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Entertainment and Devices Key to Microsoft’s Future Success
Posted by: Julie Young (IP Logged)
Date: September 5, 2013 05:00PM

On Aug. 23, 2013 Microsoft (MSFT) announced the resignation of Steve Ballmer as CEO. Ballmer’s tenure with Microsoft began in 1980 when he joined the company as its 30th employee. Throughout his career he managed many of Microsoft’s business divisions before becoming CEO in January 2000.

Taking over as CEO at the beginning of the 21st century, Ballmer was faced with battling anti-trust lawsuits that pelted the company throughout the first decade of his career as CEO. At the same time Microsoft also launched Windows XP and entered the video game industry with the Xbox. Ballmer also led the company’s entrance into the cloud computing services market with the Azure Services Platform in 2008 and spearheaded the direction of the company’s mobile operating system introduction in 2010.

In 2010 Microsoft transitioned its financial segmentation into the following five divisions: Windows, Server and Tools, Online Services, Microsoft Business, and Entertainment and Devices. Since the beginning of 2011, the company has steadily grown its core Microsoft Business while taking large market share gains in Entertainment and Devices.

In 2013 the Microsoft Business segment generated revenue of $24.7 billion with a three-year compound annual growth rate (CAGR) of 8.7%. Operating income grew steadily ending 2013 at $16.2 billion with a three-year CAGR of 11%. Revenue in the Microsoft Business segment is primarily derived from Office products which generate over 90% of sales for the segment. This segment appears set for continued growth as demand remains high for Office products.

Meanwhile, Entertainment and Devices has shown the greatest growth of the company’s five business segments over the past three years. In 2013 it generated revenue of $10.2 billion with a three-year CAGR of 18.7%. While operating income has been volatile over the past three years due primarily to gaming hardware investments, the segment has shown a three-year CAGR of 17.9%. Growth in Entertainment and Devices appears ready to continue growing at a similar pace with the introduction of Xbox One in November 2013 and the company’s announcement of its acquisition of Nokia’s Devices and Services business on Sept. 3, 2013.

Microsoft’s Xbox One is intended to revolutionize the use of television entertainment systems. Its games have new visual effects and digital capabilities. Its system features also allow users to interactively access all of the entertainment system's capabilities at once including games, movies, music and television.

Selling for $500, its initial sales will target serious gamers. However, it will also complement the Entertainment and Devices segment’s existing gaming products including Xbox 360 and Xbox Live Gold. The product’s launch date is November 22, falling within the same launch period as Sony’s PlayStation 4. Pre-sales of Microsoft’s Xbox One appear to be slightly lower than Sony’s PlayStation 4 which has reported pre-sales of nearly one million game consoles.

The Nokia acquisition announced on Sept. 3 will also contribute to growth in Microsoft’s Entertainment and Devices business segment. The acquisition solidifies Microsoft’s existing relationship with Nokia who already manufactures approximately 80% of smartphones in the market that use Microsoft’s Windows Operating System. The acquisition is valued at $7.2 billion. It will add 32,000 employees to Microsoft including Nokia’s CEO Stephen Elop who is prospectively a potential candidate for Microsoft CEO.

As a new chapter begins for Microsoft, execution and innovation in Entertainment and Devices will be a key factor for the company’s future success.

Over the past three years Microsoft’s success has been evident in its stock return which gained 40.81% for the three-year fiscal period 2010 to 2013. For the same period it outperformed the iShares Dow Jones U.S. Technology Index ETF by 5.71% and the iShares S&P Global Technology Sector Index ETF by 8.1%.

Given the strong momentum in Entertainment and Devices and the support from its core businesses, its stock return growth prospects continue to remain strong. With a one-year price target1 of $35.38, it has approximate upside potential of 11%. Investors should continue to track the execution of Xbox One sales and transition of the Nokia business which will be key factors influencing near-term growth.

1 The price target is derived from Bodie, Kane and Marcus’ intrinsic value formula. The intrinsic value formula discounts the stock’s projected one-year future cash flow by the risk-free rate on the one-year Treasury note and includes adjustments made for specific market assumptions including the stock’s beta and market risk premium.

Disclosure: No holdings.


Stocks Discussed: MSFT,
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