Smartphone and tablet foray is yet to produce results
Microsoft’s (MSFT) acquisition of Nokia played a large role in its foray into the tablet and smartphone segment. In spite of Nokia being a respectable brand in cell phones at one time, it failed to charm customers in the current ever-changing and burgeoning smartphone space. Microsoft rebranded the Nokia Lumia phone as Microsoft Lumia. It is not yet clear if Microsoft will make any changes to the phone to keep in pace with the Google (GOOGL) Android and Apple (AAPL) iOS. However, it is likely that the tablet and smartphone section will likely cause a dent in its margins. Earlier, Microsoft reported gross margins in the range of ~70–75%, which has come down to 64–65%. Reduction in margins also implies that the focus of Microsoft is actually changing from software to consumer hardware and cloud. It is to be seen if the rebranding of the Lumia phone will result in wider acceptance or not.
If Microsoft addresses its concerns, it will benefit exchange-traded funds (or ETFs) such as RAFI Fundamental Pure Large Growth Portfolio (or PXLG) and Technology Select Sector SPDR (or XLK), which have significant exposure to the company.
Increased contribution of cloud revenues may lead to shrinkage in company’s margins
With the arrival and increased adoption of cloud computing, the need for data centers has risen exponentially. The infrastructure cost of building data centers to support the cloud system is significant. Microsoft (MSFT) has been aggressive in expanding its presence in cloud space with cloud services being repeatedly cited as the primary focus of the company.
To read in detail about the cloud model, please read Market Realist’s series Why cloud business models differ from on-premise software.
As the above chart shows, cloud is usually associated with lower margins, thereby leading to lower returns on invested capital. Lower margins mean lower profitability, consequently impacting share prices of the company. Rising contributions of cloud revenues and its associated benefit could be offset by the contraction in its gross margins. Cloud reduces the cost of ownership and usage of technology, thus posing a threat to leading software companies that to date have been deriving the majority of their revenues from subscription licensing.
To read in detail about cloud computing, please read Market Realist’s series A must-know overview of the cloud computing business.