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As you can tell, I'm not concerned by Microsoft's (NASDAQ:MSFT) decision to lower pricing on its OS licenses. This was bound to happen, and if it takes a 70% price reduction to retain users in the Windows product ecosystem, then it's worth it.

In an earlier article, I mentioned that Microsoft's licensing revenue from operating systems would decline. Ironically my research was published following Bloomberg's insider scoop. Articles take a while to syndicate, and while the original copy was completed days before the Bloomberg article, there was a lot of editing that held the article back, and for that I apologize. I wish I could have offered the analysis in a timelier manner.

Microsoft's stock is rallying on falling licensing revenue?

As you can tell, markets were able to shrug-off the negative news. It's likely that market participants were expecting some sort of inflection in Windows licensing revenue for quite a while.

Source: FreeStockCharts

Source: Forecast is from Alex Cho, and 2009-2013 data is from Microsoft's annual report.

Microsoft's OS licensing business has been stagnant, and while it generated a consistent stream of cash flow between 2009 and 2013, it's losing the emerging markets to Chrome OS and Android. Chrome is a minimalist OS with very little functionality when compared to Windows, but Google can become even more threatening if it were to offer a desktop/laptop version of its Android OS.

In my forecast, I assumed Microsoft would try to maximize revenue from OS licenses for a little longer, before sales from OS licensing would decline to zero. However, my assumption was a little off, and it's more likely that an inflection point in Microsoft's OS licensing business will happen sooner than 2015. Perhaps, inflection will happen in 2014 instead. Based on that assumption I'm going to offer a modified forecast for sales.

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Source: Forecast is from Alex Cho, and historical data is from Microsoft's annual report.

I forecasted sales using the function F(X) = -271.36(x) ²+ 1,997.84(x) + 8956.79. The correlation coefficient was .64, which is pretty low, but there's no better line of fit based on qualitative and quantitative factors.

Bloomberg reports:

Manufacturers will be charged $15 to license Windows 8.1 and preinstall it on devices that retail for less than $250, instead of the usual fee of $50, said the people, who asked not to be named because the details aren't public. The discount will apply to any products that meet the price limit, with no restrictions on the size or type of device, the people said.

The decline in licensing sales is likely to be gradual, but we have no way of knowing the exact impact as Microsoft doesn't break down the licensing sales to lower-end devices. Furthermore, if Microsoft does in fact reduce pricing, we can assume that the impact will result in lower marginal revenue per license, but we're not sure if unit shipment figures will improve as a result. For Microsoft, global PC shipments are like a self-fulfilling prophecy; if Microsoft lowers prices, unit shipments will increase assuming normal supply-and demand relationships occur. If that's the case, Microsoft may be able to justify the 70% price reduction on resurgent PC demand. So if anything, it's hard to say if Microsoft is making a good or bad move.

Either way, lowering pricing from $50 to $15 can't be overcome with rising unit shipments as Microsoft's low-end shipments would need to surge by 3-4 times to result in comparable sales revenue. Because that's unlikely, I have conviction in my updated forecast.

Where will the growth come from?

I had to split OS licenses revenue from tablets and computer accessories in the below example. While tablet sales could accelerate, there's no break down on Windows surface sales separately, so I had to assume that the Windows segment generates 65% of sale from OS licenses. Whether OS licenses have declined or improved over the past three years isn't known based on the data. However, with some guess work I'm willing to guess that OS revenues will decline by about $4 billion over the next three years, whereas revenues from accessories and tablets will remain flat.

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Source: Forecast is from Alex Cho, historical data is from Microsoft's annual report.

On the bright side, historical data indicates positive growth for the remainder of Microsoft's segments. I calculated the run rate separately for each division.

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Source: Forecast is from Alex Cho, historical data is from Microsoft's annual report.

These four remaining segments will contribute to Microsoft's revenue growth, which will result in positive revenue growth on a consolidated basis over the next 3-years.

(click to enlarge)

Source: Forecast is from Alex Cho, historical data is from Microsoft's annual report.

Factoring in declining Windows licensing sales, I'm willing to estimate that Microsoft's revenues will grow at a 6.48% rate over the next three years. This is a historical presentation that's extrapolated further into the future. It does not factor in more optimistic case scenarios where Office 365 subscription revenues grow at an accelerated rate, or Nokia handset sales reaching $15 billion by 2017. Therefore, these growth assumptions are extremely conservative, and indicate that even if Microsoft's OS licensing business were to decline, the financial impact is minimal.

Conclusion

Microsoft as a whole won't report declining sales. Because of this fact, investors shouldn't worry over declining licensing revenue as Microsoft can sustain its success in other product categories. Furthermore, investor sentiment seems to have improved following Bloomberg's major scoop, which indicates that the broader market is pricing the company for future growth. Usually the market is right, and this time, I can't help but go with the momentum crowd.

Microsoft remains a buy, and with an aggressively conservative revenue forecast at 6.48% for the next three years, I don't think the news has had any meaningful impact on the long-term trajectory of the business. Microsoft is just way too diversified, and because of this it's one of the better defensive investments in the technology sector. 6.48% sales growth can easily translate into bottom-line earnings growth, paired with a 2.96% dividend yield, investors are given an adequate mix of growth and income.

Source: Microsoft Is Too Heavily Diversified To Be Impacted By Falling OS Revenue