On February 4, 2014, Satya Nadella assumed command as Microsoft CEO. Interestingly, the rise of Nadella through ranks has paralleled the underlying culture clash between heavy-handed Microsoft (NASDAQ:MSFT) and the consumer marketplace. In recent times, Windows 8, 8.1, Surface, and the collective efforts out of Gates, Ballmer, and the company to break into the mobile market have been largely dismissed as "fail plus fail equals more fail." Bulls, of course, may argue that Microsoft's mobile movement was necessary to lay the groundwork for growth amid secular PC market decline.
Going forward, Microsoft would unlock shareholder value if it were to shut down hardware production in order to concentrate upon simply supplying software across the mobile ecosystem. On March 27, 2014, Microsoft did make its crown jewel Office software available for Apple (NASDAQ:AAPL) iPad users. This latest move may back the idea that Microsoft has taken the ongoing technology war into the Cloud. As such, any catcalls presenting Google (NASDAQ:GOOG) as a formidable challenger to Microsoft Office must be deconstructed and dismissed. In reality, Google and Microsoft will continue to control separate spheres of influence.
The Microsoft Business Model
Be advised that the recent reclassification of Microsoft business units does make for somewhat difficult financial comparisons across time. Prior to 2014, Microsoft had categorized its disparate businesses according to Windows, Business, Server and Tools, Online Services, and Entertainment and Devices operating segments. Last year, Microsoft indicated that its Office software package accounted for more than 90% of Business division sales. Taken together, Windows ($19.2 billion), Server and Tools ($20.2 billion) and Business ($24.7 billion) generated $64.1 billion out of Microsoft's reported $77.8 billion in fiscal 2013 total net sales. For all intensive purposes, Microsoft has operated as a software company that offers productivity solutions to the business, or enterprise market.
The triangulation of Microsoft financial data alongside independent surveys would confirm that Redmond lords over the personal computer market. A March 2014 Net Market Share report presented estimates that Windows systems operated 90.8% of desktop computers. At that time, Windows 7 was the most popular operating system, as it controlled 48.8% share of the desktop market. For the sake of comparison, the latest Windows 8 and 8.1 systems operated respective 6.4% and 4.9% of existing desktop computers. Microsoft watchers have also often cited data from research firm Gartner before arriving at various calls for action. Gartner recently reported that year-over-year global PC shipments declined by 6.9% through the fourth calendar quarter of 2013. Gartner headlined its Q4 2013 report as the "worst decline in PC market history." Legions of bulls have actually highlighted the ongoing deterioration of the PC market as justification for Microsoft's ham-handed efforts to emerge as a mobile player.
The Microsoft Entertainment and Devices division once included Skype, Windows Phone, and Surface sales, alongside popular Xbox gaming receipts. Still, Entertainment and Devices generated a mere $888 million in operating income off $10.2 billion in 2013 operating segment revenue. Be further advised that Microsoft took $900 million in Surface RT inventory write-offs for 2013.
Microsoft was to break out its Devices and Consumer operating segment according to Licensing, Hardware, and Other subdivisions, for its most recent quarterly period ended December 31, 2013. Devices and Consumer Hardware generated only $411 million in gross margins off $4.7 billion in Q1 2014 operating segment revenue. In all, Microsoft banked $16.2 billion in gross margins upon $24.5 billion in quarterly sales. Despite the reclassifications, mobile hardware has clearly remained an albatross at Microsoft. Again, CEO Satya Nadella could unlock another growth era at Microsoft, if he were to decisively break from Steve Ballmer and shut down Hardware in favor of strictly supplying software to the mobile market. In doing so, Microsoft would also beat back Google and fortify what Warren Buffett would describe as the moat surrounding Office.
Microsoft Vs. Google Cloud Computing
Both Forbes and Fortune have already lauded cloud computing as a "revolution." The cloud has emerged as the next logical progression within the secular shift from desktop to mobile computing. The cloud allows for the creation, storage, and sharing of data across multiple platforms through Internet connectivity. The inevitable consolidation of the now fragmented cloud computing market may trigger yet another boom in productivity, as businesses, consumers, and government officials would then be free to communicate in real time, without remaining effectively shackled to one particular device and its pre-installed software suite.
Through cloud computing, a seasoned executive may create and store a document at his office desktop, before retrieving and making edits to that same document on vacation from a hotel business center computer bank. Alternatively, a young hipster may automatically store downloaded music, video, and photo files across desktop, tablet, smartphone, and Web 2.0 social media platforms. Rather than purchasing dedicated server storage space, businesses may share virtual servers with other enterprise customers, in order to slash costs. The cloud, of course, has further commoditized the computing industry.
In retrospect, Google was a most unlikely, yet important pioneer of the cloud computing revolution. Today's Google Drive traces its origins back to Google Docs, the 2005 launch and acquisition of Writely, and even Microsoft Word. Google Drive is the latest installment of Google Docs word processing, spreadsheet, and presentation programs. In effect, Google Drive provides access to a stripped down, web-based office software suite, while also enabling file storage and synchronization across multiple operating system platforms. Popular applications beneath the Drive umbrella do include Maps, Blogger, YouTube, and AdSense. As par for the course, the technology commentariat has praised Google for its powerful search tools that can easily hone in upon stored documents within the cloud.
At the time of this writing, Google is giving away 15GB in online storage, for free. From there, heavier users may upgrade to one terabyte (1TB=1024GB) of storage for $9.99 per month. Most likely, Google is following its bait-and-switch business model, where it literally gives away product, in order to drive traffic towards higher-margin Search. Venture Beat has already intimated that The Google Way may ultimately drive niche players Dropbox and Box out of the cloud market, altogether.
Enter Microsoft. Microsoft, which once lambasted its competition as "dinosaurs," can now play up its somewhat dowdy image. In terms of features, the barebones Google Docs could never compete directly against Microsoft Office. Taken further, numerous surveys have revealed that consumers do not trust the cloud storage of sensitive documents. Harris Poll research has confirmed that the 34+ age demographic lacks confidence in the cloud. As such, the powerful Microsoft may very easily marginalize Google Drive as somewhat of an unnecessary adjunct to Office and its own associated Microsoft Cloud. Microsoft OneDrive does provide 7GB in free storage. Microsoft offers an additional 200GB in OneDrive storage for $12.49 per month.
Time has described OneDrive as a logical progression for Office 365 subscribers. Office 365 provides software suite access to various combinations of five separate desktops and tablets. Again, Microsoft Office was recently made available for an iPad platform, which dominates approximately 35% of the tablet market. By many accounts, Microsoft appears poised to head off Google at Cloud Pass.
The Bottom Line
Microsoft is the epitome of a cash cow. The software juggernaut closed out its 2013 fiscal year having generated $28.8 billion in cash flow from operations. Last year, Redmond spent $5.4 billion to buy back stock, while also paying out $7.5 billion in dividends. Microsoft, of course, has consistently upped the ante in terms of returning capital back to shareholders over the years. Microsoft returned $4.4 billion back to its investors through Q1 2014 share buybacks ($2.1 billion) and dividends ($2.3 billion). This somewhat aggressive capital return policy was a 22% improvement above Q1 2013, when Microsoft spent $3.5 billion upon buybacks and dividends. The stock market, of course, functions as a pricing mechanism that discounts future growth potential, rather than simply taking account of balance sheet inventory.
Without a major shift in strategy, Microsoft may merely track the S&P 500 Index, while returning larger amounts of capital back to shareholders via buybacks and dividends over the next 18-24 months. As such, Microsoft shares deserve a hold rating. Long-term investors, however, may consider buying into Microsoft, if it were to move towards shutting down the remnants of its Devices and Consumer division, in order concentrate upon delivering software product. After doing so, Microsoft can leverage the steep margins of its software businesses to improve shareholder returns, while also thoroughly stifling the ambitions of Google Cloud.
Disclosure: I am long AAPL. 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.