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Tech Takeaways From a Rocky Week

Jason Stipp
Jeremy Glaser

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five.

This week, earnings were dominated by tech giants with several notable takeaways for investors. Here to offer the details is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for joining me.

Jeremy Glaser: Jason, glad to be here.

Stipp: So, what do you have for the Friday Five this week?

Glaser: We're going to talk about Microsoft, price-matching, Go-ops-le, Verizon and finally, we'll talk about someone who might have a little bit more time on their hands to play with their technology.

Stipp: Microsoft this week released earnings, and it was a weak quarter. Some folks are saying, well Windows 8 is coming out, so a lot of people were waiting to buy products until that release. Is that the whole story, though?

Glaser: Microsoft had a weak quarter, and like you said, it was expected to be a week quarter. This wasn't a big surprise, given that they have this product cycle that's just getting ready to get started, but I think the slowdown in PC sales is more than just the fact that there is new operating system coming out.

Consumers are really shifting away from buying new laptops, buying new desktops, and into mobile devices. They are going out and getting that iPad or that other Android tablet. They are going out and just using their smartphone, and they feel like they just don't need to upgrade as quickly. Corporate budgets remain relatively tight. People aren't out buying huge numbers of new PCs.

I think Microsoft is really banking on Windows 8 driving people to the store, but it's not clear that that's exactly going to work out. If you remember Windows Vista was supposed to do something similar, but consumers kind of took a look at the new operating system, decided it wasn't that much more exciting than Windows XP, businesses as well, and decided not to make that big switch.

Windows 7--the successor to Vista--has been extremely successful. People really enjoy using it. Given that Windows 8 has a big user interface change that will take a fair amount of learning curve to get people up and running, it could be sometime before we see huge adoption rates of it.

I think Microsoft sees that PC sales are slowing. They are trying to combat that by coming out with things like their Surface tablet, which we got pricing on this week. They are really trying to sell it as a premium product. We'll see if they are able to make inroads in that space. But certainly slowing PC sales is going to be a problem, or certainly a headwind, for Microsoft for a while just as it was in Intel's results as well.

Stipp: One area of the market where tech has had an impact is the retail sector, brick-and-mortar stores trying to compete with Internet retailers. We got some news this week from Target. It's the latest join some other companies trying to combat the Internet threat. What's your takeaway on that strategy?

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Glaser: Impact might be an understatement. I think Amazon really is just this huge goliath that is fighting these brick-and-mortar retailers, who are worried about becoming showrooms, where people come in, take a look at this flat-panel TV, take a look at even basic goods, seeing what they like and then going onto Amazon and ordering it. And that problem is just going to get worse.

Amazon is committed to rolling out more same-day delivery or next-day delivery to make it even easier for consumers to get some of those basic staples without even having to wait, say, a week or even three or four days to have it or arrive at their doorstep.

So, to try to combat some of this, Target and Best Buy and some other retailers are going to say, if you can show us an online price for the exact-same product, we'll go ahead and match that; we're not going to allow them to take that price advantage away from us.

This is a risky strategy. Certainly, people are going to the stores because of the convenience, they are going because they like to hold the goods, and trying to come down on price might get rid of some of the "showrooming" in the short term, but over the long term, online has some structural advantages that just make it easier for them to continue to provide that low price--they can keep pushing prices down. It's going to be challenging for those [brick-and-mortar] retailers. They are going to have to find other ways to survive, make it a more compelling experience to buy those goods in the store in order to get people there over the long term instead of just price-matching over the holidays and hoping that people will stick with their old habits and buy at the brick-and-mortar.

Stipp: Google reported earnings a little bit earlier than expected. They made up for that surprise by having a bigger surprise that was negative for the market, and the stock took a hit. What's your take on the Google story? Why were those results so disappointing to folks?

Glaser: Google definitely had a double whammy on Thursday. First, their Financial Publisher, RR Donnelley, accidently released a draft of their earnings statement, and when investors got a look at that, they weren't all that happy, and the stock started to sell off fairly rapidly. It was down over 10% at one point.

Investors just were not very happy with Google's performance. And I think there are few key areas. The first was that, in their cost per click, how much they are getting paid for every time someone clicks on an ad, that went down much more sharply than people had expected. Expenses rose faster than a lot of people had hoped, as Google launched a new Android tablet, and they put some marketing muscle behind that.

People were also concerned about the Motorola business. Certainly, it's not a business that Google has had for a long time. They are going to have to make a lot of changes, cut some costs there, but it's, I think, now clear that it's not going to be an easy turnaround--not that anyone thought it would be easy, but that it’s going to be a while before it's really going to be a contributor to the bottom line or that Google really sees the benefits of having this hardware business, and they can really put their imprint on that business. It's not something that's going to happen very quickly.

So, our analyst Rick Summer looked through all of this, and he thinks the competitive advantage for Google is certainly still there--that no one is going to come in and challenge them in search or challenge them on text ads. It's not an area where they are really going to see someone kind of come out of the shadows. But certainly their long-term profitability might not be quite as good as people had initially expected, that they are going to have to probably invest more in Motorola, invest more in other places of their business than maybe some investors had initially expected. I think that had a lot to do with the big sell-off.

Stipp: A bright spot in earnings this week, Jeremy, was Verizon; they had a very good quarter. What are some of the dynamics behind their customer base and why they're doing so well right now?

Glaser: Our analyst Mike Hodel called the quarter "superb" and it's very difficult to disagree with that assessment.

Verizon Wireless really is powering Verizon. They saw their Wireless revenue increased by 7.5%--margins looked really good as well--as those valuable postpaid customers continue to flock to Verizon. They're signing up for expensive data plans, expensive unlimited texting, unlimited voice plans, and they're willing to shell out quite a bit of money in order to connect all of their devices through the Verizon network.

I think when you look at just how strong their earnings are and how much cash flow they are producing, I think it shows you why there is so much urgency among some of the second-tier players, such as Sprint and T-Mobile, to gain that scale and to gain those postpaid customers, because they see the economics of it are just so attractive.

I think that's a lot of what is happening with that Softbank deal with Sprint that we've talked about over the last couple of weeks. It's a lot of the reason why T-Mobile and MetroPCS are getting together to try to build that scale--even though they'll have a lot of prepaid customers as well there--to try to convince people that they have the network quality, that they have the technology, that they have the best handsets to really get those very high-valued customers.

I think the battle for those customers is going to continue in the years to come, just because there is just so much cash there, and so much opportunity to make money.

Stipp: One likely postpaid customer who will probably have more time for browsing on his mobile devices is Vikram Pandit. He is out of Citi. We learned that this week. What is the detail behind that ouster?

Glaser: That was a big surprise. Probably with Google, those are the too big surprises of the week, because Citi reported respectable earnings on Monday, and then the next day Vikram Pandit suddenly resigns. We're not exactly clear what the story is, but it seems like he clashed with the board a little bit, that the board just thought that he wasn't the right person for the job, that he just wasn’t impacting the change in getting Citi back to their basic banking roots quite fast enough.

They replaced him with someone who ran the Middle East and Europe part of Citi, and most recently also was in charge of Citi Holdings, which was the bad bank that held a lot of the assets that Citi was trying to get rid of. I think the board was hoping that the new management team is going to have a better relationship with regulators, maybe allow them to execute on their capital plan, increase their dividend, do things like that, and will really help to get back to the core of what Citigroup could do and help grow those potential core earnings.

It's still a huge company. It's not something that can turn around on a dime. I think it wasn't that Pandit was doing a particularly bad job, just that the board had the independence to think that they could do better in another direction, and they went ahead and exercised that option.

So, we’ll have to see what it means for Citi shareholders, probably not a big radical change, but certainly one to watch.

Stipp: Jeremy, always insightful to plug in to your thoughts on the week. Thanks for joining me.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.