Microsoft (MSFT) has released earnings yesterday, and needless to say it has disappointed Wall Street. Shares were down significantly after hours and remain down about 7% pre-market at the time of writing. The main mishap seems to be around the Surface tablet, as the company has slashed prices and taken a charge against inventory. This has accounted for the majority of the miss on the bottom line. In addition business seemed to be a bit more sluggish than expected in most units, with results lower than analysts were projecting across the board.
Watching the market do its normal emotional reaction to results like these is making me giddy. Why you might ask? Because as usual, I see lots of headlines which are all focusing on the flop of the Surface RT and not paying much attention to the part of the business which really counts. Likely we will see further drops in share price, which is what really makes me excited, as I've been waiting for a pullback so I can load up with more shares. I'm not ready to do so yet, but if the price dips down to $30 or below than I will do just that. I continue to believe Microsoft is worth at least $40/share, and coupled with a large margin of safety, and a growing dividend I believe the company remains an excellent value.
The Strength of Microsoft is in the Enterprise, Pure and Simple
I am an IT consultant and I've worked many years now in Fortune 500 type companies. Anyone who is in IT or a business related function in these companies will know how strong Microsoft has become. Many of these larger companies have become in fact "Microsoft shops", in that Mr. Softie controls a huge part of the productive work they do. This is from technologies such as:
- MS Office (Excel, Word, PowerPoint, etc)
- Exchange (Outlook)
- Data and Infrastructure software (e.g. SQL Server, Hyper V)
- Azure & Office 365
Now these are not in fact necessarily the best technologies in their respective areas or even the market leaders - there are many competitor products which are just as good or better in certain use cases. Only Exchange and Office have true monopoly like market share. But that is actually not the point. From a competitive advantage and moat perspective, I believe that Microsoft is second to none, particularly around productivity software such as MS Office. What should really excite investors about this, is that the competitive advantages have actually gotten stronger in recent years. I've seen it now in several of my clients, including my current one, where large companies are choosing to roll out massive deployments of software such as Sharepoint because of how well it integrates with Lync, Office, and Exchange. So the huge market share in Office and Exchange gives Microsoft an advantage that nobody else can match, because they can leverage off of this to expand the communication and collaboration experience in ways that nobody else can do.
In addition, Microsoft continues to do very well in the data center, where its Servers & Tools segment is growing quarter after quarter. As stated in the conference call, SQL Server continues to outgrow the market and is now the second largest database in revenue after Oracle (ORCL). Revenues were up 16% in the quarter. Office 365 on Azure is also accelerating, with an annual revenue run rate now at $1.5B which is 50% growth in a short period of time. Much of the productivity applications I mentioned above (Sharepoint, Lync, Exchange) all grew double digits as well.
Despite Microsoft's struggles in the consumer area, notably its poor market share in both phones and tablets and the questionable uptake of Windows 8, none of this has me worried. That is because the growth and competitive moat in both the Server & Tools and the Business Division are I believe so strong that a case can be made that they alone are worth the entire market valuation today. For me all of these extras in the consumer market are just bonuses if they work out. I know from my experience in large enterprises, the margin of safety in this part of the business is large simply because the cost and complexity of migration projects makes it highly unlikely that businesses will jump ship from Microsoft's products once they are locked in. Just think about it - when an organization spends in the order of $100m or more on moving to Office 365, do you think they are going to change their mind and switch to a competitor's offering in 1 year? Very very unlikely, as the costs not only for software licensing but also for migration projects, business engagement and readiness, training, etc are huge. This leads to high reoccurring revenues for Microsoft, which I don't see subsiding anytime soon and it's precisely why I think the investment here is compelling because the downside risk is limited. Even the past 10 years have been evidence of this, where the company has not done well on capturing new growth markets yet at the same time the stock has not imploded either, simply due to its dependable revenue streams. For sure some of this is under threat with the canabilization of PC sales (and Windows licenses) by tablets (mostly non-Windows), however this has less threat to the enterprise business, where PC sales declines are much slower than in the consumer market.
So where does this leave Microsoft, in terms of valuation? Revenues in Server & Tools grew 9% and 2% in the Business Division. The business Division was up 7% in the enterprise but declined 27% in the consumer side due to PC sale declines. Also important here is the shift to Office 365 subscription model for many customers which means that revenue is recognized over time rather than upfront. Overtime this will lead to predictable reoccurring revenues, but it will take some more time for the run rate to get up to full speed.
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. I've seen nothing in this quarter's results which would point to evidence on the contrary. Even if growth rates were a slight tick below analysts' expectations, growth was still healthy.
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. Although growth this quarter excluding the one time Office upgrade offer was lower than this, rates should accelerate as the shift to Office 365 develops further. 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 $20B 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 an 8% rate and you receive a value of around $32/share. With a market price at time of writing now at $32.37/share (now down 8%+, I'm getting even more giddy than I was at the top of the article!), this would mean you are getting the entire rest of the business for free. For sure Windows will continue to have its troubles, and the Online Division, Surface, Xbox and other parts of the business are not huge profit generators, but I know one thing and that is that they are definitely worth more than zero. In a previous article some months ago I estimated that Windows was worth about $14/share taking into account a 0% long term growth rate in FCF. Even if you lower than to a negative rate it will still be worth near $10/share. The online division also is getting more valuable, as market share of Bing has grown above 17% and revenues were up 9% in the most recent quarter (operating performance improved by $107m). Putting it all together and Microsoft is still worth more than $40/share, probably closer to $45.
The Bottom Line
Make no mistake, Microsoft does recognize the huge shifts in the market, and as CFO Amy Hood indicated in the conference call they are in the midst of a multi-year transition towards being a full fledged devices and services company. Further evidence of this is the recent announcement of a major organizational re-alignment, which nobody seems to know yet how this will impact operations (or even reporting segments, Hood explained this will be announced in September). So there will be likely continued emphasis on growth in the consumer device market, and I'm quite sure we haven't yet seen the last of the Surface or Windows Phone products which will continue to evolve and possibly start to take market share ever so quietly. Long term investors however should rest assured that the company's incredible moat and strength in enterprise software and services will not only keep it from sinking, but it will in fact drive the company over the years to come. I expect that this will alone lead to handsome profits for the patient investor.