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Summary

  • Microsoft is an exceptionally profitable business even though it is lagging behind Apple and Google in the mobile OS market.
  • Satya Nadella has the right vision for Microsoft and is guiding the company to the right direction.
  • Microsoft's overall revenue and net income should continue to grow in the next decade due to its strong commercial businesses.
  • Microsoft's intrinsic value should be around $338 billion in market cap or $40 per share.

As an investor who likes to invest in the best tech stocks, I never thought of Microsoft (NASDAQ:MSFT) as a great company for long-term investing. This is because the company seemed to always be several steps behind Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL) in the mobile market and because the company did not seem to be forward looking enough under Steve Ballmer. To be fair, Microsoft's revenue and net profit more than doubled during Steve Ballmer's tenure as the CEO. And he also helped Microsoft grow its commercial businesses-which are exceptionally profitable-as well as to build the Xbox entertainment and consumer device division.

However, my perception of Microsoft started to change after I watched Satya Nadella's recent keynote speech and learned about his vision and business strategy for the company.

After analyzing Microsoft's cash-cow businesses and Satya Nadella's new direction for the company, I believe that Microsoft is once again becoming a great company and that the stock could be a good buy, depending on its current price compared to its intrinsic value (I will provide an estimate of the stock's current intrinsic value at the end of the article).

Microsoft as a Device and Services Company

Under Steve Ballmer's reign, Microsoft was transformed from a 'software and service-focused' company to a 'devices and services' company. However, I do not think it was the right strategy because Microsoft's core competency is not in developing mobile devices. Its core competency is in developing software (e.g. Windows and Office) and enterprise services (e.g. cloud computing) that allow individuals and organizations to be more productive and engaging in their work.

Microsoft tried to step out of its core competency to compete with Google and Apple in the mobile market because the PC market had been greatly impacted by mobile sales (this affects windows licensing sales) and because Microsoft wanted to stay relevant in the Post-PC era. However, both the Surface tablet and Windows Phone platforms have yet to gain a sizeable market share. In 2013, Google and Apple had a combined Operating System (OS) market share of 94% while Microsoft had 3.2%, according to Gartner (see image below).

The mobile OS market is a two-horse race between Apple and Google. It is not likely that Microsoft can gain a large market share unless it creates a truly unique mobile platform that can attract many app developers and device manufacturers.

Microsoft is Still An Exceptionally Profitable Business

While Microsoft may not be able to compete well with Google and Apple in the mobile market, it is still exceptionally profitable due to its commercial businesses. Microsoft's commercial businesses are comprised of volume licensing of Windows, Office and various MS software, as well as applications for businesses; cloud computing and various enterprise services. Note that Microsoft is currently divided into two business segments: devices and consumers (D&C) and commercial.

Looking at Microsoft's Q2 2014 report, you will notice that Microsoft's commercial business segment contributed the most revenue and gross margin growth (see image below). The declining sales of Windows and Office for consumers has impacted the D&C segment, while the increasing sales of Windows, Office and other services (e.g. cloud computing) for businesses has benefited the commercial segment. In fact, this has been the economic trend for the past several years. Microsoft's revenue and net income growth are largely driven by its commercial businesses.

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Source: Microsoft Q2 2014 Report

What impresses me the most about Microsoft is its consistent growth in revenue, gross profit and net income even though the company is lagging behind in the mobile and search engine markets (see image below). As I have mentioned earlier, I believe that Microsoft's consistent net income growth is largely driven by its commercial businesses-such as Office volume licensing and cloud computing-which have a lot of growth opportunities. Even though Microsoft's Windows and Office sales for consumers are declining (due to declining sales in the consumer PC market), the company's overall revenue and net income will continue to grow due to its commercial businesses.

(click to enlarge)
Data provided by Morningstar. All numbers are in millions.

Satya Nadella's New Direction and Strategy for Microsoft

The biggest factor that makes Microsoft a great company once again is Satya Nadella's new direction and business strategy for the company. In his keynote speech on March 27, Nadella stated his going forward strategy as "a cloud for everyone and on every device". This is consistent with his vision for Microsoft as "cloud first and mobile first".

Nadella's going forward strategy is different from Microsoft's previous strategy, which was stated in Microsoft's Q2 2014 Report:

Going forward, our strategy will focus on creating a family of devices and services for individuals and businesses that empower people around the globe at home, at work, and on the go, for the activities they value most.

Nadella's strategy is focused on creating great cloud computing and services on multiple devices, while Microsoft's previous strategy was to create a family of devices and services for individuals and businesses. I believe that Nadella's cloud first and mobile first strategy is the right one. The primary reason is that Microsoft's core competency is in developing software, applications and cloud computing services that allow individuals and organizations to be more productive. Its core competency is not so much in making hardware devices-this is reflected in the low Surface tablet sales compared with iPad and Android tablet sales.

There are also two recent developments that indicate that Microsoft is heading to the right direction after Nadella became the new CEO:

The first is the release of MS Office 365 for iPad for a subscription of $99/year. One of the main reasons Microsoft took so long to release the Office for iPad was Apple's 30% cut of all revenues generated from iOS apps (source: Appleinsider). Microsoft could not reach a deal with Apple under the previous management, but was successful after Nadella became the new CEO. I believe Nadella made the right decision to agree on Apple's 30% commission. This is because releasing the Office for iPad and Android tablets should greatly increase Office 365 sales, while having a small cannibalizing effect on Surface Tablet sales.

The second development is licensing Windows Phone platform for free-like Android-for OEM and ODM partners developing smartphones and tablets with screens under 9 inches (source: Microsoft News). This is to encourage manufacturers to adopt Windows Phone platform on their smartphones, which will allow Microsoft to possibly increase its market share in the mobile OS market.

Microsoft's Intrinsic Value

At the time of writing, Microsoft's stock is traded at $41.01 per share or $340.41 billion in market cap. I have estimated its intrinsic value (fair value) to be around $338 billion in market cap or $40 per share, using a simplified version of the discounted cash flow (DCF) model instead of the traditional DCF.

For the discount rate, I did not use the traditional weighted average cost of capital (WACC). Instead, I used a multiple of the 30 year treasury yield rate to arrive at a reasonable discount rate of 11%, which includes a risk premium. In addition, I have included an optimistic valuation as well as a pessimistic valuation of the stock's intrinsic value (see image below).

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The Bottom Line

I believe that Microsoft is becoming a great company again because Satya Nadella is guiding the company in the right direction to focus on "mobile first and cloud first" and because the company has an exceptionally profitable commercial business that should continue to grow in the next decade.

If you are to invest in Microsoft, you may want to invest in it when there is a sufficient margin of safety, in which the stock price is below its intrinsic value. I have estimated its intrinsic value to be around $40 per share, or $338 billion in market cap.

Sources: Microsoft Q2 2014 Report, Microsoft News Center, Gartner, Appleinsider, Morningstar and Yahoo Finance.

Source: Why Microsoft Is Becoming A Great Company Again