– Google and Microsoft both whiffed on 3Q12 but the results say little about either firm’s ability to deliver against longer term opportunities – both are positioned to win in the new emerging paradigm.
– Google pulled an IBM and pinned its miss on currency, but the soft economy, Motorola, the costly Nexus7 launch and a mix shift from Google sites to partners were also painful.
– Investors are fixated on cost per click, with the 3% QoQ hit raising questions on the monetization of mobile. Google doesn’t see it that way and expects strong future growth from portable platforms.
– Microsoft’s weak 3Q is hard to evaluate ahead of the 4Q new product roll outs. Based on IBM and Intel, IT demand is probably flagging, but a strong Windows8 upgrade cycle could power through it.
Someone at R. R. Donnelley screwed up my lunch yesterday by precipitating the oddest pre-release that I can remember. The big Google miss hit the tape and festered there until management could halt trading with the stock already down 9%. Explanations were not proffered for a few hours, and even then, Google stuck to its “less is more” philosophy of guidance. Shortly after market close, Microsoft joined the party by lobbing its own 3Q12 miss into the punchbowl next to Google’s. On the heels of poor results from IBM and Intel on Tuesday, what is a tech investor to think?
Google management was quick to point out that currency had hit its legacy revenues 4.6% YoY and 1.1% QoQ, making its adjusted revenue growth a more robust sounding 24% ex Motorola, an explanation/excuse that echoed IBM two days earlier. The strengthening dollar is also reminds us that despite our own economic problems, it is worse in other parts of the world, where Google derives more than half of its revenue. In that context, perhaps 19% growth in an advertising driven business model shouldn’t be a disappointment. The acquisition of Motorola didn’t help either, with a $527 million loss for the quarter knocking $1.58 off of quarterly earnings. Google’s in-house hardware design, the Nexus7 tablet, undoubtedly also lost money for the quarter on razor thin gross margins and a variety of launch costs.
Investors zeroed in immediately on Google’s advertising cost per click (CPC), a measure of the average pricing that Google is receiving for its advertising. CPC has been trending down for several quarters, offsetting continued robust growth in the number of ads that Google has sold. The conventional wisdom is that the CPC slide is directly caused by the shift from PC platforms to mobile platforms, which are believed to yield much lower prices. The fear is that this gap between desktop and smartphone advertising is permanent, an assertion that Google categorically denies. Given that search advertising rates are generally determined at auction, I suspect that a weak economy has a direct impact on bidding behavior, even though the growth in the number of bidders is evident in the growth in the total number of ads. Within this process, mobile ads – as new and relatively untested properties on the bidding block – may be seeing particularly cautious bidding. Google argues that the intrinsic properties of mobile ads – location awareness, proximity to the point of purchase, etc. – should make them MORE valuable as typically conservative buyers get more comfortable with them. Instead, management points to a mix shift toward ads sold to its network of partner sites at lower prices as the bigger factor in the 3Q12 dip in CPC.
None of this puts a dent in Google’s biggest assets. Google has built the biggest and most technically sophisticated distributed data processing infrastructure on earth, giving them substantial cost and performance advantage for the processing and storage intensive applications that are driving the TMT sector forward – applications like video streaming, maps, social networking, big data, e-commerce, even search. Google has also nurtured Android into the world’s number one smartphone platform with better than half of the global market and more than 500 million users. Today, Google monetizes these assets through advertising, most of it coming from search, but the potential levers go far beyond CPC. Given this perspective, a 3% sequential drop in ad prices on the back of the 1% rise in 2Q does little to change our basic bullish long term thesis.
After the Google drama, Microsoft’s miss was a bit of an afterthought. It’s a given that Mister Softy is suffering through the same PC slump and enterprise data center slowdown that plagued Intel and IBM, but unlike those other two stalwarts of the old paradigm, Microsoft has big plans for 4Q. Windows 8, Windows Phone8, Windows RT, Office 2013, Outlook.com – Microsoft is refreshing ALL of its major software platforms at once over the next few weeks. In addition, the high profile Surface line of Windows 8 tablets – self designed and branded by Microsoft as a showcase for its debut as a new paradigm platform player will hit the stores, along with flash new smartphones from Nokia and HTC. With all that excitement ahead, management is hoping that 3Q12 will be forgiven.
Part of the 3Q12 miss comes from revenue associated with pre-orders for the big upgrades being pushed back into 4Q. $800M of the $1.3B in deferred revenue posted was from Windows 8 pre-orders and 40% higher than pre-order volume for Windows 7. Also within the $1.3B number was $138M from an Office upgrade offer. Moreover, some of the 33% YoY decline in the Windows division is due to customers holding back on Windows 7 purchases to wait for the new release. Still, adding back the deferred revenue, the Windows division would still be down -17% YoY, a reminder that upgrade or not, Microsoft must still navigate the decline of the traditional PC.
In the enterprise, Microsoft is showing more strength than either IBM and Intel, driven by its prowess in the cloud. The server and tools division, now the second largest division and contributing 28% of revenue, was up 8%, with SQL server sales over 20%. SQL is a widely used business intelligence database with some elements in the cloud. Microsoft Business Services on the other hand, is a bit difficult to read into since revenue from Office is usually booked there and is set for a reboot in the coming weeks. Adjusting for the impact of Office, top line revenue growth within that division was relatively flat. On the advertising side, the Online Services division reported 15% growth in advertising driven by search growth and still not enough to offset that division’s losses. Microsoft’s Online Services division hasn’t made money since 2006.
After all the puts and takes, Microsoft failed to meet 3Q12 expectations, but the big launches in 4Q12 will make or break the stock in the near term. Despite the Windows 8 hype, expectations are not too out of whack for 4Q12 and Microsoft might even beat them. I think, however, that investors may be placing too much importance on the near term reception for the new platforms. It may be that consumers will need more time to warm to the excellent and differentiated Windows Phone 8 experience, particularly given Microsoft’s long history of failure in the smartphone market. It may be that evaluation periods for Windows 8 will be longer given its departure from the traditional Windows experience, and that broad adoption of Windows 8 tablets will also play out at a cautious pace. However, even if the next two months of sales for the new platforms are disappointing, no company is better positioned to lead enterprises into the tablet/smartphone world than Microsoft – iOS is closed and expensive, Android is fragmented, and neither Apple nor Google will support legacy applications, manage security, or enable customization the way that Microsoft will. It will be far, far more difficult for companies that do not even call on enterprise customers to make inroads on Microsoft’s home turf than it will be for Microsoft to gain traction with carriers and consumers.
For our full research notes, please visit our published research site.