15 cent miss was a result of both a revenue shortfall and higher cost of goods sold and operating expenses.

Side note: About 20 years ago, I was a partner in a small skiwear business with a French manufacturer whose principals had been in the apparel business for several generations. I will never forget my first meeting with him, as he explained the economics of the clothing industry. He said, in his thick but charming French accent, “Inventory is death.”

What he meant is that distributors and retailers have to buy and finance their clothes to sell in the next season. If they are wrong, they have to eat the costs as all unsold merchandise has to be sold at heavy discounts to clear your warehouse for the next season. So having too much inventory is “death” to a small business, and you have to do everything in your power to be right — or be carted off.

Well, the same goes even for large companies even though it is easier for them to finance their mistakes. The reason it is so interesting for Microsoft, though, is that it has always been a software and software services company for the most part. Software companies have fantastic profit margins because they don’t have to carry any inventory. When customers want the software, it is essentially created from thin air — even more so now that updates are delivered digitally rather than on CDs.

So now Microsoft seems to want to transition into being a device company, and that means it has to learn to deal with the agony of unsold inventory and a much more unstable level of COGS (cost of goods sold). Microsoft execs always think they are the smartest people on the planet and can deal with anything through sheer force of intellect, and they are learning now, for the umpteenth time, that is not the case. It’s really hard to be a device company like Apple (AAPL) and it takes a special corporate culture. I think MSFT will find it very hard to make the transition.

MSFT was down 5% in the afterhours trading, so it’s a bit late to short now but I will look at it for a short if it rebounds back to recent levels. It’s going to be a long year for the Redmond giant as it adjusts painfully to the new course its management has set.

InvestorPlace advisor Jon Markman operates the investment firm Markman Capital Insight. He also writes a daily swing trading newsletter, Trader’s Advantage, which aims to capture profits of 15% to 40% and often as much as 100% to 200% in less than 90 days. 

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