Microsoft: No More Mister Softy!
After a decade of bumbling, MSFT may be getting its act together. While investors have focused on the underwhelming consumer reception for its portable devices and the risk to the Windows franchise, MSFT has positioned itself on the right side of the major changes transforming enterprise IT. Windows8 is far from perfect, but legacy application support, low cost hardware from many vendors, and tightly compliant implementations, are critical concerns for CIOs and significant advantages for MSFT. Moreover, only MSFT offers a consistent user interface from smartphones, through tablets, ultrabooks, and desktops, on up to VMs on data center servers. MSFT has also embraced the cloud, offering Office and Exchange as SaaS products, introducing a truly cloud-based ERP suite, and hosting enterprise customers on its distributed data center infrastructure. We believe these differentiated cloud offerings will strengthen MSFT’s leading position in the enterprise, even as the bounty from Windows’ desktop dominance slowly wanes. Meanwhile, MSFT’s consumer side will improve slowly, as enterprise adoption spurs employee interest in Windows portables, and as Xbox flexes its muscles as the leading living room portal for cloud content. Consensus expectations run well above the isocurve of growth and margin assumptions embedded in the current valuation, and there is risk that the PC decline yields short term disappointment before the expansion of MSFT’s cloud businesses is sufficient to offset it.
MSFT’s valuation has stagnated as the PC era drifts to its end. Total PC shipments have stagnated and will turn downward as tablets are cannibalizing consumer PC sales and as enterprises evaluate cheaper, non-PC alternatives. The death of the traditional PC will be long, slow and irreversible, and anticipation of it has driven MSFT’s market cap to unusually low multiples. While the deterioration of the prodigious cash flows from the Windows franchise will weigh on the company’s financials, we believe that investors are underestimating the potential for new initiatives to drive future value.
Windows 8 will be the leading enterprise platform. The adoption of virtualized data centers, cloud hosting and mobile applications will lead enterprises toward cheaper user devices, such as smartphones, tablets and ultrabooks, with less robust processing and storage than traditional PCs, and relying on VM or cloud resources rather than a full Windows style OS. However, Windows RT/Phone will be very successful in competing for this market, albeit at lower price points. MSFT has the advantage of better compatibility with legacy applications, a common user interface across its platforms, and strong relationships with enterprise IT. In contrast, Apple’s closed system and high priced devices are anathema to enterprise buyers and Android’s fragmentation carries security concerns. BYOD will be brought back under IT department control, just as grass-roots departmental PC purchases were reined in 25 years ago.
Transition to public cloud will be more substantial than most estimates and MSFT is well positioned to benefit. Cloud-based infrastructure-as-a-service (IaaS) is estimated to 50-75% less expensive than the all-in cost of private data center capacity. While there are significant transition costs and lingering security concerns, we believe that, with time, these obstacles will wane and the best IaaS providers will grow their performance and cost advantages, making Public Cloud the predominant enterprise IT architecture for the next era. Azure is a well-designed cloud platform and MSFT has the scale, infrastructure sophistication, and customer positioning to be a leader in IaaS hosting.
Office and Exchange have been repositioned as true SaaS products, protecting their dominant position albeit at a potential adjustment to sales trajectory. MSFT has been aggressive in revamping their cash cow productivity franchises before competitive threats would have weakened their dominance. The pre-emptive move could dampen near term revenue, with pre-paid software purchase shifting to annual service contracts, but the SaaS implementation could help build demand for Azure sales and consumer adoption, while increased utility and automatic upgrades raise barriers to competition.
MSFT is ideally positioned to attack traditional software rivals with SaaS applications and infrastructure software. Legacy enterprise software players, like Oracle, SAP and IBM, have not truly embraced the SaaS approach and lack the infrastructure to compete on cost and performance. Microsoft followed SaaS pioneer Salesforce.com into the CRM market with modest success and MSFT’s recently launched SaaS-based Dynamics ERP targets the biggest part of the enterprise applications market, exploiting the company’s substantial cloud infrastructure and IaaS platform advantages vs. its traditional rivals. We expect Dynamics to be very successful over time, with further applications opportunities in industry vertical solutions, content management software, and business intelligence applications.
Xbox is an intriguing consumer platform, but Windows portables will be driven by enterprise adoption over time. Near term Surface and Windows Phone sales are poor indicators for long term consumer adoption of the MSFT platform, as market reality dictates an enterprise first strategy. We believe that MSFT consumer portable platform will gain a sustainable 3rd place position over time, as enterprise adoption influences employee platform decisions. Meanwhile, MSFT has sold more than 75m Xbox units since 2005, with more than 40m currently subscribing to Xbox Live network service. With this, MSFT is easily the #1 route for on-line video content streaming to the living room TV. In the fervor for the next Apple TV, MFST’s inside position is often forgotten, but is nonetheless valuable.
Near term forecasts are tricky with old platforms declining and new businesses rising, but the assumptions embedded in the valuation are very, very conservative. The isocurve of sales growth and margin assumptions consistent with the current market price is considerably below the sell side consensus. With MSFT’s potential in cloud hosting, SaaS applications, and consumer platforms underappreciated, we believe there is considerable likelihood that the company exceeds long term expectations. Still, the transition from the dominant PC platform will be fast and painful, leaving risk that the company could disappoint in the short run.
For our full research notes, please visit our published research site.