Microsoft (NASDAQ:MSFT) is in an interesting place at the moment - which is only in part to losing Bill Gates from day-today management. It created one of the dominant global businesses of the late 20th century but has struggled to move beyond the core products that drove this success. The Client (Windows), Server and Tools (enterprise solutions) and MBD (Office) divisions drive 83% of revenues and over 100% of operating profits (the On-line Services and Entertainment divisions are still operating at a loss).
Microsoft has spent a lot of money and resources (especially senior management focus) on the aborted (maybe) attempt to acquire Yahoo (NASDAQ:YHOO). We agree with the analysis that the pursuit of Yahoo is an attempt to compete with Google (NASDAQ:GOOG) in what has become one of the dominant global businesses of the early 21st century (on-line advertising driven by search). The Microsoft acquisition of Powerset is a further example of this strategy of aiming to compete directly with Google.
At Valuecruncher, we are not convinced by this strategy of competing with Google - we are not alone. We completely respect Microsoft’s previous successes in following into and then dominating markets. But in the on-line advertising and search market we see some of the same network effects that suggest a “winner takes all” competitive situation. At Valuecruncher we can see a situation where Google’s current dominance is eroded – but not because of a head-to-head battle with either Yahoo or Microsoft (or a potential combination). At Valuecruncher we believe that Microsoft should be looking beyond the current competitive situation to the next big profit pool. Hockey great Wayne Gretzky when asked about why he was successful is credited with the quote “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be”.
Easily said we recognise, but that is our view of where Microsoft should be directing their strategic efforts – not competing head-to-head with Google in a market their competitor dominates.
Any potential acquisition of all, or part, of the Yahoo business clouds any current valuation discussion of Microsoft. Some influential Microsoft insiders have suggested in a piece of high-level analysis that 1% of the global search market is worth US$1 billion in market capitalisation. Microsoft’s potential acquisition of Yahoo valued their share of the search market at more than that - US$47 billion for approximately 20% market share. What about the core Microsoft business? What if we ignore the potential Yahoo scenarios – what is the core Microsoft (MSFT) business worth?
The core Microsoft business is reasonably easy to value – if you exclude growth options. The business is growing well (if not at the levels of ten years ago) with robust margins. There is capital expenditure required to achieve the revenues and profitability. There is strong competitive positioning around these core products but with credible low-end competitors that have the potential to disrupt (i.e. Google Docs). The current business will change as technology develops – but as the current dominant player, Microsoft is well positioned to respond to competitive threats and to potentially lead innovation. At Valuecruncher we are not sure that Microsoft should be investing heavily in the on-line advertising and search market - they should be aiming beyond it.
Microsoft grew revenues from US$36.8 billion in 2004 to US$51.1 billion in 2007 – an 11.5% compound annual growth rate. Our assumptions of revenues for the next three years are US$60.0 billion in 2008 growing to US$74.0 billion in 2010 – a 13.1% compound annual growth rate. We have projected EBITDA margins to be flat at 40%. We have used a terminal growth rate of 4.5%. We calculated this terminal growth rate based on year three growth of 10.4% dropping to a 4% stable growth rate by year 10. We used a terminal capital expenditure number of US$3.0 billion. We have used a WACC (discount rate) of 10.5%. Both the terminal growth rate and WACC have a material impact on the valuation.
Our analysis incorporates the cash on the Microsoft balance sheet – Valuecruncher calculates a net debt number.
Our analysis gives a valuation of US$33.01 which is 20% above the current share price of US$26.03. The market appears to be placing a negative value on the noise around an acquisition of all or part of Yahoo. Focusing on the harvesting the core business and innovating (by making small bets) beyond that core appears to be the highest value strategy for Microsoft.
Based on our analysis the core business looks undervalued. Play with our assumptions – what does your analysis say?