A lot has been written recently about troubles that Microsoft (NASDAQ:MSFT) is having in the consumer technology market. This includes the company's miniscule market share in smartphones, despite strong efforts in the past year with WP8 and the generally positive reviews it has received. Improvements have been notable in the good initial growth of the Nokia (NYSE:NOK) Lumia line. Even so, the company has not been able to gain more than a few percentage points in total market share. As of Q4 2012 shipments, MSFT still only had 2.4% OS market share, a distant 4th place behind Google's (NASDAQ:GOOG) Android, Apple's (NASDAQ:AAPL) iOS and BlackBerry (NASDAQ:BBRY). Also the rise of tablet computing in the past few years has put a continued pressure on PC sales, which has had an impact on the sales growth potential of Windows OS licenses. With the recent release of Windows 8 and beginning of the subsequent upgrade cycle, FY13 Q2 revenues did increase 11% at the Windows division. However, this is not very exciting when you realize that this also includes sales of new products (Surface RT and Pro tablets), and lots of doubts have been raised about the lackluster consumer uptake of the new OS, with some pundits even comparing it more to Windows Vista rather than Windows 7.
Looking at the rest of 2013 in the consumer markets, the position of Microsoft is still quite uncertain as PC sales are forecasted to decline more than 1% in 2013 according to IDC, despite the uptake of Windows 8. Also with the continued strong competition in the smartphone and tablet space, it is not clear at all whether Microsoft can capture significant growth and market share.
However despite all of this, I still believe Microsoft is an excellent value today and investors should not be worried about the company's future. The reason is simple really, and that is the sad but true fact that most financial journalists and media pundits focus too strongly on flashy consumer products (phones, tablets, etc), and fail to rightfully acknowledge where the real strength of the company is - namely from within the Enterprise.
Looking at the competitive moat and growing strength of the Microsoft ecosystem in the snail-paced enterprise world, it quickly becomes clear that the valuation from this perspective is truly compelling.
Microsoft is Quietly Building a Powerful Communication & Collaboration Ecosystem in the Enterprise
Virtually all office workers are well versed in the MS Office suite. There is probably no monopoly stronger in technology today. What not everyone is aware of however, is how Microsoft is quietly expanding this to create a social and communication stronghold on the enterprise market. Recently, the company has purchased Yammer for $1.2B in 2012 and Skype before that in 2011 for $8.5B. The company now controls all of the popular major communication tools which are used in the enterprise, namely: Yammer, Lync/Communicator, Skype, Microsoft Instant Messenger. The last one is now being phased out and fully merged with Skype. As a social micro blogging and collaboration tool, as early as 2010 Yammer was being used in 80% of the Fortune 500 companies.
As an IT Consultant, I can tell you that the combination of all of these tools with the MS Office Suite for increased productivity is a competitive advantage that nobody else can offer on the market. Currently, I work heavily with MS Sharepoint which is Microsoft's enterprise content management solution (ECM). For those of you who are not well versed in the IT world, these solutions allow large organizations to store, manage, and share their unstructured content across the enterprise. This consists of all types of MS office documents, images, text files, application specific files, emails, etc. With the current growth in data expected to be an astounding 4300% until the year 2020 according to CDC, it is very important that enterprises have a very good vision and strategy on how to manage and classify properly their high value content. This is especially true with global organizations which need to collaborate and share this information in the most efficient and cost effective way across different locations, time zones, cultures, languages, etc. In the pure ECM market, there is a lot of competition from other major vendors, including the likes of OpenText (NASDAQ:OTEX), EMC (NYSE:EMC), and IBM (NYSE:IBM). Looking at it from this angle only, all of these tools offer comparable services or in some cases arguably better functionality than MS Sharepoint.
However Sharepoint has a couple of compelling advantages which make it particularly appealing for many enterprises, and should continue to drive strong growth in the years ahead. First, it has always offered a more visual UI which makes its product inherently more appealing to many users. Many companies use Sharepoint also as a web portal and not just for content management. Secondly, and I think much more importantly, from a productivity standpoint Microsoft can offer a lot of compelling advantages which its ECM competitors cannot - specifically near-seamless integration with MS Office and Exchange since they are all Microsoft products. Since virtually all organizations use MS Office for business productivity and Exchange for email, this makes collaboration with a suite of these tools much more appealing to very large global Fortune 500 companies. This is a large part of the value story that has led to my current client as well as the company I work for to adopt the combination of Sharepoint, Exchange, MS Office, Lync/Communicator, and Yammer on a massive scale (in both cases >100k employees). This is a powerful ecosystem which I don't think any other competitor can currently compete with Microsoft on. The value proposition of concepts such as complex content storage and management, business process design, big data analytics and CRM are strengthened when the technologies delivering these capabilities are able to seamlessly intertwine with social collaboration and productivity tooling. This is exactly what the Microsoft ecosystem can now bring in the enterprise.
Looking at the numbers, The Business Services Division saw revenue increases of only 3% in the most recent quarter, however, this is somewhat impacted by weak consumer PC sales as about 20% of revenue comes from this. Most importantly, renewal rates for MS Office are near all-time highs and bookings saw an impressive 18% growth including 10% growth in multi-year license renewals. Exchange, Sharepoint and Lync saw double-digit growth with a huge 35% increase in Lync. This further backs up the compelling value story I've described above in the productivity combination of using these tools together.
Cloud Computing Adoption Strengthens Microsoft's Enterprise Ecosystem even Further
The Server and Tools division of Microsoft grew revenues by 9% in the most recent quarter with multi-year licensing deals and customer bookings both growing in the high-double digits. With continuing strength and growth in Cloud Computing expected in the next decade, Microsoft should continue to see above-average growth in this segment. The competitive advantages here are strong as well - namely because organizations have slow upgrade and renewal cycles for these technologies and services and the switching costs are huge. Customers which are undertaking multi-year projects to adopt Windows Azure as their cloud platform for productivity (Office 365, Sharepoint, Dynamics, etc) are not about to switch to another vendor. With the various forms of Cloud computing expected to grow at CAGR rates between 18-40% in the coming 5 years, Microsoft will continue to be well positioned to take advantage of this. The growth could be bumpy due to variations in corporate IT spending from year to year, but I do expect a long-term growth rate of about 10% to continue.
Putting a Value on the Enterprise Business Segments
So looking at the growth prospects and strong ecosystem that Microsoft has built in the enterprise, how much is this worth? Both the Business Division and Servers and Tools can be expected to grow quite predictably in the coming 5-10 years, just as they have previously. The Business Division has grown revenues from about $10B/year in 2002 to around $24B in 2012. Looking at recent trends, coupled with a strong share repurchase policy we can reasonably assume an 8-10% growth of FCF going forward in this division. It's a similar story in Server and Tools, which has actually grown faster in the past 10 years than the Business Division. Revenues have increased from about $5B in 2002 to more than $19B today, which is closer to a 12% CAGR. Putting these two divisions together, I think we can safely assume a 10% growth rate in FCF. In the past year, Microsoft had a FCF of about $27B in total, of which more than 50% was attributed to these 2 divisions. Assuming 50%, this is $13.5B, which is $1.61/share. Discounting this at a 10% rate and you receive a value of around $27/share.
The Bottom Line
With the current market price for the entire company just over $28.60/share this is quite compelling. Granted the Entertainment & Devices and Online divisions do not currently contribute much to the bottom line. Although for sure there is some growth potential there as well, as Bing! is doing much better as of late, and a new Xbox will arrive soon. However, the Windows division can still be expected to grow somewhat, and at the very least remain a relatively stable cash cow. There is some threat here as PC sales are increasingly cannibalized by tablets, but even if you assume FCF growth in the Windows division slows to near 0% long term you are still looking at a value of about $14/share for Windows alone. This would bring the value of the entire company north of $40/share, which would represent a fairly attractive margin of safety from current levels.
More and more global companies are buying into the enterprise productivity value proposition and joining the ecosystem, which is clearly evident from the growth in some of the peripheral communication tools such as Lync, which grew at 35% in the most recent quarter. In addition, strong growth in enterprise cloud computing will continue to lift Server and Tools at a healthy rate. The high level of complexity and implementation costs of these projects, further supported by double-digit growth in multi-year license agreements really presents a strong moat and margin of safety. The current market is underestimating the staying power of these divisions, and as a result you get the rest of the company more or less free. Although likely past its heyday, Windows as an OS is not going away anytime soon and the value of this unit alone added to the enterprise focused business means that the company is undervalued by at least 30%, not even counting the net $6/share in cash on the balance sheet.
I predict investors with a multi-year time horizon will be well rewarded in the long run with Microsoft.