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Jelly Roll Capital Equity Research |
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Market Analysis, Education, and Wall Street-Quality Stock Reports |
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Microsoft (MSFT) |
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Selected Analyst Coverage (Target): Credit Suisse — Outperform ($40) Deutsche Bank — Buy ($40) Bear Stearns — Peer Perform ($29-$35) |
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MSFT Closed at $35.60 on 12-31-07 |
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Released 1-1-08 |
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Microsoft (ticker: MSFT) is the world’s largest software company. The company has five operating segments that provide services ranging from its well-known Windows OS and Office Suite and Xbox entertainment system, to its Windows Server software and online advertising business. · In the last week I’ve reviewed Microsoft’s strategy with respect to the acquisition of online advertiser aQuantive and the partnership with social networking site Facebook. Those two articles offer a picture of Microsoft’s high-growth markets going forward. · If aQuantive’s expertise can generate even a minor expansion in effective realized CPMs (rate per thousand impressions) then this deal could suddenly become much more accretive than most people seem to be accounting for. To throw some conservative numbers out there, if… -The MSN network gets 75 million visits per month Now multiply whatever marginal eCPM benefit aQuantive can deliver to the MSN content network by 108 million, and you get some kind of mental model about the synergies and leverage in the transaction. · Microsoft has long relied on its MSN Network as a mainstay of its online presence. With the addition of Facebook for advertising, Microsoft is actually becoming more like Google in that it is decentralizing its content structure to focus more on user-created experiences. Whether this current hybridization approach continues to shift Microsoft to a more user-centric bias in the coming years is still open to debate, but they certainly have the cash to make acquisitions should that be their desire. · After smashing analysts’ estimates in the last quarter, the stock has found legs and new enthusiasm, and trades in the mid-$36s. Net of cash, that represents roughly 23x earnings for a company that has averaged a 25% return on equity in the last decade. Every year in that time has seen the company generate more than $6 billion in free cash flow as well, so Microsoft offers a degree of consistency in a tech world known for quickly chewing through companies without viable long-term plans. · Google (GOOG) has been heralded as the Microsoft-slayer on a number of fronts, and with the Google Docs app the company is promoting, many are worried that Microsoft’s main cash cow – its Office software – is being targeted. The thinking goes that Google’s offering Docs at $50/user/year, it can squeeze Microsoft’s spending on R&D and related areas, ultimately allowing Google to surpass Microsoft in other areas. This is far too much of a stretch connection at the current time, however, as Google Docs still has mainly entry-level functionality that will limit its appeal. For the time being, Microsoft’s most important business appears safe. · Closely following MS Office in importance is the Windows operating system platform. While the Vista product and launch was far from perfect, the natural adoption and upgrade cycle in businesses provides immense benefits to Microsoft as the natural favorite, particularly among corporations. Yes, sales of Apple Mac products have been growing quickly and that will mean Windows will have marginally lower adoption rates than launches of old, but Macs still have a single-digit market share and this bodes well for Microsoft. To put it another way: a 1% market share gain is a 12-15% boost for Apple, but only a 1.1% loss for Microsoft. · These two segments (Client for Windows and Business Division for Office) account for more than half of revenues and nearly all of operating profit; so their continued success is vital to the overall health of Microsoft (see graphic).
The question with a company like Microsoft is ‘how do you move the needle?’ · In this case, I believe Microsoft is pursuing a good strategy by leading with several online initiatives while still offering reasonably dynamic software solutions. · To lead with the Online Services Business [OSB], something good is happening at MSN and that could be exactly the kind of spark Microsoft needs to show it can mass-monetize the online world. I realize the time series is still limited and there is much to prove, but in terms of incremental gains a 25% month-over-month jump is huge for a site the size of MSN Video. More natural consolidation should take place – likely at the expense of AOL and MySpace – and that looks to benefit the larger and faster growing players, of which MSN is now second behind the YouTube/Google juggernaut. · How will this help OSB? Traffic growth will translate to additional advertising dollars, and I’ve said that I expect the aQuantive acquisition to help Microsoft drive somewhat higher advertising rates, which could be an underappreciated consequence of that acquisition. Further, OSB will likely be a huge beneficiary of the massive influx in online advertising dollars that will be moving online in the next five years – upwards of $20 billion. OSB has seen minimal growth in the last two years and FYE2007 saw total revenues of $2.5 billion, so I’ll be looking for explosive growth from this segment in the near future as a number of factors listed above should start to come together. The 25% year-over-year revenue growth in the last quarter was a start, and once that starts flowing to the bottom line I expect it to be a high-ROIC segment for Microsoft. · For the more general growth in Client and Business Division services, the main driver will be PC unit growth, which is estimated to be about 10% in 2008. Because those two divisions average an operating margin near 70% and there is a good deal of operating leverage, earnings should grow in the low to mid double digits as long as PC unit shipments stay around 8-10%. Obviously there is some potential upside depending on the growth in OSB, and Servers aren’t irrelevant, but between 12-15% should be a reasonable near-term forecast. · Given MSFT’s anticipated earnings growth, its balance sheet position, cash flows, and business risk, the fair value target for MSFT is $30, putting MSFT shares as being undervalued by approximately 16% based off Monday’s closing price of $35.60.
Disclosure: The analyst has no position in MSFT or its derivatives. |
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