We affirm a $56 price target on Microsoft Corporation (NASDAQ:MSFT), based on a 20x forward multiple on our 2016E EPS of $2.90. Our investment thesis is centered around the belief that this antiquated cash-cow is getting a makeover, priming itself to be the face of the computing cloud market in a few years. With cloud-and-mobile-focused CEO Satya Nadella at the helm, Microsoft has experienced triple digit growth y/y in Office 365, Microsoft Azure, and Dynamics CRM revenues, which signals Microsoft is crucially penetrating the cloud computing market from all key angles - IaaS, PaaS, and SaaS.
Concurrently, other key segments of Microsoft's business look to continue their healthy topline growth. The Surface continues to flourish where the iPad is suffering - overlapping the utilities of a smartphone and desktop, as opposed to just making a bigger-screen smartphone. Xbox prices have been slashed, and as a result, sales are taking over Playstation sales for the first time in a long while, and we believe that gap is only widening given certain spec advantages of the Xbox One.
The demise from a software-and-hardware giant has been a slow and painful one for Microsoft, but penetration into a cloud computing market that has a 20-35% expected CAGR between now and 2018 could all but heal the wounds suffered in that demise. The tech industry is the most continuously-changing and fluid climate in business, and adaptation is crucial to sustaining healthy growth. Nadella realizes this, and is changing Microsoft into a forward-thinking cloud company, that, with more than $90 billion in cash, has the resources to develop Azure and Dynamics CRM into top-of-the-market products.
Moreover, Microsoft Office is still the number one used and purchased utility software in the world, so Microsoft already has a jump on its audience for Office 365. Nadella's strategy has been to convert Office software users to Office 365 users, in accordance with the macro-tech transition from software-to-cloud, and the conversion has so far been successful to the tune of triple digit growth every quarter so far this fiscal year.
For all these reasons, we feel that Microsoft is positioned for substantial growth going forward as the company embraces and aggressively pursues its transition to a cloud-and-mobile based company.
Valuation ProcessTo value Microsoft, we have employed an exit multiple model on 2016 earnings. To find 2016 earnings, we forecasted revenues and margins for each of Microsoft's five operating segments:
To arrive at a fair exit multiple, we used a comparable PEG analysis, adjusted for over-stretched prices using the Shiller Ratio.
D&C LicensingD&C Licensing comprises Windows OEM Licensing and other non-volume and academic licensing of Windows Operating System, non-volume and academic licensing of Office Product Set (desktop), and the Windows phone operating system.
We forecast this segment's top line to continue its slow decline. We believe Microsoft will continue to lose PC market share as consumers transition to less costly and more convenient alternatives, though we do affirm that Microsoft should keep most of its business professional consumers. Office consumer has been declining as users move towards Microsoft's cloud-based services, such as Office 365, and we believe this trend should continue, in line with management's guidance.
The only segment of D&C Licensing we expect to experience positive topline growth going forward is the Windows phone operating system, as this is consistent with Nadella's mobile-and-cloud focused vision. Moreover, Windows is expected to grow and capture market share at a 29.5% CAGR between now and 2018, according to IDC. These estimates mark Windows as the fastest growing operating system over the next four years.
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These assumptions for slow decrease in Windows OEM and Office Consumer as well as accelerated growth in Windows Phone can be seen in our model below. We maintain gross margin should remain relatively constant going forward at roughly 92%.
Microsoft's Hardware operating segment can be broken down further into two sub-segments: Computer & Gaming Hardware (Xbox and Surface) and Phone Hardware (Lumia Phones and Non-Lumia Phones).
We expect Xbox Platform to grow 15% y/y in Q4 Fy15 in units sold due to a recent price cut from $400 to $350 for the Xbox One. We believe 43% (vs. 45% in Q3) of total Xbox units sold should be Xbox 360s, while the majority 57% (vs. 55% in Q3) of total Xbox units sold should be Xbox Ones. We believe this slow transition is representative of the gaming market transitioning from old technology to new technology.
From Fy16 to Fy18, we expect units sold growth to slow to 5% y/y due to tech advantages and continued price cuts. We also expect the 360 vs. One split to gradually grow to 30/70. It follows from these observations that Xbox Live Gold membership should grow in line with Xbox Platform sales, which is what we model.
As stated earlier, we believe the Surface will continue to experience success as a blend of the smartphone and the PC, and believe sales will grow to stabilize around 4 million units/year, which we believe is a conservative estimate.
Our revenue model for these assumptions can be found in the following figure.
As shown in the IDC figure earlier, IDC estimated 47 million Lumia phones in 2014. Compared to actual Fy14 sales numbers, this estimate was 14% too high. If we extrapolate and assume IDC's 2018 estimates are 14% too high, we can say that we reasonably expect Microsoft to ship 110 million Lumia phones in 2018, which equates to a 24% CAGR between now and then. We further expect a rapid decrease in non-Lumia phones, consistent with the current trend.
These assumptions are modeled in our following Phone Revenue Model.
We then assume gross margins grow in the Phone business (which they should since Microsoft gets higher margins on its Lumia phone business) and that gross margins remain relatively constant in the C&G Business.
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D&C Other comprises resale revenues (Windows Store, Xbox Live Transactions, and Windows Phone Store), Bing (Search Advertising and Displayed Advertising), Office 365 Consumer, First Party Video Games, as well as other consumer products.
In line with history, we believe this segment should experience a steady 5-10% topline growth. Minecraft remains one of the most popular first party video games, while Xbox Live, Windows Store, and Windows Phone Store transactions should post steady and healthy growth as Xbox and Lumia sales increase. Management expects Bing to reach profitability by 2016, in line with the trend that RPS has increased over time and looks to increase into the future.
We do not forecast any drastic changes in operational efficiencies, so we assume a 20% gross margin going forward for this segment, consistent with the historical average.
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Microsoft's Commercial Licensing segment comprises of server products (Windows Server, Microsoft SQL Server, Visual Studio, System Center, etc.), volume licensing of Windows Operating System, Microsoft Office suite for Businesses, Microsoft Dynamics, and Skype.
Due to historical seasonality, we expect a strong Q4 in Commercial Licensing relative to Q3, but believe that the overall declining trend of this segment should continue going forward, albeit a marginal 1% decline.
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Microsoft's Commercial Other operating segment comprises the Commercial Cloud (Office 365, Microsoft Azure, and Dynamics CRM) and Enterprise Services (support services for businesses using Microsoft technology).
We believe this segment is the key driver of Microsoft's growth going forward. Office 365 has new mobile management and adds about 1 million users per month at its current rate. According to Microsoft's website, more than 5 million organizations use Microsoft Azure, leading to 3x more data being stored over the past year. Microsoft Azure also integrates with Office 365, which is important for corporate application. Dynamics CRM has stayed with social and mobile changes for business, and paid customers have doubled in the past year. Dynamics CRM also integrates with Office 365.
Per the infographic below, we can see that IDC forecasts a 31% CAGR between 2014 and 2018 in Public IT Cloud Services spending (for more information on this market's growth potential, as well as why Microsoft should not acquire Salesforce.com, view our other SA article found here).
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We thus project high growth rates in the Commercial Cloud segment, including a 17% sequential growth from Q3 to Q4 2015, and a 31% y/y growth from 2016 to 2018 to match IDC's expected market CAGR.
We believe these growth rates are sustainable due to high barriers to entry in the cloud market. It is very costly to develop data center infrastructure, and such data infrastructure is mainly accessible to large tech corporations such as Amazon (NASDAQ:AMZN) and IBM (NYSE:IBM). Moreover, we believe Microsoft's cloud products' compatibility with Office 365 is a competitive advantage the company possesses, since many large corporations currently employ Office 365 services and will soon seek to employ further cloud services. After 2018, we believe these growth rates should level off as market becomes saturated, but we believe at that point Microsoft, a large corporation, should have a large market share of the cloud market.
We believe margins should continue their sequential improvement before stabilizing around 45%, a comparable cloud market margin.
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Following our segmented analysis above, our complete revenue model forecasts strong topline growth going forward for Microsoft.
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To translate this into our Earnings Model, we forecasted total D&C operating expenses to be roughly 25% of top line. Historically, this figure has ranged from 25-28% of top line, and we believe operational efficiencies going forward should shade operating expenses going forward more towards the bottom end of that range.
For total Commercial opex, we projected opex to be 30% of commercial revenue, again towards the bottom end of the 30-33% historical range.
With no debt, Microsoft will pay no interest expense, and the company's tax rate has ranged from 22-24%, so we assume a 23% constant tax rate going forward.
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Our analysis leads to us to forecast a Fy16E EPS of $2.90, roughly 14 cents above analyst estimates of $2.76. To value the stock, we applied a forward earnings multiple on our Fy16E EPS based on a comps PEG analysis using 2015 to 2016 growth rates, and adjusted that fair PEG using the Shiller Ratio to account for overstretched prices.
We use the Shiller Ratio because we believe that, looking at the CAPE chart, these cyclically-adjusted P/Es follow a quasi-mean-reverting trend, and that currently stocks as an asset class are historically overpriced (trade at premium P/Es). It would be unfair to assume that stocks will continue to trade at premium multiples one year from now (considering their high-low cycle and a looming interest rate hike), so we believe it is most fair to mark P/E ratios down to the Shiller mean. The market is currently trading 41% above the Shiller mean.
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We use IBM, Oracle (NYSE:ORCL), SAP (NYSE:SAP), Apple (NASDAQ:AAPL), Salesforce.com (NYSE:CRM), and VMware (NYSE:VMW) as comps, representing a handbag of traditional cash-cows and new-age cloud-based companies and thus accounting for both the old Microsoft and the new Microsoft. In this group, the mean fwd PEG is 2.38. Discounting this by our 41.22% overstretched factor (from the Shiller mean), we believe Microsoft should trade at a 1.40 1-year fwd PEG. This gives a 19.44x fwd earnings multiple. We thus establish a $56 price target on Microsoft.
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The risks inherent to our investment thesis include:
Disclosure: The author is long MSFT. (More...)The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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