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Summary

  • Microsoft is one of the top companies in the world with a market cap exceeding $300 billion.
  • The lack of handheld penetration has been the biggest weakness of Microsoft in the recent past.
  • The company is finally turning around its hardware absence with Xbox success and the acquisition of Nokia.

In the past decade or so, the most significant change in the technology sector is the smartphone revolution. This revolution had an impact on most organizations that operated in the technology sector. It changed the way in which business operated and at some level altered the business model of almost every technology organization. The software giant, Microsoft, initially missed out on this revolution by not entering the hardware arena and not focusing enough resources on its Windows Phone software.

The smartphone revolution resulted in the decline of PC growth and negatively impacted the windows business. There is an industry wide perception that Microsoft is on its way out with the declining PC segment and its much publicized management troubles. We do not agree with this perception because while enjoying its Windows/Office revenue, Microsoft was busy building a diversified business that ranges from hardware to cloud solutions. Microsoft is repositioning itself as a hardware and cloud services company and in our view this would be the key to its future success. We are initiating coverage on Microsoft and this report analyzes Microsoft's prospects in detail. The first part of this detailed business analysis is as follows:

The Business

Microsoft (MSFT) is a technology company operating in the industry of business software and services. The company develops and licenses software and provides related support. It is also involved in the development of electronic devices including entertainment devices like the Xbox and smartphones (recently acquired from Nokia). For reporting purposes, Microsoft's business is divided into the consumer and devices and commercial segments. Both segments are further sub-divided into licensing, hardware and others. In the six months ended 31 December, the company generated around 45% of its revenue from the consumer and devices segment. This primarily includes revenue from consumer Windows, consumer Office, patent licensing revenue, Xbox sales, other devices, search advertising and display advertising. The remaining 55% revenue was generated from the commercial segment. This includes revenue from commercial Windows, commercial Office, client access licenses (provides access to certain servers), consulting services and cloud services. This report will analyze the recent financial performance and the consumer side potential of Microsoft.

Market Performance

Shares of Microsoft are listed on NASDAQ and are currently trading around $38. The long-term trend of the share's performance is quite stable. The valuation of the company grew by around 34% in the last year or so. It managed to surpass EPS estimates in 3 out of 4 quarters in calendar year 2013. This seems to be the reason behind the valuation growth. The Xbox One launch could be another reason for this growth in valuation. The following table summarizes the performance of the company and projects the future performance based on revenue and EPS metrics:

The table reveals that the revenue and EPS of the company have been growing in a non volatile fashion in the past and is expected to do so in the future. Looking at these figures, it appears that Microsoft is a company for long-term investment for investors that prefer dividends over capital appreciation. To test this assumption we will analyze recent business and financial trends for Microsoft.

Recent Financial Performance

Revenue, Margins and EPS

The company managed to post revenues of $24.5 billion in the most recent quarter which reflects a growth factor of 14% on a year-on-year basis. The growth in revenues was supported primarily by the sales of Xbox during the quarter. Operating income grew by 3% on a y/y basis, and the company posted an EPS of $0.78, as compared to $0.76 in the same quarter the previous year. It is evident from the results that the operating income and EPS did not grow at the same pace as revenues. This is because the margins on Xbox were quite low as compared to other segments in the revenue mix. The table below illustrates the margins of the company:

Comparisons

Consumer:

Q2 2014

Q2 2013

% growth in revenue Y/Y

Licensing

92.45%

89.9%

(5.59)%

Hardware

8.69%

27.13%

68%

Other

22.92%

44%

(10.3)%

Commercial:

Licensing

92.5%

92.01%

6.91%

Other

23.31%

15.5%

28.1%

Overall Margin

66.21%

73.47%

Net income margin

26.7%

29.72%

*Calculated from MSFT Q2 2014 SEC filing

It is evident that the revenue mix shifted toward a low margin business in the most recent quarter. Sluggish PC demand has also affected the margins and will continue to do so in the future. On a positive note, the commercial segment experienced growth. Overall the company should improve its margin in consumer hardware and commercial (others) if it wants to improve its EPS consistently in the future. The consumer PC situation is not going to improve anytime soon and will affect consumer licensing even more. Moreover, Windows mobile efforts are not currently working out for Microsoft as the market is dominated by Android and Apple (NASDAQ:AAPL). The charts below reveal the recent revenue mix for the company:

Source: MSFT SEC filings

  1. The revenue mix is shifting toward low margin business.
  2. Despite an increase in commercial revenue its overall share decreased from 46% to 45%. This indicates that the commercial revenue is growing at a slower pace as compared to other segments like consumer hardware and commercial (other).

Cash Flows

Microsoft generated around $28.19 billion in operating cash flows during the trailing twelve months, and the cash balance stands at around $83 billion (MRQ). The company is also maintaining a healthy current ratio of 3.17. The balance sheet and cash position of Microsoft is quite satisfactory. On the dividend front, the yield is around 3%, and the company's operating cash flow yield is around 9.02%. In simple terms, the company is generating 3 times the cash it needs to pay dividends. This translates to a cash retention rate of 66%. All in all, Microsoft has a strong cash position to support capital expenditures and its diversified business portfolio.

Overall, the performance of the company is satisfactory, and the consistent incremental performance indicates that the risk associated with the stock of the company is low.

Recent Business Performance and Future Prospects

Consumer and Devices

The consumer and devices segment is further divided into licensing, hardware and other. The segment grew by 13% overall, but Windows OEM revenue declined by 3% amidst slow consumer demand. Future prospects of each sub segment are as follows:

Licensing:

Licensing predominately includes consumer Windows and consumer Office and its growth depends on two factors: the growth of PC and laptops and the adoption rate of alternative products like Linux and Android.

The consumer PC market is expected to shrink further in the coming years according to Gartner. The following table depicts consumer PC shipments in the current and next year:

Source: Gartner

The unit shipments of PC and laptops are expected to decrease at a CAGR of around 5% in the coming years. This is not a good sign for the consumer Windows segment as it is mostly featured in desktops and laptops. In the smartphone industry Android is expected to dominate in the coming years. The future of consumer Windows largely depends on whether Microsoft manages to unify Windows for different platforms. However, the data from Gartner also presents an interesting projection for operating systems. Despite slow PC growth and the domination of Android, Gartner predicts a growth in device shipments featuring Windows.

*Source: Gartner

IDC also sees Windows growing in the tablet market. They believe that Windows' market share in tablets will reach 10.2% by 2017 (which is currently just around 3.4%). In light of these estimates, we believe that overall consumer Windows shipment will remain flat and growth will come from enterprise, with a hint of growth over the next few years. This means that the company will sustain revenues while finding other avenues for growth.

In the productivity software market, Microsoft is the dominant player and generates considerable revenues from its Office suite. In 2012, the market share of Office was around 90% according to Gartner. In short, Microsoft seems to be the leader in this arena for now but Google (NASDAQ:GOOG) is posing a threat with Google Docs. Google Docs is free to use while Microsoft Office is paid. However, the functionality of the latter is significantly better. Microsoft also launched Office 365 Home to counter the threat from cloud-based Google Docs. It claims that it had sold 2 million premium subscriptions of Office 365 by the end of September 2013. According to Josh Waldo, Senior Director Cloud Partner Strategy:

"Office 365 is the fastest growing business in Microsoft history."

InfoWorld rated Google Apps for business and Office 365 at 8 and 8.5, respectively. Both packages have some positive aspects. Office's privacy policy states that it does not scan the documents of its clients while Google states that it will scan them for more targeted advertising. Hence, Office 365 is a better choice for enterprises because confidentially is usually a top priority of any business. This also explains the growth of Microsoft Office in the enterprise segment as businesses tend to avoid cloud-based services because of the risk to their confidential information. Office 365 also has the added advantage of familiarity. As Office has been in use for years now, its learning curve is not steep. On the other hand, Google's package is also easy to use and is not loaded with functions that are not required by the average employee. Office is mostly used by professionals and students, and because tablets and smartphones are not that easy to use when it comes to Office tools, the domination of Android does not come into play here. Sponsored research by IDC ranks Microsoft Office as the 3rd most demanded skill for all U.S. occupations.

*2Source: IDC

Taking into account all the factors discussed above, in our view Office 365 has a slight advantage over Google Apps, and it is expected to grow in the future. Microsoft's optimism is rightly placed in this context.

Hardware:

The hardware segment includes the Xbox, entertainment consoles, Surface and related accessories. The hardware segment has witnessed a growth in the most recent quarter. Microsoft managed Xbox sales of around 7.2 million including 3.9 million Xbox One consoles and 3.5 million Xbox 360 consoles. The company's surface revenue more than doubled to $893 million in the second quarter. Xbox One sales are expected to be at around 9 million units this year. Michael Pachter, an analyst at WedBush says:

Both Sony and Microsoft should deliver substantial profits from their gaming businesses over the next several years."

Microsoft earns royalties for every game title sold, and this will spur gaming unit revenues in the coming years. According to a report, console software sales will grow at a CAGR of around 11% in the next two years to reach $15 billion in 2015. Therefore, the Xbox is expected to be profitable at higher margins in the coming future thanks to game royalties and unit sales growth.

Surface tablets appear to post a positive performance, but the underlying performance was not that impressive. Despite doubling revenue, Microsoft ended up posting a loss of $39 million on these tablets. However, as mentioned elsewhere in this report, Microsoft's tablet business is set to achieve a 10% market share by 2017. We believe the company will experience growth in the tablet market, but not as much as predicted in a report by IDC due to limitations of its mobile software and ecosystem as compared to the Android and iOS. The tablet segment is not a key one for the growth of Microsoft as a whole.

Conclusion

Microsoft has a diversified business which encompasses various segments from the technology industry. The company has shown stable financial performance in the past and is expected to do so in the future. These two factors make Microsoft a quality low-risk investment. The revenues of the company are expected to grow in the future mainly fueled by its enterprise licensing, cloud solutions (including Office 365) and hardware (such as the Xbox) sales. The fact that businesses use desktops and laptops for work purposes makes Android irrelevant in this segment and hence, Windows is expected to maintain its share of the enterprise space. We believe that margins will fall to some extent this year due to low margin segment growth, but the growth in revenues will support the EPS and hence, the share price will grow in a stable fashion. All in all, the opinion mentioned at the start of the report holds and Microsoft is a quality, low risk investment for the long term because of its enterprise segment, office capabilities, Xbox ecosystem and future cloud potential.

Source: Why Microsoft Is A Must For Your Retail Portfolio

Additional disclosure: Equity Flux is a team of analysts. This article was written by our Technology analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.