Microsoft (MSFT) moved higher on Tuesday, with the action largely attributed to an upgrade from Jefferies (see here); the analyst for the firm bumped his price target to $42 per share, and supplied the following sum-of-the-parts valuation to justify that new target:
|Segment||Value / Share|
|Server & Cloud||$12|
|Total||$42 / Share|
There are two things that jump out to me from this breakdown:
WINDOWS – With 8.4 billion shares outstanding for Microsoft, the value implied from the Jefferies analysis is roughly $42 billion for the Windows & Windows Live division. Compare that with this graphic of Windows & Windows Live financials for the past few years:
It’s important to recognize that there’s a bit of noise in the 2013 results: cost of revenue increased $1.8 billion for the year, reflecting increases in product costs associated with Surface and Windows 8, as well as a charge for Surface RT inventory adjustments of approximately $900 million. In addition, sales and marketing expenses were higher, with a $900 million increase in advertising costs associated primarily with the launches of Windows 8 and Surface. There’s an argument to be made about whether or not those costs should be considered recurring. If we assume they’ll be ongoing costs, the Windows division is trading at approximately 5x operating income, according to the valuation presented above; using a rounded number of $10 billion to account for the one-time nature of some of those costs, we come to a multiple around 4x. Looking at industry expectations (from Gartner, IDC, etc.) for PC shipments over the next few years (which can be wrong, but likely not by tens of millions of units), those metrics appear quite dire, to say the least.
BING/OSD/XBOX – The valuation from above suggests these businesses are cumulatively worth negative $25 billion to Microsoft. I want to examine this claim further; breaking out Bing from the Online Services Division (OSD) isn’t feasible, so let’s look at the results for the segment as a whole:
Bing was launched on June 1, 2009. Since that time, the Online Services Division has seen revenues increase more than 55% in the past four years; while the division has continued to report operating losses, we’ve seen a material turn in the trend over the past two years (the fiscal 2012 measure shown excludes the goodwill impairment charge). As I’ve noted in previous articles, Bing continues to gain share as well: In the U.S., the search engine accounted for approximately 12% of the market at the end of 2010; this past month (according to preliminary reports), Bing hit 18% market share for the first time. In the coming months, the search engine will move into an important position on Microsoft’s next iteration of Windows 8; there’s also been some chatter about the search engine making its presence in the Office productivity suite in the near future.
You’d think that, if anything, the value of this asset has increased materially in the past few years, as the search engine continues to take market share and will soon account for one-fifth of the overall market, at which point it will likely hold twice as much market share as the next closest competitor. (By the way, that next closest competitor derived 40% of its revenue from search in the most recent fiscal year - with 80% coming from search + display advertising, where Bing competes - and has a public market value around $35 billion.)
According to the analyst, you would be wrong.
Next, let’s consider Xbox: Microsoft recently announced that the number of subscribers to the company's Live service now exceeds 48 million worldwide; those individuals are paying $60 per year to use the service, which amounts to nearly $3 billion per annum in largely recurring revenue.
The perception that these are a bunch of gamers is bunk. The average subscribing household spends 84 hours a month – or nearly three hours per day – using the service; more than half of that time is spent watching videos and listening to music, not playing games. Those who are wondering what company will make the first move in securing a stranglehold in the living room should take a closer look at Microsoft’s position.
As of their most recent quarterly filing, Netflix had 28.6 million paid subscribers – or about 40% less than Xbox Live; that factor is largely offset by the fact that NFLX subs are paying more on an annual basis than XBL subs. If you look at the income statement for Netflix over a period of years, you won’t find much that makes you jump out of your seat; yet for some reason Netflix has a public market valuation approaching $20 billion, and Xbox is (apparently) worth peanuts - with the analyst saying the franchise has "zero to negative value," according to Barron's.
These numbers simply don’t make sense in my mind – much like the price target hike from $33 to $42; I can’t tell what’s happened in the past few months that changed Microsoft’s intrinsic value by nearly 30%, or $75 billion; maybe it has to do with the stock making a similar move year to date.
As I think about these things, I come back to the fact that I’m looking at this from a much different perspective than our fellow analysts do: “Value” isn’t a random multiple on a current measure of operating income that changes as stocks fluctuate to justify a target near the current price.
I find it very, very difficult to believe that Microsoft couldn’t sell Bing and Xbox in a relatively short period of time, and pocket at least $10 billion (I think that number is very conservative); anybody that looks at the reported financials is likely to agree with this assessment (we'll see if either of those things come to fruition under a new CEO, but I doubt it). It’s only when you start the exercise with a desired outcome in mind that you end up with plug figures that push you towards some truly outlandish conclusions.
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.