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Summary

  • Microsoft shares have rallied nearly 20% in the last six months to close above $41 a share on June 16.
  • As a result, the market capitalization increased to $342 billion and the current market price is in line with our stock price estimate.
  • We believe that the stock is fairly valued and the upside potential for the company is limited.

The stock price for Microsoft (NASDAQ:MSFT), the maker of the Microsoft Office productivity suite and Windows operating system, was languishing below $35 for months. However, it rallied nearly 20% in the last six months to close above $41 a share on June 16. As a result, its market capitalization increased to $342 billion and the current market price is in line with our stock price estimate. We believe that the stock is fairly valued and the upside potential for the company is limited. In this article, we will explain our stance on Microsoft and the risk associated with the company.

New Measure Aim To Stem Decline In Market Share

Microsoft's biggest revenue driver is its Office productivity suite. According to Trefis calculations, this segment generated approximately $24 billion in revenue in calendar 2013 (this number is calculated based on the quarterly results declared in 2013), and we expect this to grow to $30 billion by 2020. Furthermore, this division has the highest profit margins (65%) for Microsoft primarily due to a dominant 93% market share in the productivity suite market. However, Google (NASDAQ:GOOG) (NASDAQ:GOOGL), with its Google Docs offering, is chipping away at this market share.

To compete with Google Docs, Microsoft launched Office 365 in 2012 and it offers most of the Office features in Software as a Service (SaaS) format. This product helps improve the user experience with mobile, social and cloud features - a technological shift that is transforming the way software is perceived by users. We think that Microsoft Office has a sticky user base that is reluctant to shift to a new platform and is critical for many professional and personal users.

However, until recently Microsoft Office was absent from the Apple's iPAD and iPhone platform. The company has fixed this with the launch of Office for iPad, which follows a freemium model. [1] With new launches and a loyal user base, Microsoft Office should be able to stem the decline in market share to around 90% by the end of our forecast period. However, if the market share were to decline to 80%, our stock price estimate could decline by 5%.

Server Business Gaining Strength

The server business is Microsoft's second largest business, making up around 24% of its total value. The margins for this division at 38% are the lowest, and it generated revenues close to $22.5 billion in 2013. Microsoft generates around $1,500 per unit of server software sold, and has around 75% market share, according to our estimates. In spite of its relatively low margins, the server business is key for the company's long term prospects. Many Microsoft customers depend on SQL servers for mission critical and business intelligence needs. Big data analytics and data storage also are gaining popularity. SQL servers help clients in querying databases and analyzing such data. We expect SQL's market share to increase in the future and that will bolster the server division.

Furthermore, Azure platform, a cloud offering based on Windows servers and development tools, is fast gaining popularity among enterprise users. Even if the server license business were to lose steam, Azure is well positioned to absorb the shock as it clocked in more than $1 billion in revenues in FY13.

Moreover, Microsoft exchange server provides seamless compatibility with Windows based PCs and other Microsoft products such as the Windows Phone and the Surface tablet. This presents an opportunity to cross sell other Microsoft products such as Windows PC licenses and mobile devices. We think that Microsoft will maintain its market share in the server software division on changing business needs and seamless integration of its products across platforms.

Discounts on OEM OS Prices To Bolster Sales

Windows Operating System is Microsoft's third largest division and makes up around 14% of its stock value. In 2013, the company generated approximately $18 billion from this division, selling each Windows license to OEMs for approximately $52.

The sales of its flagship Windows 8 OS, which was launched in 2012, has not met expectations. To bolster sales, Microsoft is offering discounts on Windows 8.1 prices, the latest version of the OS, to OEMs to bolster sales and maintain its market share. Furthermore, the company phased out support for Windows XP in April. We expect that these efforts will bear fruit and license sales will pick up gradually. However, this new policy to subsidize license cost will negatively impact Windows pricing per PC. We estimate Windows license per PC will decline to $42 by 2020, and limit the revenue growth for the division.

In sum, new PC shipments together with the existing installed base of Windows PCs, should help Microsoft post growth in license sales. This should help stem the decline in OS market share as the company will be able to limit client migration. Currently, Microsoft has approximately 78% market share in the operating system space, and we expect that to stabilize at 75% by 20.

Focus On Hardware Sales

With global PC shipments still experiencing a decline in demand, Microsoft is increasingly pursuing its devices and services strategy to reduce its reliance on PCs and expand its footprint into the hardware domain. Furthermore, the company is increasingly targeting enterprise customers to reignite sales of Windows as corporations around the world continue to prefer Windows for their operating system.

The company recently acquired Nokia's (NYSE:NOK) phone division. Currently, demand for sub $200 smartphone is strong in emerging economies and Nokia has good presence across these geographies and price points. We expect that Microsoft will be able to sell more smartphones in the coming future. [2] Furthermore, the company has recently launched Surface 3, which targets business/enterprise clients. We estimate that sales of Surface 3 can boost Microsoft's revenues. [3] These device sales can boost revenues for Microsoft meaningfully in the future.

Other divisions expected to add to profitability

We expect Windows 8.1 to aid the adoption of Microsoft's Bing search engine. We estimate that the service has around 2.6% global search market share, but we expect this to expand over our forecast period with Bing as the default search engine on the OS. This improvement will contribute to an increase in Bing's market share, which we think will reach around 4% by the end of our forecast period.

Skype continues to gain traction and continues to roll out services across mobile platforms that supplement its PC application. Skype complements the existing Microsoft product portfolio. Currently, Microsoft offers a host of products across the personal and enterprise domain. In the personal domain, Microsoft has MS Home, Windows Messenger and Hotmail. For enterprise solutions, it offers LYNC and Exchange, which generated nearly $1 billion in revenues in FY2013. With Skype, Microsoft has a unique option of providing collaboration software that would encompass most of its products. We believe that Skype will turn profitable for Microsoft by the end of our forecast period.

We currently have $41.23 price estimate for Microsoft, which is in line with the current market price.

Disclosure: No positions.

Source: Microsoft Fairly Valued At $41