In the past 10 years, Microsoft’s (MSFT) stock has essentially done nothing. Considering the way most people talk, you would think the same is true for the company. In reality, the financials have continuously improved – with revenue and diluted EPS increasing at a CAGR of 10% and 14.5%, respectively, over the past decade (in fiscal year 2012, used adjusted earnings of $2.73, which excludes the aQuantive impairment charge).
While I could talk about products and the future, this is in many ways unknowable, and an unproductive use of time. A more appropriate route would be to first talk about the history of the company by segment over the past few years, then address the implications of the current valuation, and finally end with my views as to why the stock is an attractive investment for long-term investors.
Microsoft is comprised of five segments: Windows & Windows Live Division (W&WL), Server and Tools (S&T), Online Services Division (OSD), Microsoft Business Division (MBD) and Entertainment and Devices Division (E&D). Before we dive into the individual segments, let’s take a look at the breakdown of sales and operating profit by segment in fiscal year 2012 (the operating income on a segment level includes certain corporate level activity, so it does not correspond directly with the operating income reported at the parent level in the 10-K):
|Segment||Sales||% of Total||Operating Income||% of Total|
As we can see, the company is highly concentrated in three areas: Windows & Windows Live, Server & Tools, and the Microsoft Business Division. As we’ll see in the coming sections, one of these businesses has stalled as of late, while the other two continue to push forward and are driving the growth across Microsoft as a whole. The two smaller divisions (Online Services Division and Entertainment & Devices) are significantly smaller than the other three segments and have a limited impact on overall financial results (although mounting losses in OSD are starting to take their toll); we’ll take a look into these areas as well to see what we can tease out about Microsoft’s long-term plans, and where these businesses fit into the mix.
Windows & Windows Live
Windows & Windows Live is largely focused on the development of PC operating systems (OS), with the company’s flagship product, Windows, driving the division; revenue growth is largely correlated to the growth of the PC market worldwide, as roughly three-quarters of W&WL revenue comes from OS software purchased by original equipment manufacturers (OEM’s), which they pre-install on equipment they sell in the market place. As has been widely publicized, PC shipments have slowed in a big way. Here’s a multi-year view of worldwide PC shipments (as reported by Gartner) to put the short-term movements into context (remember, Microsoft’s fiscal year does not align with the calendar year – so this data isn’t directly comparable, but simply relevant as a guide for market growth over a period of a couple years):
|2007-2011||+82M / Year||Four Year CAGR – 6.8%|
As always, each investor must draw their own conclusion from what they’ve researched; if you’re like me, you probably are a bit shocked to see such figures. You wouldn’t expect an industry that so many have written off as dead to grow at nearly 7% per annum in the depths of a global recession, particularly when selling a product that has a high ticket price and a life span of a couple years or even longer, depending on the user (for the average person, the computer on their desk is good enough as long as it still turns on. I’m still running XP on a PC that I’ve had for more than years).
This data paints a different picture than what’s presented in the financial media. And that’s expected. They have a vested interest in keeping you glued to the TV, lest you miss any key information about how the world is rapidly changing before your very eyes. This same idea is directly applicable to the success of the Windows operating system; despite talks of the rise of Apple (AAPL) and Google (GOOG) Chromebooks, the reality is that Microsoft still commands about 90% market share.
Server and Tools
To start with, let’s take a second to think about the growth of Server & Tools, and what that means for Microsoft: Since 2002, this segment has seen revenue and operating income increase at a rate of 12% and 26% per annum, respectively (from $6.16 billion in sales and $747 million in operating income) – with CFO Peter Klein noting on the Q4 call that the “opportunity for future growth [in S&T] has never been better.” Since fiscal 2008, operating income has increased $3.3 billion, easily covering (and more) the drop-off in the Windows & Windows Live segment. As noted on the Q4 call at the end of July, the company expects the majority of the business (multi-year licensing and enterprise services, which account for roughly 80% of sales) to grow double digits again in 2013, with the remainder (transactional licensing) to slightly lag the overall server hardware market. (Worldwide server revenue grew nearly 8% in 2011, according to Gartner.)
Online Services Division
I recently wrote about Bing and its fight to take market share from Google in the United States (the picture is even more disheartening abroad); I concluded the article with the following:
“The fact that Microsoft, after spending billions of dollars, has only made a small dent on the market to date, is truly astounding: Remember, we’re talking about a product that the majority of consumers consider more attractive during blind tests (at least according to MSFT), that offers a tangible benefit over the competition (essentially paid to search via Bing Rewards), and could switch to with the simple click of a mouse. It appears that Charlie may have been right to say that he’s never seen such a wide moat – because even the market clout of Microsoft and more than $10 billion has done little to unseat the dominance of Google in U.S. search.”
While I stick by those statements, it’s important to recognize something: Microsoft has grabbed control of roughly 16% of the market with Bing alone (with MSFT-Yahoo combined at 28% to 30%) in about three years. This is most important to look at in context of Microsoft’s market share in both PC operating systems (where they control about 90%) and their stranglehold with Office, which also commands a low-90’s market share (estimated at 94% by Gartner in 2010).
When people talk about Google Docs and other offerings like Open Office, this is a great metric to compare to: Despite the fact that Bing has been around for half as long as Google Docs (first elements launched in 2006), it has attained roughly four times as much share in its target market (BBC estimate was 4% share for Docs in 2010 – the latest data I could find from a reliable source). As always, it’s nice to look at the underlying figures behind the sensationalized “news” stories we’re bombarded with on a continuous basis.
The future for Bing is blurry, and I don’t think I can make any reasonable estimates as to what level of share would result in a tipping point for profitability and more importantly, when that could be attained - if ever. As such, for the sake of conservatism, I’ll assume during valuation that the division continues to bleed cash, and that it is perpetually funded by Microsoft’s cash cows.
Microsoft Business Division
The business division consists of the Microsoft Office system (comprising mainly Office, Office 365, SharePoint, Exchange, and Lync, which collectively account for over 90% of MBD revenue) and Microsoft Dynamics business solutions, which may be delivered either on premise or as a cloud-based service. As noted in the previous section, the threat to Office (at least to date) has been blown way out of proportion – Microsoft still completely dominates the productivity suite marketplace, and Office has now been installed on more than 1 billion PCs.
In July of this year, Microsoft unveiled the latest version of Office. And it is believed that the company will release iOS and Android versions of Office 2013 next year. Early reports have even suggested that upcoming versions of Office would be subscription based – a move, that if duplicated in the PC space, would go a long way to cutting back on piracy (this could be a material opportunity over time: In places like China, for example, the company estimates that roughly 90% of Microsoft users in China are running pirated software).
Entertainment & Devices
In Entertainment & Devices, Microsoft is focused on Skype (acquired in May 2011), Windows Phone (and related patent licensing revenue), and Xbox, which has picked up some steam after a long uphill battle; the original Xbox was released more than a decade ago, and lost Microsoft money for many, many years.
Recently, Xbox 360s have dominated the U.S. market, with September being the 21st consecutive month where they were the No. 1 selling consoles, commanding nearly 50% market share. To date, the company has sold more than 66 million consoles worldwide, with more than 40 million of those users subscribing to the company’s Xbox Live service.
Like a lot of places in the company’s business, this is important because it has tie-ins to other Microsoft offerings, as outlined by CFO Peter Klein on the fourth-quarter call: “Xbox continued its evolution as an entertainment platform and has solidified its place in the living room. With the help of Kinect and Bing, discovering and accessing content has never been easier. And with the recently announced Xbox SmartGlass, we look to make entertainment smarter, more interactive and more fun.”
This is yet another example where the media (particularly in their speculation about what Apple might be working on in the living room) has overlooked a critical part of the equation – Microsoft already has a solid (and consistently growing) user base, and that doesn’t appear to be changing anytime soon. As we start to think about connectivity across multiple devices (which everybody is focused on), it increasingly becomes clear that Microsoft has a toe-hold in all relevant markets (or is working to solidify that position, as in mobile and tablets), and often has some lock-in among devices that incentives users to stay loyal to the company’s offering – an incentive that I think only becomes stronger as the next wave of products (such as SmartGlass, for example) focus on interconnectivity.
Looking at the past year, Microsoft generated $31.6 billion in cash from operations, and spent $2.3 billion on capital expenditures – resulting in free cash flow of $29.3 billion. Averaging out the past three years, this figure comes to just north of $25 billion. In addition to this, the company has spent about $20 billion over the past 10 years on mergers and acquisitions. As such, I include this in the estimate of free cash flow (if management consistently spends it on the business, I don’t believe it should be considered as capital free to be distributed to owners), and come to a three year trailing average FCF of roughly $23 billion.
Looking at the balance sheet, we see that Microsoft ended their fiscal year with $63 billion in cash and equivalents, compared to $10 billion in long term debt – leaving us with a net cash position of $53 billion. Some people believe that you should simply see how much this is on a per share basis and subtract it from the share price before attempting to calculate the FCF yield. I think this is a bit too aggressive and discount the cash balance by 35% to adjust for the fact that in a worst case scenario, Microsoft may eventually accept the penalty and repatriate the cash to the U.S. – at which point, it would be worth roughly $35 billion to MSFT shareholders.
After backing out the adjusted net cash of $35 billion, the Microsoft investor is essentially paying $215 billion for this business (based on a market cap of $248 billion and a stock price of $29.40); on a per share basis, you are paying roughly $25.25 per share ($4.17 per share in adjusted net cash) for $2.74 per share in free cash flow (roughly 9.2x three-year average FCF) after normalized M&A activity.
Using a reverse DCF and a 12% required rate of return (discount rate), that valuation would imply nominal FCF growth at a rate of just 1% per annum, in perpetuity; this compares to an FCF/share measure that has grown consistently over the past decade at a rate of roughly 10% per annum.
Look at the businesses in question – Bing is gaining share, and the Online Services Division is slowly but surely gaining ground. Office is successful as it’s been in Microsoft’s history, with business customers deploying the 2010 version five times faster than the previous version (2007). Windows 8 is set to be launched across multiple form factors, and Microsoft will continue to dominate a PC market that by estimates from firms like Gartner and IDC (and despite what the media says) is likely to continue growing, and exceed 500 global million units sold per year by 2015 (Windows is currently on more than 1.3M PC’s around the world).
On both Windows & Office, the company is working day in and day out to eliminate the prevalence of privacy – a huge opportunity that is completely overlooked by the financial community; and the dominant living room entertainment device, which currently has more than 40 million members, whom pay $60 per year on average (roughly $2.4 billion) to access the online gaming and entertainment services offered on Xbox Live.
Thinking about all these things (and what they might potentially mean for Microsoft), let’s compare this to the recent period – a period that included the Vista flop, little/no success with Windows Phone, billions lost in the fight for search market share, the $6 billion-plus write-down of the aQuantive acquisition, and other strategic errors from Microsoft; over that time period, as I noted above, free cash flow per share (with the terminal period adjusted for normalized M&A) has increased at a rate of roughly 10% over that period, likely putting the company in the top decline among all large cap companies.
Microsoft is less than two weeks away from the launch of Windows 8, a seminal event in the company’s transformation; in the 2012 shareholder letter, Microsoft CEO Steve Ballmer said the following: “There's a remarkable amount of opportunity ahead for Microsoft in both the next year and the next decade… It truly is a new era at Microsoft — an era of incredible opportunity for us, for the 8 million developers building apps for our devices, for the more than 640,000 partners worldwide and, most important, for the people and businesses using our products to reach their full potential.” I think that the opportunity is as clear as it’s ever been – yet Mr. Market is pricing the company’s common stock as if it will never grow ever again. With continued long-term expansion of the Windows & Office franchises, solid growth in the increasingly important Server & Tools business, and the potential for Microsoft to find new avenues for growth in the living room or via tablets, mobile devices, and in the cloud, this is an opportunity that shouldn’t be overlooked.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "Patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.