The Microsoft Mantra

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About: Microsoft Corporation (MSFT)
by: Karl Ahlstedt
Summary

Microsoft continues to deliver growth and innovation at an accelerated rate. Largely priced in at current levels.

Satya Nadella is performing well in the CEO role and is the driving force behind the move into big data and cloud technology.

Acquisitions of recent years appear to have reversed the trend of mediocre results, with LinkedIn the standout performer raising revenues from $960m to $5.3bn since 2016.

Investment Thesis

Microsoft (NASDAQ:MSFT) is up 18.8% YTD boasting a market cap of $915bn; this is largely due to positive factors that are in the author's opinion largely priced in. While Microsoft retains various hot spots and opportunities such as the performance at LinkedIn, the current pricing levels remain elevated.

Background

Microsoft employs over 100,000 people worldwide and operates in over 100 countries (Microsoft, 2019); it faces significant challenges in many core products or cash cows. In the short term, Microsoft is immune to most economic factors due to its size, cash reserves, and diversity in its product portfolio. Microsoft has a market cap of around $900bn, up from $250bn in 2016 (Google Finance, 2019). Historically, MSFT has retained large cash reserves on its balance sheet; in Q2 2016, it reported just over $102bn in cash, cash equivalents, or short term investments (Microsoft, 2016); now standing at $133.7bn as of October 2018 (Microsoft Annual Report, 2019).

The Microsoft Mantra

Microsoft aggressively conquered the 90s and early 2000s, and once again, it appears to have found its way back towards innovation and dominance. As an outsider looking in, these are the three areas Microsoft appears to be currently excelling in:

  • Creating great software and distributing it far and wide.
  • Leveraging size, reach, and expertise to conquer new markets as they emerge.
  • SaaS - This subscription-based model provides greater margins compared to traditional alternatives and is likely to be the future model for much of Microsoft's cash cow product portfolio.

Positive Developments

2016 LinkedIn acquisition

LinkedIn has a dedicated audience of professionals which is an area Microsoft has strived to succeed in over recent years. Working on productivity and assisting professionals to communicate provide an excellent overlap in this specific area, and this echoes an area where synergistic effects could occur as a result of this acquisition (Kelleher, 2016).

Theoretically, it is widely believed that deal execution and integration in M&As is difficult and notoriously hard to achieve successfully. Microsoft itself has had varying degrees of success in this area and investors may well remember the repeated write downs to the smartphone business. Termed by the FT as the "ill-fated $7.2bn purchase of unit from Nokia". Exploring other large M&As made by Microsoft and there is a clear trend of mediocre results. aQuantive and Skype have demonstrated historic uncertainty. A significant change in strategy compared to historical mergers is that LI continues to be run independently, perhaps avoiding issues associated with integrating two companies in the traditional sense.

In the author's opinion, one key underlying asset of value in this acquisition is the newsfeed built into LI. Expanding the environment of the newsfeed to become the "go-to" destination for users who want to explore careers, companies, and the wider industry has the potential to create a market as big as Facebook is for social interactions. If Microsoft can dominate the social space for professionals before Facebook, this could be the single best move the company has made this decade. This is a form of long-term value creation but one that is at best unlikely to succeed in the manner mentioned above. It does provide a long-term opportunity that arguably more than justifies the price paid for LI.

This also taps into a key strength of LI, which is providing the services around employment which employers, employees, and prospective employees all find valuable and useful.

This notion is supported in terms of the breakdown of revenue, with talent solutions contributing 65% of revenue in Q3 2016. This area encompasses all of the paid for services LI provides to recruiters and commercial companies using this to hire additional staff. Premium subscriptions provide 17% of revenue, and this notably encompasses Sales Navigator, the lead generation service and LI provide.

https://i.gyazo.com/a5ef5c5465fc66f565d4a004d0cbfb44.png

(LinkedIn, 2016) Figure 1

Fast forward to full-year 2018 results and LI reported revenue of $5.3bn, up from $2.3bn for full-year 2017, offset somewhat due to the timing of the merger occurring in late 2016. The annual report indicates revenues primarily consisting of talent solutions, in all likelihood to a greater extent than the 2016 figure of 65% shown above.

Furthermore, synergies exist within Microsoft Dynamics as well as customer relationship management and enterprise relationship management point solutions to integrate and develop suite solutions for professional and enterprise customers. It may be argued that Microsoft is optimistic that LI will act as a lever with which to consolidate professional users profile data across the entire Microsoft network. This may be further enhanced by building on technology such as the personal assistant for Windows, Cortana (Bright, 2019).

LI retains highly experienced data experts which may bolster the human capital resources of the wider company. With the pivot towards this high growth area by all major tech firms, this is widely considered as a competitive advantage (Hachman, 2018).

The data collected by LI may also prove highly valuable to Microsoft. It is a broad data set encompassing previous employment, interests, qualifications and the connections made to other users. This may prove useful as Microsoft continues to build new and innovative solutions targeted at managing customer and enterprise relationships.

An often overlooked implication of this deal is the acquisition of Lynda.com, a subsidiary of LI. Microsoft has a longstanding history of providing technical certification and is considered a credible qualification within the respective industries. Microsoft may see this as an opportunity to expand into many other subjects with Lynda. This has potential in that Microsoft could pioneer and dominate this albeit less valuable sector of social and educational learning platforms (Foley, 2016).

The Microsoft search engine Bing may also indirectly benefit from integration with the LI platform. This may be realized in Bing delivering the best search for the professional market.

Ultimately, there appears to be solid preparation by Microsoft and a clear path towards to realizable synergies.

In the author's opinion, the profitability and valuation of LI will likely be set based on its success in its current growth strategy, or by the success of Microsoft in integrating the complimentary services to add significant additional value. This is relatively speculative, and the author considers this acquisition to be and remain of relatively high risk.

Gaming Industry Growth

This segment can be generally split into two parts, Xbox remains the mainstay of Microsoft gaming operations, but its acquisition of Minecraft, the introduction of the Windows Store and its longstanding publishing arm now titled Xbox Game Studios provide a sense of flavor as to the width and breadth of Microsoft operations within this segment.

Overall gaming revenues for 2018 saw growth in the region of 14% or $1.3bn growing to an aggregate of circa $10bn due to strong Xbox software and services revenue growth of 20% predominantly based on external third-party titles performing well. In terms of exposure to the gaming industry via Microsoft, revenues stand at circa 9% of group performance and this is unlikely to materially change in short to mid term horizons, again relative to other segments. Therefore, it is perhaps unjustified for investors to use Microsoft as a play on the gaming industry, despite somewhat widespread commentary attesting to the fact.

Moving forward, Xbox will likely perform in-line with expectations and continues to remain on par with the Sony PlayStation equivalent, and the next generation of hardware is unlikely to upset the balance that exists today. Caveats to this might include significant acquisitions of the major gaming companies or a revolutionary new type of format that causes substantial change and opportunity for those at the forefront. Various technologies have been touted as such, most prominent being VR headsets and more recently Google's Stadia. These trends have not been adopted at the rates analysts have predicted in the past, and with no new hardware on the horizon, which is to say we will continue to see iterative not revolutionary improvements, the short to mid term environment remains relatively stable for Microsoft in the gaming arena.

Microsoft Office

The continued trend to move users from one time purchases to annual subscriptions via Office 365 provides the catalyst for continued growth in this area. This is especially true for commercial licenses while consumers have been slower to adapt, and while the pace of change has been lower, it has thus far been steady providing cautious optimism in this SaaS approach.

Adoption of Office by non-users remains a core challenge, with further headwinds in the form of various markets and particularly demographics with lower disposable incomes still using unlicensed and pirated Office software on a widespread basis. This in the past has been tolerated to a large extent, with former CEO Bill Gates stating that the job today is to get people using Microsoft software and that the job of tomorrow is figuring out how to make them pay for it.

From a practical standpoint, Office is becoming an increasingly attractive cash cow for Microsoft as it continues to mature.

Microsoft Windows

The future of Windows is a less certain, despite its lead in terms of market share which currently stands at circa 4x that of Apple and this month hit 800m MAUs according to Yusuf Mehdi, Corporate Vice President of the Microsoft group.

https://i.gyazo.com/813bedb8027e430ed1de32c198e56569.png

(Source: Twitter, 2019)

Yet this is largely the result of providing Windows free of charge to a large and substantial number of existing users of Microsoft products. At the time of the Windows 10 launch, it was speculated that this would be the last definitive version of Windows as the company transitioned towards a subscription model as it had done with Office as detailed above. The future commercialization strategy for long term prospects remains unclear, and while Microsoft likely possesses big plans for this flagship line they have up until this point remained tight-lipped as to the direction the group will take moving forward.

Azure & The Cloud

Arguably late to this particular party, Microsoft has since made up ground in the last few years against frontrunner Amazon (NASDAQ:AMZN). Jeff Bezos, founder of Amazon recently commented on how in terms of the cloud the environment surrounding it was something of a miracle. Usually, when a company discovers a highly profitable and scalable process of doing things, in this case cloud technology, it usually takes 12-24 months for competitors to cannibalize that innovation by way of copying and competing. Bezos felt that he had been given a 7-year head start, with competition only as recently as 2016-17 beginning to add pressures to margins and headwinds to growth (The Fly, 2018).

Management - Satya Nadella

CEO since 2014 Nadella is credited with Microsoft's turnaround over the following years. Leading the Windows line from a lagging Windows 8 to Windows 10 which as noted above, gained widespread adoption and cemented the core OS market position for the company.

The two major acquisitions under Nadella include GitHub and LinkedIn, with the latter having been explored above. GitHub similarly represents attractive potential and has gone a long way in the open source community in developing a more effective approach to bridge the opposing ideologies of open vs. closed source software. A developer for many years, Nadella possesses an insight into how to fix at least some of the friction between developer communities seen in recent years.

Overall, in the author's opinion Nadella is in aggregate a great CEO of a talent and expertise not seen since Gates. The embracing nature of Nadella for creating the future takes a certain kind of vision, and this is shared across many of the noteworthy tech leaders, both past and present.

Headwinds & Adverse Performance

Big Data - Privacy Implications

Big data and regulatory changes in recent years continue to pose a material headwind to Microsoft's bottom line. No stranger to litigation, Microsoft previously sent team's of lawyers across the globe in the hope of minimizing legal issues as they arose (The Guardian, 2012). In addition to this, the relationship between Bill Gates and the US government proved both difficult and costly to Microsoft over the years, with tech veterans all too familiar with its monopolistic practices through the 90s and into the first few years of the millennium.

The most significant historic legal case would be "United States v. Microsoft Corp" in 2001 which Microsoft lost but later repealed largely successfully. This narrowly avoided the company being split into two separate entities, but over time, the aggregate market share of Microsoft continued to decline, and the monopolization issue generally fixed itself.

Today the new frontier is the cloud, big data and AI that is collecting and processing data to provide valuable commercial insights. This is a problem that applies to most major tech companies, the data they retain helps with driving ad revenues and other, perhaps nefarious insights (notably in the political sphere, and how this data allows advertisers to more effectively target and manipulate particular demographics). Although it should be noted that this is less of a problem for Microsoft than it is for the likes the Facebook and Google, who rely intrinsically on these abilities to control and process data in a commercial way. Potential regulatory changes provide a material adverse headwind to Microsoft and other sector participants.

Financials

Special Items:

Research & Development:

As the table below illustrates, aggregated spending on R&D at Microsoft continues to grow modestly while Apples spend has grown aggressively in recent years. Historically, Microsoft has outspent competition by a substantial margin. It is difficult to specifically pinpoint the value of this, but it is a reasonable assumption to assume a substantially higher rate of spend relative to competitors was a competitive advantage now largely eroded.

Microsoft

R&D Spend

Apple

R&D Spend

2015

$12bn

2015

$8.1bn

2016

$12bn

2016

$10bn

2017

$13bn

2017

$11.6bn

2018

$14.7bn

2018

$14.2bn

(Source: Microsoft & Apple, 2018)

Balance Sheet

Boasting a net book value of $82.7bn Microsoft trades at a 9x multiple with its assets achieving a return on capital of around 25%. This is considered solid performance, and it should be noted (as with all major technology companies) that traditional metrics of profitability on assets provide only a partial picture. This is due to the extremely low capex associated with most forms of growth, output is largely irrelevant to the level of core assets maintained. An example of this might be the incremental cost per user to Bing, it is miniscule to the point of irrelevance (Microsoft, 2018).

Caveats aside, the balance sheet continues to strengthen with cash and equivalents standing at $113.76bn at the end of 2018. This is a potential war chest on a scale that very few companies have access to and is indicative of how substantially Microsoft could move forward on opportunities should they arise.

Acquisitions and mergers provide an alternative use for cash on hand but are again unlikely as the scale of purchase needed to make a dent in a $100bn+ stockpile is rather significant. Furthermore, equity prices are elevated arguably across most developed markets providing a disincentive for M&As compared to recent years.

DCF & Valuation

2018

2019

2020

2021

2022

Revenues

$110.36

$119.19

$128.72

$139.02

$150.14

Operating Profits

$36.47

$39.39

$42.54

$45.95

$49.62

Tax at 19%

$19.90

$7.48

$8.08

$8.73

$9.43

Actualised Free Cash

$16.57

$31.91

$34.46

$37.22

$40.19

Discounted Cash Flow

$15.78

$28.94

$29.77

$30.62

$31.49

2023

2024

2025

2026

2027

Revenues

$162.16

$175.13

$189.14

$204.27

$220.61

Operating Profits

$53.59

$57.88

$62.51

$67.51

$72.91

Tax at 19%

$10.18

$11.00

$11.88

$12.83

$13.85

Actualised Free Cash

$43.41

$46.88

$50.63

$54.68

$59.06

Discounted Cash Flow

$32.39

$33.32

$34.27

$35.25

$36.26

Assumptions:

Discount Rate

5%

Growth Rate

8%

Tax Rate

19%

10 Year Present Value

$308.09bn

(Source: Author & Company Reports, 2019)

Firstly, it is worth noting the figures in the table above are in billions of dollars. Other assumptions going into this model include a growth rate of 8% which is projected based on the past five years performance as well as discounting 2018's large tax charge due to the recent tax cuts in the US, which led to large inflows of capital back into the US from overseas. This provides a reasonable foundation to project forward, which aggregates to around $308bn in added value over the next decade.

In the author's opinion, this is relatively disappointing, at a market cap circa $900bn the added value leads to less than impressive rates of return if bought at market prices today.

However, this $300bn in added value could end up translating into $600bn worth of increases in share price, but this is far from certain. Capital paid out in dividends, share buybacks and so on would adversely impact aggregated book value had the company not engaged in such activities. Thus, it is somewhat unreasonable to suggest this $300bn will turn into highly profitable assets for the company and earning the respective increase in equity values associated with such a positive development, at least for the most part.

To further touch on the growth estimates, it was calculated based on previous performance and should remain stable based on global trends towards further digitalisation. The specifics are difficult to pinpoint, but technologies such as AI, Big Data and the IoT coupled with the historical demand growth across many of the areas Microsoft operates within provides the baseline for future expectations. As discussed above, cloud technologies continue to grow exponentially and so continued progress in this area is a particular catalyst of note.

In terms of share price expectations, Microsoft is currently trading at an all-time high. As previously discussed, this is in the author's opinion due to other positive developments being priced in. However, the short to mid term price expectations continue to be set by market sentiment, which is likely to remain favourable providing short term upside.

Historically the last decade has been kind to Microsoft, seeing its share price rise from circa $20 to $120. While the value creation detailed above is conservative, it is unlikely that a similar trend from $120 to $720 will occur over the next 10 years. Admittedly, the field of technology advances in unpredictable ways, and so the future is extremely challenging to gauge, and so most projections should be taken as merely that, projections.

Conclusion

To conclude, Microsoft is a great company and has regained both favor from Wall Street that is encapsulated in its share price, and its vision towards the future. Nadella has performed well, perhaps highlighted by the less than stellar performance of predecessor Steve Ballmer.

The balance sheet remains strong and growth expected to continue at current rates moving forward. This is likely to culminate in reasonable but not exceptional performance across the next decade, at least in the author's opinion. Microsoft continues to look expensive relative to profitability and asset base metrics, but this is hardly a revelation, Microsoft has traded beyond its perceived fundamental value for decades.

Microsoft will continue to deliver acceptable performance, but in the author's opinion does not look substantially over or undervalued. In short, I remain neutral on Microsoft and generally believe there are better alternatives for investment in other areas.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.