The shares of Microsoft (NASDAQ: MSFT) are up 25 percent year-to-date, in line with the NASDAQ. This is actually a dramatic shift after years of underperformance. Its share price is up by 21 percent and 18 percent over the past 5 and 10 years, respectively, versus the NASDAQ, up 73 percent and 111 percent.
Investors are becoming more optimistic that Microsoft’s growth will, at least somewhat, accelerate — or it may even be reborn following recent restructuring and repositioning. Microsoft held its financial analyst day late last month and revealed more details on its new reporting structure last Friday.
There are a few key questions, but first and foremost: will Microsoft succeed in its push into more exciting, faster growing markets and offset ongoing erosion in PCs which hurts its core Windows and Office product lines?
Microsoft’s rise came from its innovative operating system, but more importantly how it positioned itself in the growing personal computer market. Unlike its competitor Apple (NASDAQ: AAPL) who wanted to sell the device and operating system, it made the decision to not chase the hardware market but license its operating system. It won, came to dominate that market, and is making way for its position in other cornerstone software markets such as with its Office suite and the server market.
This is worth remembering, because Microsoft rose on the back of the PC, followed by notebooks. For more than a few years now, the PC and notebook markets have faced pressure from growth in tablets and smartphones. The refresh cycle, how often users buy a new device, also slowed. This has caused Microsoft’s earnings growth to slow substantially. Eighty percent of operating profit at Microsoft is tied to the core Windows and Office product lines.
Microsoft has had mixed success trying to gain share in the more rapidly expanding markets of smartphones, tablets, and now Cloud. It appears it is finally gaining some footholds in critical markets and the firm may have turned a critical corner.
Mixed Success in Critical New Markets at Microsoft
Microsoft introduced new products and updated old ones over the past few years in the sexier and, more importantly, faster growing tablet, smartphone, and cloud markets. It has had some success finally in smartphones, as well as in Cloud. However, it is making its second attempt into the tablet market, after the disappointing results of the original Surface.
In Cloud, Microsoft is starting to have some success in two critical products: Office 365 and Azure. Analysts estimate its cloud business has doubled versus last year’s levels. Microsoft is currently developing a “touch first” offering of Word, Excel and PowerPoint for Windows 8 as well as other devices. This innovation could help its core business but also lead to share gains in tablet and other devices. It was largely glanced over by analysts, but success or failure here could play a critical long-term role. Office is still the preferred choice and this is a move that can head off the competition.
The introduction of Surface 2 also occurred in September, and was another attempt to gain share in the increasingly competitive tablet market. Apple’s iPad and Google’s Nexus are also the cornerstones in that market along with Amazon’s (NASDAQ: AMZN) Kindle line. The original Surface was unsuccessful, and unless Windows 8 sees greater adoption or excitement, it’s hard to see Surface 2 making a substantial dent into the market.
In smartphones, Microsoft beat out Blackberry for a distant third place in the smartphone market, and has decided to buy Nokia’s phone business. With Nokia, Microsoft gained a channel to ride the success of the Windows Phone pairing with the Nokia Lumia. Windows Phone OS now accounts over three percent of all smartphone shipments. This compares to Google’s Android at over 75 percent and Apple’s iOS at 17 percent. Interestingly, Google decided with Android to use Microsoft’s strategy from years earlier and license its operating system for smartphones.
The purchase of Nokia fits into Microsoft’s new focus on the device. Devices have driven the success of many companies in recent years, first with smartphones, then tablets. However, innovation in these device markets is getting more challenging, with an increasing number of players all selling technology that looks like slightly different versions of the same thing. That is usually the recipe for declining margins behind increasing competition.
That said, the purchase of Nokia’s business gives Microsoft control to push further and harder into the smartphone market. It can invest cash, add new devices, and likely continue to gain market share. It proved once how important having the OS is and it needs to at least be a player here going forward. Overall, it was a solid strategic decision.
Key Strategic Points Outlined at its Analyst Day
Steve Ballmer, Microsoft’s retiring CEO, outlined Microsoft’s near-term priorities at the analyst day event but could not provide a timeline. First, win in Cloud with Office 365 and Azure. Second, ensure Windows PCs remain the primary productivity devices. Third, gain share in mobile. Four, Microsoft wants to innovate in high-value activities such as value-added meetings. It also announced a change in reporting going forward that was expected — it will report financial results now in “Devices and Consumer” and “Commercial.”
The Cloud and mobile goals are looking achievable but still somewhat uncertain. The goal of keeping PCs relevant is partially out of their control as tastes may continue to adopt tablets. Given that 80 percent of profit is related to Windows and Office, this is concerning, but it may be over-blow. The development of touch-based Office products is an opportunity. It can still continue to dominate the market share in the core market and cement Office 365 into mobile. The Windows line is the bigger challenge but adoption in the developing world could help offset the share losses to tablet in PCs.
Microsoft’s story will take time to unfold. While its new Xbox will increase interest later this year, it is not sizable enough to make a real dent in long-term growth rate. That is tied to the initiatives that were outlined. The ability of the next management team to execute and innovate in software that powers productivity in the Cloud, smartphones, and tablet market will drive the long-term growth rate.
If the company gets too hardware-focused in an increasingly competitive hardware market, it could misallocate capital and fall short for investors. Either way, the stock is priced at a reasonable level, should see mid- to upper single-digit FCF growth over the next five years, and has upside if it can succeed in these some of these goals. While it’s not the sexy tech play, Microsoft looks to be in the early phases of a turnaround. It is priced based on some conservative forecasts giving upside to the shares.
What are your thoughts on the future of Microsoft? Will it ever grow again, or is it a declining cash cow?
John has seven years of experience as an equity analyst following various stocks and sectors. As a senior equity analyst, he received awards from the Wall Street Journal and Financial Times for his writing.