During the past two years, software developers in Redmond, Wash
., have been fine-tuning the millions of lines of code that comprise Windows 8, the latest version of Microsoft's (Nasdaq: MSFT)
ubiquitous software operating system. It's been an ambitious task, as Microsoft has developed various flavors optimized for the proliferating number of computing devices. There's even a version for smartphones and tablet computers.
Judging from surveys in the tech community, the major software push has been a success. The various flavors of Windows 8 have been quite stable, when compared to previous versions, and offer an impressive array of features.
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Trouble is, Windows isn't being judged against preceding iterations. It's being judged against very impressive software platforms being offered by Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG) and others. As a result, the bean counters at Microsoft can no longer simply sit back and count the cash coming in from the regular Windows upgrade cycle it once enjoyed during the 1990s. In fact, there may not be much of an upgrade cycle at all -- at least according to short sellers.
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Since early November, concerns have been growing that lofty expectations for Windows 8 won't be met. Short sellers have taken note: The short interest rose 11% to 110 million shares in just the two weeks ended Nov. 15 (data were released Nov. 27). It's worth noting that on Nov. 13, two days before the data were compiled, Steven Sinofsky, president of the Windows division, was let go. It's unusual to see such a high level departure just weeks into a major new product launch.
It's pretty hard to overstate the importance of the Windows franchise to Microsoft. Apple and Google have copied the company's business model by developing an operating platform that can host a wide range of ancillary services. If Windows loses market share -- and mind share -- then that bodes ill for the company's other divisions.
Looking for clues
In coming weeks, investors will be seeking any data points to help clarify how the new Windows launch is proceeding. The company has been touting the fact that roughly 40 million copies of Windows 8 are now in circulation, though it appears that a large number of those are simply pre-loaded by PC makers that have yet to actually sell the computers to end-users.
In a troubling sign, research firm NPD Group notes that Microsoft-based PC sales fell roughly 20% in the past four weeks, compared with a year earlier. Though some of those PCs were pre-loaded with Windows 7, demand for Windows 8 computers was likely equally lackluster. This may underscore the short sellers view that tablet computers will continue to take market share away from PCs. Can Microsoft take meaningful market share in tablet computers from Apple and Google? It's simply too soon to know, but such gains are essential if Microsoft is able to offset the persistent weakness in PC sales.
Microsoft operates on a fiscal year that ends in June, so results for the current quarter will appear fairly early in earnings season. At that time, the company will likely discuss an enthusiastic response from consumers, yet it's the numbers -- not the hyped story -- that you'll want to track. Analysts had been anticipating roughly $22.5 billion in sales and earnings of about 90 cents per share for the current quarter, though those figures have been slowly trending lower as the quarter has progressed.
Yet short sellers aren't necessarily focusing in the immediate uptake by consumers. Instead, they are focused on the much more important corporate market the Microsoft ecosystem still predominates. And in that sphere, there is cause for concern. Coming out of the Great Recession of 2008, companies upgraded to Windows 7, and are generally pleased with the functionality and stability of that iteration of Windows, according to Gartner Group. The tech research firm predicts only 20% of enterprises currently using Windows 7 will have migrated to Windows 8 by 2015, which would mark the slowest upgrade cycle in Microsoft's history. The company has typically seen at least a 50% upgrade rate, three years after a new version of Windows has launched.
Analysts at Citigroup don't agree that a slow uptake is the result of a disappointing product. Instead, Microsoft is simply falling victim to a seismic change underway in computing. "Our view remains that initial lackluster demand for Windows 8 PC is a sign of a transition underway towards touch-enabled hardware that will take some time." Of course, the investment community is known for patience when it comes to stock-picking.
Risks to Consider: As an upside risk, the total embrace of the tablet computing opportunity could again make Microsoft relevant to the consumers who have more recently embraced Apple and Google.
Action to Take --> Did Microsoft make a leadership change in its Windows division because the early uptake for Windows 8 was weaker than expected? That's likely what short sellers anticipate, but it is still too early to draw such a conclusion. We'll get a better read on the Windows 8 launch when quarterly results are released in January. And we'll also soon hear about 2013 budget priorities from major information technology departments. If Gartner is correct, then Windows 8 will not be a major priority for many companies, which could spell trouble for the stock.
If you own shares of Microsoft, then you need to take note of the fast-rising short position. Track the ongoing progress for Windows 8, and if it appears that demand is lackluster, then it may be wise to exit the stock before short sellers really profit.
-- David Sterman
David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.