Microsoft - Little Known Revenue Streams Have Big Potential

| About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) stock has been rising despite a sharp slowdown in PC unit shipments. The company's new version of Windows operating system is facing problems with users finding it difficult to adjust to the new Metro interface. The stock is going up because the company is just not a Windows seller, but has large diverse revenue streams, which most investors don't know of. Its server software, Office suite and Xbox products generate billions of dollars in revenue each quarter. They are also equally if not more profitable than the Windows OS segment. Microsoft is an enterprise software giant playing a critical role in enterprise IT. Products from other technology companies such as Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL) are highly visible as they are consumer technology companies. But Microsoft is more of an enterprise technology company. Microsoft has one of the biggest R&D budgets in the technology industry spending almost ~$10 billion annually. While a lot of the R&D spending is focused towards maintenance and development of existing products, a large percentage also goes into the development of new products. In the past few years, Microsoft has developed large new revenue streams from areas like cloud computing.

Microsoft's new Revenue Streams

1. Microsoft Azure

Cloud computing is one of the fastest growing segments in the technology industry. While investors are aware of the main beneficiaries of this trend such as VMware (NYSE:VMW), (NYSE:CRM), and Amazon (NASDAQ:AMZN), they might not know that Microsoft has quietly become one of the biggest players in the space. Microsoft has exploited its huge strengths in the enterprise technology area to generate more than $1 billion in annual revenues from Azure and other cloud services. The company's Azure service is showing spectacular growth and Microsoft may overtake the current leaders to become the No.1 cloud computing company in the next 5 years. While Microsoft is still behind market leader Amazon with only ~20% of companies using Azure as compared to 71% for Amazon, Microsoft is growing much faster. Microsoft is also forcing Amazon to reduce prices for its cloud services. Microsoft has a comprehensive software portfolio consisting of database solutions, server and desktop operating systems, business productivity software, communication software as well as collaboration products. The company gives a comprehensive software solution as a cloud computing vendor. This is difficult for other cloud computing companies to match since they don't have such an in-house software solution.

2. Augmented Reality - IllumiRoom

Large technology companies are preparing themselves for the next big wave in technology products - Augmented Reality (NYSE:AR). Apple and Samsung (OTC:SSNLF) are set to come out with a "smart watch" while Google has already given "Google Glass" to developers for developing apps. Microsoft has a strong presence in the living room thanks to the millions of Xbox products. The company also has a large number of subscribers to its Xbox LIVE service. The company plans to further strengthen its living room offering by offering an AR product - IllumiRoom. This product will enhance the TV set by allowing the whole wall to be used as a viewing screen. It will also add realism through 3D effects. According to news reports, Microsoft has advanced quite rapidly in developing this product.

3. Patent Revenues - Android becomes a Microsoft Cash Cow

Microsoft has one of the largest patent portfolios in the world due to its two decades of software dominance. The company is using its patent power to extract revenues from almost all major Android product sellers. Microsoft has cleverly not targeted Google because Google has an equally strong patent portfolio. The Seattle giant has targeted companies, which don't have the patent power to fight MSFT. Microsoft has already struck license deals with 20 Android hardware companies (HTC, LG etc.) and is in the process of signing more deals. The company recently signed deals with top Asian companies - Foxconn and ZTE. Qualcomm (NASDAQ:QCOM) gets almost $2 billion in revenue every quarter by licensing its CDMA and 4G patents to mobile phone companies.

We don't know exactly how much money is being made by Microsoft from Android sales. It is being speculated that MSFT makes $1-$8 from each Android device shipment. This means that Microsoft could be making $500-4000 million in annual revenues from Android devices.

4. Next Generation Gaming Console - Xbox 720

The global game console industry is almost completely dominated by three companies - Sony (NYSE:SNE), Microsoft and Nintendo. While Sony and Nintendo have already announced their next generation products, Microsoft is expected to do so in the near future. Microsoft makes massive profits by selling games to its large base of Xbox console users. Xbox 720 launch should further boost sales and profits from this segment.

Microsoft Risks

  1. PC and Laptop sales falling due to rapid tablet adoption - IDC and Gartner Inc. reported that worldwide PC shipments, in the third quarter of 2012, had contracted by the highest amount since at least 2001, compared to the same time a year ago. As a result, HP (NYSE:HPQ) and Dell (NASDAQ:DELL) have seen their stock prices diving to new lows. The other constituent of the Wintel duopoly has also seen its stock price touch 52-week lows. Tablet sales are cannibalizing the sales of desktops and laptops, as most frequently used PC functions such as Internet browsing, email and games are available on tablets. This decline in PC sales has made a number of analysts bearish on MSFT.
  2. Microsoft Windows 8 Sales have not been encouraging - Market reports about sales of MSFT's latest Windows 8 O/S have not been encouraging. Despite MSFT's claims about higher sales of Windows 8, skeptics have pointed out at lower ASP as a result of upgrades.
  3. Office is under threat from Google Apps - Microsoft Office is seeing a strong competitive threat from Google Apps. By smartly putting this application on the cloud, Google has managed to circumvent the need for installing the software on MSFT's Windows O/S. There are reports that Google Apps is gaining increasing traction amongst enterprises, which are attracted by the lower pricing and other cloud advantages.

Financials and Valuation

Microsoft is looked upon as a mature company that is losing out to new technology leaders like Apple or Google. While Microsoft's growth has not matched Apple or Google, the company has managed to grow at a respectable ~10% rate over the last decade. The company has one of the highest margins in the world for a company of its size. Microsoft has more than ~$50 billion in net cash and generates almost ~$7.5 billion in operating cash flow every quarter. Microsoft stock has seen a strong upsurge in the last few months due to a number of positive catalysts. The company's forward P/E is just ~10x and trades at a big discount to the S&P 500. The company has been raising its dividends sharply since 2008 and currently gives a dividend yield of ~2.6%.


Microsoft is a huge company with diverse revenue streams having substantial competitive barriers. There are a lot of technology "one trick ponies" that are being given fancy valuations because of past growth (Facebook (NASDAQ:FB) is the best example). Investors don't realize that these one trick ponies can suddenly get decimated through new innovation or trends. Microsoft not only has a vibrant consumer technology business but also has strong roots in the enterprise technology space. The company is generating new revenue streams such as Azure using its massive R&D budget. New products like IllumiRoom will ensure that Microsoft remains at the forefront of technology change. Microsoft has also been making an aggressive push into the mobile devices market by launching the Surface tablets and partnering with Nokia (NYSE:NOK) in the smartphone industry (Read about Microsoft's mobile push). I remain optimistic about Microsoft given its cheap valuation and new products.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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