Microsoft: A Primer On Major Trends

| About: Microsoft Corporation (MSFT)
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Microsoft Corporation (NASDAQ:MSFT) is one of the leading software and hardware producers in the world. Its products range from the X-Box 360 to Azure cloud servers. It has five main divisions, but the Windows and Windows Live, Servers and Tools, and Microsoft business divisions make up more than 80% of revenue and nearly 100% of operating profit. Thus in examining this company, it makes sense to focus on these three divisions, as these will be the drivers for the company in the coming years.

The two biggest news items for the company have been the debut of Windows 8 and the debut of the Microsoft Surface tablet and new Windows-based smartphones. These ideas are inextricably intertwined because Microsoft's mission is to create interconnectivity between all its platforms—PC, phone and tablet—and it will accomplish that through the new architecture in the hardware and the new operating system, Windows 8.

Windows 8 is an aggressive iteration of the operating system but probably necessary, given the total difference between demand for this operating system and that for past operating systems. Windows 8 honestly appears to be a strong effort on behalf of Microsoft. The interface is vastly different from past operating systems due to the Metro system. Windows 8 is clearly built with the tablet/smartphone in mind, if not a priority, because many of the features are designed to be used through touching, swiping and other motions.

Even the PC version incorporates a new touchpad which should please users. Inevitably there will be criticism even as Microsoft works out the bugs. This occurs with every major launch being tested as publicly as Windows 8. However, given the high profile of Windows 8, I expect Microsoft to present a polished product unlike, Vista which should help the product succeed.

However, I do not believe Windows 8 will do as well in the business sector. Windows 7 has been extremely successful already selling over 500 million licenses to date. Not only is this the largest amount of licenses sold, but also the highest penetration of a windows operating system, as approximately 68 out of every 100 computers shipped and uploaded with an operating system had Windows 7. This limits the amount of business sales Windows 8 will have.

Further evidence of this is the fact that Windows is encouraging business to upgrade to Windows 7 before Windows 8 comes out, partly because system refreshes take a while and Windows XP support ends in two years. As a whole, business licenses do not have the growth potentials of other areas, especially given that Windows 7 could easily stay on PCs for ten years just as XP has on many. Additionally, the look of Windows 8 is vastly different from prior operating systems, making business even less likely to adopt the system.

Nonetheless Windows 8 will most likely be successful. Its success, however, is very much dependent on the success of its tablet and smartphone iterations. This is because Microsoft is really pitching interconnectivity, indicating that network effects will be an industry driver. Smartphones are here to stay and the tablet poses not only a leisure opportunity but also a way to innovate on the business side due to the portability offered by a tablet.

Microsoft honestly had no choice to go into the market even though many consider this outside of its traditional market. Reviews currently run the full spectrum, and only time will tell if it is a good product. However, one part for concern is the estimated $600 price tag. This is troublesome in my opinion because Microsoft hasn't established the cache that Apple is to charge that much in the tablet market; lower-ended tablets are a couple hundred dollars less.

Additionally, if part of the goal of the tablet is to create a network effect, one must wonder why Microsoft doesn't try and undercut the market for long-term gain. In summary, predicting the long-term success of the tablet and smartphones is difficult at best, and possibly impossible. However, clarity is on the horizon, namely through coming reviews of the hardware and order backlogs as we approach the release.

The Microsoft Office Suite remains a strength of the company, as it is constantly being updated and added to. Recent additions include the Lync system which would further the connectivity that Microsoft is pushing. Office's greatest strength is arguably its turnover. Unlike operating systems, consumers refresh office much more, frequently providing the company with steady income.

Microsoft's biggest strength though lies in its servers and technology segment. Windows has an absolute stranglehold on the market as 75% of servers run a Windows platform. Microsoft's revenue from this segment has grown every quarter out of the last seven in the 10%-15% range. More significantly, the market is growing organically and shows no sign of slowing down. This makes sense as not only is the number of devices (PC, tablet, etc.) growing, but the interconnectivity between them is increasing too, creating huge demand for more server service. I believe this to be the most bankable catalyst for Microsoft in the coming years.

Creating a price target for Microsoft is not only difficult, but possibly fruitless. Microsoft operates in many major markets—all with different dynamics. Generating true revenue estimates requires intricate knowledge of these industries, which is best left to those researching for a living. Additional valuation is difficult because Microsoft has no true competitor. In the software market, it competes with Apple, Linux, and others; in the tablet market, it competes with Google, Apple, and other hardware producers; and in the server market, it competes with Oracle and others. All of these companies are quite varied and their relative valuation is tricky. However, absolute valuation is not unreasonable.

Microsoft has been a model of consistency. It has nearly doubled its revenue over the past seven years (10% CAGR) with remarkable consistency—there has only been one year when revenue dipped, which occurred understandably during the recession. Net income and operating income have nearly tripled over the same time span (18% CAGR) with the same consistency. For the foreseeable future, given the company's growth in servers, strength in business and innovation with Windows 8 and the tablet, it cannot continue this top-line revenue for the next few years.

It is quite remarkable that Microsoft has been able to increase its operating margin and net profit margin from 25% and 22% to 39% and 33%, respectively. Yet Microsoft's price has barely moved over that time period. This has mainly been due to the compression of valuation, as the company was trading near a P/E multiple of 30 in 2004 and now sits around 10, which is more than a fair valuation for a mature company. Therefore, future increases in earnings and incomes should move the stock accordingly, and the company should not have to work hard to keep increasing margins. However, to expect Microsoft to grow rapidly would be a mistake. The opportunities are simply not there.

There still are other reasons though to like this company—its free cash flow and dividend. The company has consistently increased its dividend at around 15% rate and has even admitted in recent interviews that it plans to focus more on dividends with its free cash flow than buybacks. I would be confident that this will continue. The company's free cash flow yield based on 2011 earnings and the current price is nearly 9%, but with growth of earnings in 2012 should approach 10%. This truly illustrates well-run operations. Along with its very strong cash position, the free cash flow provides ample opportunity for Microsoft to continue its dividend and investment into other adventures.

In my opinion, if you're looking for a company that will double in 2-3 years, look elsewhere. Microsoft remains a strong company, albeit with some noticeable flaws. If you're looking for an 8% yearly return with a healthy 3%+ dividend that will help you sleep at night, Microsoft is a solid pick.

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