Microsoft (MSFT) is one of the most controversial companies in the technology sector, if not the entire market. Its defenders argue that it is a tremendously undervalued company whose future is being underestimated. And its detractors argue that it is a company whose long-term future is in serious doubt.
Over the past 10 years, Microsoft has returned just over 11%, but that is a number that lags the major indices, especially the NASDAQ.
(click to enlarge)Microsoft's stock has been range-bound for years due to several key issues, which we have profiled in previous articles. From a corporate culture that suffocates innovation, to failures in mobile and search, to concerns about cloud computing, Microsoft has been seen as a company that is always on the cusp of posting weakening financial results, which its critics see as inevitable. And yet, that has not happened so far. Microsoft posted record revenue and operating income in its most recent quarter, and is upbeat about its future. Record results have been common at Microsoft, and yet the stock has done nothing. Microsoft's moribund stock price is due to more to perception issues, and not fundamental concerns, at least not yet.
We have written about Microsoft extensively in the past, and much of what we have written has been critical. We criticized the company for a number of reasons, and cautioned readers that the stock should not be bought because it will be going nowhere until Microsoft gives investors absolute certainty that it will survive the transition away from desktop Windows and Office. Recently, however, our opinion has changed, and we will use this article to outline why that has happened.
Can Microsoft Truly Grow Beyond Desktop?
People do not invest based on the past. They invest based on future expectations of profitability and cash flows. With Microsoft, past or present cash flows and profits have never been the issue. Rightly or wrongly, the stock has been "dead money" for so many years because of pervasive worries about the future. However, recent events at Microsoft have given us increased confidence that the company can secure a place in the future of computing.
Microsoft's Server & Tools division is the company's fastest growing division by sales, with division revenue rising 14.1% in the most recent quarter, compared with overall revenue growth of 5.96%. Perhaps more importantly, Server & Tools operating income rose 28.55% in the most recent quarter. By contrast, overall operating income at Microsoft grew just 11.65%. Server & Tools is now Microsoft's 3rd largest division by revenue, and based on current trends, will likely become the largest within a few years. As for profitability, Microsoft will need larger revenues to exceed the profitability of its core divisions, due to lower margins at Server & Tools [the division's 38.01% operating margin is weak by Microsoft's standards (the business division has an operating margin of almost 65%)]. The opportunity in servers, however, is much bigger in our opinion, and so is the opportunity for margin expansion, which is almost certainly underappreciated, given the fact that worries about Microsoft's legendary margins find their way into almost every bearish argument about the stock (including our own previous arguments).
Morgan Stanley analyst Adam Holt met with Microsoft's CFO Peter Klein and IR director Koefoed, and his comments about that meeting impressed us. Holt's thesis on the stock, while noting that Microsoft is cheap, does not focus on valuations, which is a refreshing change (Holt did note for good measure that Microsoft is trading at a free cash flow yield of 15%, which is "dirt cheap"). Rather, Holt directly addresses the issue of margins, central to worries about Microsoft. Holt believes that Microsoft's new products will be accretive to margins, and that there is room for margin expansion. Microsoft has increased prices on its SQL 2012 line by up to 15-20% in some cases, and that this price increase has been absorbed by the customer base. With Windows 8 Server set to see some modest price increases as well, Holt sees margins expanding in upcoming quarters and fiscal 2013. Holt also states that, "additionally, meaningful improvements in System Center will help total ASPs, while substantial upgrades of the Hyper V capabilities should drive the premium Windows Server mix above the 25-30% levels seen today." The server upgrade cycle is alive and well, and Microsoft seems to be a prime beneficiary of that. Checks seem to show that demand for other cloud offerings, including Office 365 and Windows Azure is growing. It is Windows Azure that we would like to focus on.
The Azure platform is Microsoft's cloud computing offering that lets customers run applications through Microsoft's network of data centers. Azure also includes online database solutions and CRM solutions. Azure is crucial to Microsoft's future: if the company cannot retain customers as they move to the cloud, it could very well lose them forever. Microsoft knows this, and it is pricing Azure aggresively as a result, in large part to outfox Amazon (AMZN), which has emerged as one of its chief competitors in the cloud computing space with its EC2 platform. And in a rare occurrence in the past few years, it seems Microsoft has the upper hand. Of course, since this is Microsoft' the upper hand is due to financial strength rather than outright innovation. But in this case, it does not matter.
True to form, Amazon has priced its EC2 platform to try and undercut its competitors and corner the market, just as it has done so many times before, This time, however, it is unlikely to work, due to the financials of both companies. Microsoft, with its fortress balance sheet and enormous cash flows, has a good deal of room to maneuver on pricing. It can do whatever is needed to retain customers. Amazon, however, does not have that luxury. Over the past few years, Amazon has expanded into many new markets, amassing many new competitors. Amazon is battling Apple (AAPL) in tablets, Best Buy (BBY) and Walmart (WMT) in retail (among others), Barnes & Noble (BKS) in e-books, and Microsoft. All of these investments have spread Amazon thin, and the company's financials show it. In Amazon's most recent quarter, net income plunged to $130 million, and it is set to post an operating loss of $110 million this quarter, based on the midpoint of guidance. Expenses at Amazon are soaring, and the company is stretched thin battling on so many fronts. Microsoft and Apple compete in many markets too, but they have the financial firepower to do so. Amazon does not. With $5.715 billion in cash & investments, Amazon does not have the financial strength to devote full attention to every market. It will likely have to choose at some point in the future where it wants to direct full attention to. Microsoft, with tens of billions in net cash and investments, can afford to outspend Amazon by a huge margin.
Bing, Mobile, and The Ballmer Factor
Our previous articles (linked to above), have cited Bing, Microsoft's weakness in mobile, and Steve Ballmer as liabilities that make it impossible for us to invest in the company. However, recent events have served to alter our attitude towards these factors.
Bing is still a black eye for Microsoft, with the online division losing $479 million in the last quarter, and billions since inception. However, losses narrowed dramatically year-over-year (down from $776 million in the year-ago period), and as long as Microsoft's overall business keeps growing, those losses can be absorbed essentially indefinitely, or online can finally reach profitability. While we would prefer to see Microsoft simply shut down Bing, the company is unlikely to make such a public exit from the search business. We have previously written than Bing is one of the reasons not to invest in Microsoft. So why are we discounting it now? Because strength in the rest of Microsoft's business lines is enough to offset losses in the online division.
Microsoft's deal with Nokia (NOK) is progressing well, and Lumia sales are growing slowly but surely. In any case, Microsoft will not give up on Lumia, or Nokia, because it is the company's last chance to gain a presence in the smartphone market. We believe that Windows Phone can achieve third place in the smartphone market, and have written extensively on Nokia's position in the market.
Furthermore, Microsoft can help solve problems in this market in classic Microsoft fashion: with large infusions of cash. According to Reuters sources, carriers across the globe, including those in Europe and the United States, want Windows Phone to succeed, so that it can be used as leverage in negotiations with Apple and Google (GOOG). Carrier executives say they want to see Nokia and Microsoft (meaning just Microsoft) spend more on marketing Lumia phones, and that carriers are prepared to do their part to support sales. For Microsoft, increasing marketing spending is easily done, and is an investment the company should make if it wishes to be successful in smartphones.
And what of Steve Ballmer? We continue to believe that he is the biggest drag on Microsoft's stock price (even moreso than margin concerns), and that Steve Ballmer must be ousted as CEO of Microsoft. The upcoming launch of Windows Phone 8, and Windows 8 for tablets are crucial for several reasons. They represent Microsoft's last chance to gain a foothold in mobile computing. Windows 8 must sell well this holiday season on both fronts. However, if it does not, that could prove to be a catalyst for the stock, as we have written in a previous article. Should Windows 8 fail, it will likely trigger discussions about Steve Ballmer's continued leadership of Microsoft. Hedge fund manager David Einhorn has already voiced a desire to see Ballmer go, and should Windows 8 be a flop, we believe that other investors will begin to clamor for Ballmer to go. While the board has expressed confidence in Ballmer, every CEO has the "full confidence" of his or her board right up until the point that they do not. Windows 8 is too important for Microsoft for someone to not be fired if it flops. And that someone should be Steve Ballmer. Microsoft is in need of new leadership, and a CEO who can transform its corporate culture. Innovation must be allowed to take hold at Microsoft, and the bitter internal political battles must end. We think that as the server division gains prominence, the internal power of the Windows and Office divisions will fade, and that such a decline will allow for a decrease in corporate infighting.
Acquisitions: A Necessary PR Move
Microsoft, with $56.659 billion in net cash & investments, as well as an AAA credit rating (one of just 4 U.S. companies), has plenty of room to make acquisitions. Many years have passed since Microsoft has been seen as an existential threat to competition. Virtually no one sees Microsoft as a threat to competition. If anything, Apple and Google receive more regulatory and public scrutiny on the competitive front. This change in perception gives Microsoft room to maneuver on the acquisition front, and the company would be wise to strike.
There are many software companies that Microsoft can acquire, and many would serve as PR victories. Microsoft does not need an acquisition to strengthen its financials. It needs an acquisition to dispel the notion that it has no future in the cloud. And with almost $10 billion in quarterly operating cash flow, Microsoft has plenty of ability to finance almost any deal. So who could Microsoft buy? Almost any software company would do the trick.
Salesforce.com (CRM)? Easily done, and Microsoft will gain control of a company that almost everyone sees as the leader of the cloud computing market. And under Microsoft, Salesforce can likely be a profitable business because the company would likely cut down on Salesforce's huge stock compensation expenses. Citrix Systems (CTXS)? Microsoft can finance a takeover with a 43% premium (worth $20 billion) with 2 quarters of operating cash flow and gain control of a major player in virtualization. VMware (VMW)? That would be tricky, but still doable. To gain control of VMware, Microsoft would have to take control of EMC. With a market capitalization of over $51 billion, a takeover of EMC would deplete Microsoft's cash reserves, given the premium needed. But with EMC comes 80% of VMware. Microsoft could then spin off EMC's core storage business and buy the remaining 20% of VMware, giving it control of virtualization market leader. Red Hat (RHT)? If everyone thinks Microsoft will be doomed thanks to open source products, like those from Red Hat, why not buy Red Hat and take care of the problem the Microsoft way?
Given the current market climate, Microsoft would be wise to move. Stock prices are depressed across the world, and there are ample opportunities for the company, both here in the United States and abroad.
We did not actively address Microsoft's valuations as a reason to be positive on the stock. People have been arguing that Microsoft is a buy due to its low P/E ratios for years, with no success. Cheap is not a reason to buy shares of Microsoft. However, recent initiatives in the server business have shown that Microsoft is capable of adapting, and that margins in that business should rise, providing upside to earnings. Windows Phone sales are growing slowly but steadily, and should Windows 8 be a flop, at a minimum debate will likely begin on whether or not Steve Ballmer is qualified to lead Microsoft, which should provide a catalyst for the stock to rise. 2012 and 2013 are set to be interesting years for Microsoft, and we believe that they will be positive ones for the stock price as well.
Additional disclosure: We are long shares of MSFT and WMT via the SPDR Dow Jones Industrial Average ETF. We are long shares of CRM and GOOG via a mutual fund that assigns the company a weighting of 3.64% and 2.1% respectively.