Cloud computing is a double-edge sword for Microsoft. The impending move to web-based applications threatens to commodify the Windows PC operating system while opening up new revenue and profit opportunities in the deployment and delivery of cloud-based software services. Microsoft's server and business application software products are well positioned to ride the cloud computing wave even as the Windows PC OS franchise bears the brunt of the incoming tide.
The switching costs that form the moat around the Windows PC OS franchise are declining, and we expect Windows to lose market share and pricing power over the next decade. Software applications aimed at consumers as well as businesses are increasingly being delivered over the Internet for standardized consumption via web browsers. Such cloud-based services sever the historical ties between applications and operating systems and lower the barriers for switching among computing platforms. Further, the proliferation of non-PC computing devices such as smartphones and tablets is exposing users to alternative operating environments such as Google's GOOG Android and Apple's AAPL iOS and could make users more amenable to try alternative platforms for their primary computing device. Easier switching among platforms will directly result in reduced revenue and economic profit opportunities for the Windows PC franchise.
Cloud computing also threatens Microsoft's predominantly desktop-based Office franchise, but we expect the firm to successfully transition this business to a new cloud-based model. The Office 365 initiative is evidence of management's commitment to a software plus services model, and compelling economics suggest that the firm has sufficient incentive to walk the talk. As Microsoft makes services such as Exchange, SharePoint, and Office Web Apps available in a hosted, subscription-based model, we expect commercial customers to stick with their incumbent provider (Microsoft) to ensure consistency of existing workflows and minimize risks through the transition to cloud. This stickiness will prevent competitors like Google from making significant inroads into Microsoft's installed commercial customer base, although competition for new customers will be more intense. Nevertheless, Microsoft's ownership of broad suites of integrated products should help the company win competitive battles and maintain its market share even as the business model evolves, in our opinion.
One business' bane is another's boon. Application developers need software platforms to develop and deploy cloud applications, and Microsoft's Azure is poised to emerge as one of the largest platforms for cloud computing. Microsoft has the opportunity to migrate its existing army of .NET developers to the Azure platform, and the company has wisely focused on making this transition easy for customers. Further, similar to their on-premise counterparts, we expect cloud platforms to be very sticky as a result of high switching costs, enabling vendors to reap significant economic profits. Competitive dynamics should favor early entrants like Microsoft, and we do not expect the playing field to get very crowded; the combination of first-mover advantages stemming from the stickiness of platforms, breadth and depth of technological expertise required to develop a robust offering, and large up-front capital investments pose formidable barriers to entry. As a result, we expect Microsoft to build an economic moat around Azure and generate high returns on invested capital from this business.
While the transition to cloud computing will affect Microsoft's business over a long period, the firm's near-term financial performance will be driven by demand for its current products. Windows 7 is enjoying a strong cycle following tepid customer interest in Windows Vista, and Office 2010 appears to be off to a solid start. The server and tools business continues to grow as SQL Server gains market share and demand for Windows Server remains robust.
Valuation
We are raising our fair value estimate to $35 per share from $32 to account for cash earned since our last report. Our revised fair value implies 2012 price/earnings of 11.3 times, excluding net cash. Major technology transitions take a very long time, and we have modeled Microsoft's performance over a decade to capture the economic implications of the shift to cloud computing. Broadly, we forecast that growing revenue and declining operating margins will combine to deliver flat to low growth in total operating profits. Revenue from the Windows PC operating system business will decline significantly over the next decade, but growth in server and tools revenue, primarily Azure, will more than offset this revenue loss, in our opinion. We expect continued growth in revenue of the Microsoft business division as the software-as-a-service model expands Microsoft's share of customers' IT spending and also increases the market reach of hosted services such as Exchange and SharePoint.
Although cloud services will fuel continued revenue growth, these businesses will generate significantly lower operating margins compared with the firm's historical Windows and Office cash cows, given the hardware and management costs associated with delivering hosted services. The net effect of higher revenue and lower margins will be flat to low growth in operating profits as the revenue mix shifts toward cloud-based services through the decade, in our opinion. Finally, while we do not forecast any material upside from Microsoft's efforts at building a competitive search business, our model does assume that the online services division will stop hemorrhaging cash in the latter half of the decade.
Risk
The inevitable transition to cloud computing is the primary risk to Microsoft's businesses. Although we believe the firm will successfully transition its Office and server products to subscription-based cloud services, business model transitions are notoriously hard to navigate and have tripped up countless enterprises. Apple's and Google's growing share of consumers' spending on technology products could spark a faster-than-expected decline in share of the Windows PC platform in the enterprise.
Management & Stewardship
CEO Steve Ballmer's 3.95% equity stake and chairman Bill Gates' 6.41% equity stake clearly align their interests with those of outside shareholders. Director compensation and executive incentive compensation are both weighted toward stock awards, which generally bode well for long-term creation of shareholder value. Shareholders' ability to call special meetings and cast nonbinding advisory votes on the company's compensation practices also reflects well on the firm's corporate governance. While such policies and practices earn Microsoft an excellent Stewardship Grade, we have a mixed opinion on the firm's management. Over the past decade, management has done well to protect the firm's Windows and Office cash cows and build the server and tools franchise. However, the company appears to have missed opportunities to convert its early presence in several markets such as smartphones and tablets into strong competitive positions. We are skeptical of the firm's record with acquisitions and particularly disconcerted by the failed acquisition bid for Yahoo YHOO in 2008 at significant premium to our opinion of the target company's value at that time. Finally, a stream of recent executive departures raises questions about the firm's direction and strength of the remaining leadership bench.
Overview
Financial Health: Microsoft has a solid balance sheet, with nearly $52 billion in cash and cash equivalents, and about $12 billion in debt. We expect the company to generate more than $20 billion in free cash flow annually, allowing it to comfortably service the debt while continuing to invest in expanding the business.
Profile:
Microsoft develops the Windows PC operating system, the Office suite of productivity software, and enterprise server products such as Windows Server and SQL Server. The Windows PC and Office franchises collectively account for nearly 60% of the firm's revenue, and the server and tools business contributes 24%. The firm's other businesses include the Xbox 360 video game console, Bing Internet search, business software, and software for mobile devices.
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