Seeking Alpha
Long only, deep value, registered investment advisor, portfolio strategy
Profile| Send Message|
( followers)  

Microsoft's (NASDAQ:MSFT) competitive environment is somewhat reminiscent of Rome in the 4th and 5th centuries when the barbarian hordes were at the gates of the great empire. Instead of the Huns or the Visigoths, Microsoft is dealing with the likes of Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) which have beaten Microsoft to the punch in mobile and touch, threatening the grip of Microsoft Windows and its lucrative operating systems business. While the early skirmishes have been lost, I believe that Microsoft is in the midst of a radical and broad offensive that should lift profits significantly over the next several years, and ultimately set the stage for wonderful gains in the stock. The majority of Microsoft's businesses are picking up market share, but because PC sales are in free-fall, obscuring market participants' perceptions of the company, investors have the opportunity to buy the stock at a deep discount to its intrinsic value with a strong margin of safety.

Watching market participants and television pundits' obsession with Apple harkens back to the late 90s tech craze when Microsoft, Intel (NASDAQ:INTC) and Dell (NASDAQ:DELL) were kings. The psychology of a relatively short-term slide in stock price on a glamor stock leads to tremendous negativity, and often nonsensical decision making. In the case of long-term Microsoft investors, 13 years of lackluster stock performance obscures solid business performance, and colors perceptions on the future investment potential in the stock. Even a relatively fast growing business like what Microsoft has been over the last 13 years will struggle to keep pace with a stock that is trading at 80, 60, or even 30 times earnings. Smart businessmen buy businesses in recessions or times of extreme pessimism, which sets the stage for a bargain purchase price. Think about Wells Fargo's homerun (NYSE:WFC) acquisition of Wachovia or John Malone's de facto controlling purchase of Sirius Radio (NASDAQ:SIRI) in the Great Recession. The time to buy Microsoft is when blood is in the streets and the wolves' frenzy is preventing investors from seeing the whole picture.

I believe that Microsoft is quietly beginning to become the dominant cloud based provider of software as a service. Office 365 is an extremely exciting concept where businesses can constantly have access to the newest Office version through a subscription service. This change has ramifications for revenue recognition because the company doesn't book the full license sale up-front, but instead it provides a recurring revenue stream, and I believe that it can potentially further deepen relationships with the customer. In addition Microsoft is developing the Windows Blue software as a service platform, which will regularly update the Windows platform. This dramatic change in how Microsoft delivers its products is very attractive for the company and for consumers. Microsoft can now adjust its offerings based on customer feedback, reducing the negative stigma associated with misfires such as a Windows Vista, which damage the brand and lead consumers to seek alternatives. Windows 8 has a lot of attractive features and was a necessary development in an increasingly touch-driven computing environment, but Windows Blue will allow the company to aggressively modify the offering based on consumer needs and requirements. Microsoft has often had several years go by before being able to make a significant upgrade to its Windows operating system, despite plowing huge percentages of revenue towards R&D, but now the company can continuously build upon its moat through continual innovation that is more responsive to this dynamic technological environment. Microsoft management mentioned that one in four of its enterprise customers now have Office 365, and the business is on a $1 billion annual run rate. I believe the combination of the conversion of former Windows XP users to other Microsoft operating systems and the shift towards Windows Blue will accelerate the continued adoption of new platforms by its key enterprise customers.

Intel is releasing its Bay Trail Atom processor later in the year, which promises to deliver tablets and hybrid PCs with extended battery-life and lighter mainframes at more affordable price-points. I've visited a lot of different stores and have also shopped online for various tablets and hybrids, and I believe the Surface Pro is the most attractive option that I've seen thus far. The key problems with it are low battery-life, a high price-point, and the distribution is much more limited than most of its competition. The positives are that the devices offer incredible performance and a wonderful looking design, far superior in my opinion than the other hybrids I've seen or tried. Most of the other hybrids are too heavy or have unattractive designs, but the Surface is light and sleek. I believe the Surface was more or less an effort to highlight the potential of Windows 8 to push the key suppliers to enhance their efforts, but the price point is intentionally high so that the company doesn't completely alienate its partner manufacturing companies through cannibalizing sales. I believe this is also a big reason why Microsoft hasn't materially enhanced its distribution network for the products because right now it is very difficult to procure one, unless you have a Microsoft store nearby, or if you are willing to order the device online. I recently went to a Best Buy (NYSE:BBY) mobile store in Miami Beach, and they carried the Windows RT in-store, but for the Pro, the consumer would have had to order it for delivery and it wasn't available to physically try out. Because software is the secret sauce to Microsoft's long-term profitability, it doesn't make sense to disrupt the whole hardware supply chain by coming in with a much lower price-point, but I believe the stage is setting for a much more diverse and dynamic mobile computing market, where Microsoft has a much better chance of stealing market share. Intel's lighter and more efficient chips should serve as the catalyst that sparks enhanced innovation.

On April 18th, Microsoft reported relatively strong results for the 3rd quarter. Revenue was up 18% YoY to $20.489 billion, operating income was up 19% to $7.612 billion, and diluted earnings per share were up 20% to $0.72. Adjusting for special revenue recognition on upgrade offers and a $733MM European Commission fine, revenue was $18.831 billion, operating income was $6.687 billion, and diluted earnings per share were $0.65. Net income was $6.055 billion in the 3rd quarter, up from $5.108 billion in the 3rd quarter of 2012. The Microsoft Business Division had $6.32 billion of revenue, which was up 8% YoY. Adjusting for the net recognition of revenue related to the Office Upgrade Offer and Pre-Sales, the division's revenue increased 5%. Multi-year licensing revenue grew 16%, while unearned revenue grew 13% to $17.1 billion. In the quarter, the company released the latest version of Office, which is geared towards improving the experience on mobile, social and the cloud.

The Server and Tools business generated $5.04 billion in revenue, up 11% YoY, led by double-digit percentage revenue growth in the SQL Server and System Center. Management pointed out that Microsoft's Hyper-V virtualization product has gained a solid 4 points of market share over the last year. The Windows Division had revenue of $5.70 billion, up 23% YoY. Adjusting for the recognition of revenue related to the Windows Upgrade Offer, Windows Division non-GAAP revenue was flat. Non-OEM revenue grew 40% during the quarter, driven by sales of Surface and continued double digit growth in volume licensing. Windows is still a lynchpin for businesses across the globe, highlighted by the fact that volume licensing of Windows is on track to deliver almost $4 billion in revenue this year, and nearly three-quarters of enterprise agreements signed this year include Windows. Microsoft's improved performance in Server and Tools allows the company to effectively leverage its cross-selling capabilities far beyond what it was able to achieve in the past. I believe that Microsoft has the best opportunity to follow IBM's (NYSE:IBM) business model of enhancing its portfolio of products with small acquisitions where it can leverage its salesforce to enhance growth.

The company is making progress in transitioning businesses from Windows XP to Windows 7, and currently two-thirds of enterprise desktops are running Windows 7. During the quarter, Microsoft finally released the Surface Pro, which seems to be performing quite a bit better than the RT, but clearly there is room for improvement. The Online Services Division generated revenue of $5.70 billion, up 23% YoY. Online advertising revenue grew 22%, driven primarily by an increase in revenue per search. The Entertainment and Devices Division posted revenue of $2.53 billion, up 56% YoY. Adjusting for the recognition of revenue related to the Video Game Deferral, the division's non-GAAP revenue increased by 33% in the quarter. Xbox Live increased its membership by 18% from the prior year, to an astounding 46MM members across the globe.

Microsoft ended the 3rd quarter with 8.429 billion shares outstanding. The stock has traded up to around $30.79 recently, based on news that an activist investor has taken a $2 billion stake, so the market capitalization is roughly $259.52 billion. The company has $74.483 billion of cash, cash equivalents and short-term investments, offset slightly by $11.949 billion in long-term debt, so the net cash position per share is roughly $7.42. Therefore, the enterprise value is roughly $196.99 billion, or $23.37 per share. Based on Microsoft's current $.23 quarterly dividend, the current dividend yield is approximately 3%. Microsoft's mean analyst estimates for 2013 and 2014 according to Morningstar are $2.96 and $3.16, respectively. Amazingly, Microsoft trades at less than 8 times earnings after backing out cash, and earnings have been negatively impacted by massive R&D expenditures that have dramatically broadened the product portfolio of the company. Look at the absurdity of Salesforce.com's (NYSE:CRM) valuation and imagine if Microsoft's SAAS offering catches fire, and what incredible value an eventual spin-off can create. I've touched on my feelings about management and capital allocation in the past, but I'd suggest continuously accumulating Microsoft shares on dips, for one of the more attractive risk-adjusted opportunities in the technology space.

Source: Barbarians At The Gate For Microsoft, But History Will Not Repeat