It's hardly news that value plays in tech don't often work out as well as value hounds would hope. Simply put, almost nobody cares to own value-priced tech names absent some brighter prospects for growth. There is no doubt that Microsoft (Nasdaq: MSFT) faces numerous challenges in maintaining its status with consumers and enterprises. But are those challenges really so formidable that this stock should carry multiples more commonly associated with commodity companies like Rio Tinto (RIO) or BHP Billiton?
The Bear Case
The problems with Microsoft can be summed up in a few words – Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG), VMware (NYSE: VMW), ARM Holdings (Nasdaq: ARMH). More broadly, I mean that Microsoft's core businesses are under stress and threat from the advent of mobile devices that don't run Windows or other Microsoft products and that are replacing PCs that do. What's more, Microsoft has to deal with the migration to a cloud/software-as-a-service based model, increasing amounts of freeware, and just a general shift in IT to a brand new world.
Not helping matters is the long-repeated platitude that tomorrow's tech leaders generally fatten themselves on the bloated carcasses of yesterday's tech leaders.
Throwing Stones At The Windows
It would certainly seem that Microsoft would be a ripe target for the next generation. After all, the company still gets about 80% of its profits from Windows and business products like Office. Now, though, PC sales are in the dumpster and people are buying smartphones and tablets instead – devices that don't run Windows. And if these devices don't run Windows, they won't be running Office either – and it's not just the mobile market that's chipping at Office, as this article is being written with Open Office on a notebook that uses Windows but no other Microsoft products.
A New Model With New Metrics
As the balance of device power seems to be tilting toward mobile, the way in which businesses and consumers access software and information is also changing. Cloud is on everyone's lips and the migration to software as a service would seem to threaten some of the stickiness (and high pricing) that Microsoft has long enjoyed for its products. At the same time, virtualization and Big Data are changing how the back-office of enterprise IT runs.
And Yet … Microsoft Is Not Dead Yet
All of the above is more or less true – even Microsoft itself has acknowledged it to some extent. But the question remains whether Microsoft truly deserves to carry the sort of multiples that are more commonly seen among vendors of iron and copper.
While tablets and phones may be changing how people compute, neither Apple, Google, nor Samsung have made any real inroads into the back office where these devices have to be stitched in to the enterprise IT system. What's more, the company's Azure platform should be a significant player in the future cloud world – a world that is still fairly short on development tools. At the same time, the company's Office 365 represents just the beginning of a cloud/SaaS strategy.
Don't forget, too, that Microsoft has not just conceded the mobile market. The company's partnership with Nokia (NYSE: NOK) is about to deliver its first smartphone to the U.S. and early reviews of the Lumia have been rather favorable. At the same time, the company is not only looking to try to reestablish a new WinTel model in tablets (offering software to coincide with new chips from Intel (Nasdaq: INTC), but also expand into ARMH-based devices as well. This will be challenging, as the instruction sets for the chips are different, but should not an insurmountable challenge. Moreover, don't forget about the Skype deal – something of a wildcard in the mobile world at this point.
Time Is On Its Side
For all of the talk about how the IT world is changing, it never seems to change quite as much as people want to think it will. To name just one example, where is the so-called paperless office? To this point, Microsoft is deeply embedded in enterprise IT – from Windows to Office to SQL Server and that is not going to disappear overnight.
Yes, Microsoft has lost a step or two and has to fight against other heavyweights like IBM (NYSE: IBM) and Oracle (Nasdaq: ORCL), but there's a huge base of business to fund its migration to the next generation and that base will likely wither more slowly than analysts believe. Plus, it's not always vital to be first – Microsoft wasn't first in PC software all these many years ago and it didn't seem to do it lasting harm.
The Question Of Value
Assuming that Microsoft can continue to show growth in businesses like tools and entertainment, today's valuation seems to predict that Windows and Office will basically erode to nothing over the next decade. That seems like a pretty unlikely event – even if the company's efforts in mobile computing don't make it the leading OS company, it will extend the decline curve.
What's more, it is interesting to see the disconnect between what the analysts are saying and what they are modeling. Plenty of analysts are down on Microsoft and believe that Windows/Office is doomed by Apple/Google/ARMH and that the company's own efforts in mobile and SaaS aren't enough to maintain its business. And yet, when it comes to their cash flow models, very very few of them seem to have the courage to actually model declining free cash flow over the next decade.
Right now, a model based on just 2% free cash flow growth and a 10% discount rate suggests Microsoft shares should be worth something north of the high $30s. Certainly perception is important in tech stock investing and the perception around Microsoft is that it's too bloated, too old, and too hidebound to adapt to the new realities of the corporate IT world. But the perception of IBM wasn't much better not so long ago and that company has undergone a remarkable improvement in valuation and perception. If a few things go right for this company and management can induce the Street to believe in its growth prospects, it could be quite a winner.