Microsoft's Future Is on Shaky Ground

By Daniel Sparks - October 1, 2012 | Tickers: AAPL, GOOG, MSFT, NOK | 0 Comments

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A close look at each of Microsoft's (NASDAQ: MSFT) business divisions reveals a very uncertain competitive landscape.

With the software giant trading at just 8.6 times TTM free cash flow (FCF), the market assumes a -0.31% growth rate in FCF over the next 12 months. In other words, some of this uncertainty is definitely already priced into the stock. But any Microsoft investor (or potential Microsoft investor) should be aware of it.

Let's examine each division, one-by-one.

1. Windows & Windows Live Division

Unfortunately for Microsoft investors, Microsoft's cash cow is on the decline as Windows continues to lose market share. There are some short-term opportunities, with the Windows 8 launch just around the corner, and a higher adoption rate with Windows 7 (50%) than ever before. But in general, the trend-line for this business segment is a definite decline, in terms of both volume and margins.

This business segment gets really uncertain when you try to estimate the speed of the decline. Windows switching costs are falling fast as consumers spend more and more time on non-PC devices like smartphones and tablets. Exposure to Google's (NASDAQ: GOOG) Android and Apple's (NASDAQ: AAPL) iOS decrease switching costs for PC operating systems as consumers increase their spending on these non-PC devices. Adoption of Apple's OS X is a serious threat to Microsoft, as Apple's PC market share continues to increase, while Microsoft's continues to shrink. And the long-term picture doesn't look good, either: Schools are switching in droves to Macs, resulting in students that are adopting OS X and iOS as they are alienated from Windows. How fast will this business division dwindle? It's difficult to tell.

2. Server & Tools

There is a lot of opportunity in this business division, which already represents a significant portion of revenue at 25%. It represents Microsoft's enterprise solutions, and is home to SQL Server, System Center, and Windows Server 2012. But the real, long-term value in this business division comes from Azure, an operating system for cloud computing. As cloud computing grows, Microsoft will ride the wave of demand as a first-mover. Barriers to entry are high: Cloud operating systems require a breadth of technological expertise and large up-front capital investments.

The uncertainty for this business division lies in the timing and volume of the major shift in enterprise computing to enterprise cloud computing. How long will it take for companies to begin to more actively adopt cloud solutions? Who knows? But it could take longer than Microsoft investors hope.

3. Online Services (Bing)

Microsoft's Online Services division is hemorrhaging cash. It will probably take several years for this division to begin to generate free cash flow for Microsoft, especially with Google as Bing's major competition. Google is laser-focused on search and will do everything it can to protect its search business. With Google as a competitor, I think it would be dangerous to forecast much value-added growth in this division. To do so would be purely speculation.

4. Microsoft Business (Office)

Microsoft Office is probably Microsoft's most "sure thing." Representing a larger portion of revenue than any other business segment, the Microsoft Business Division derives most of its revenue from its Office suite. Microsoft Office is the norm for business and academia when it comes to productivity software. It's installed on over 1 billion PCs around the world.

With Microsoft Office 2013 coming this fiscal year, investors have some upside to look forward to here. Plus, some of its other cloud-based productivity solutions in this division, such as SharePoint and Exchange, offer strong and "sticky" sources of continual enterprise revenue.

5. Entertainment and Devices (Skype, Xbox)

While definitely on a hot streak for Microsoft, the gaming console and gaming development industry is up in the air right now. The Xbox has been the best-selling console in the US for the last 18 consecutive months, but its future is questionable. As more consumers spend their tech dollars with Google, Apple, and other device makers, the gaming industry is evolving fast.

As soon as the processing power of an iPad is fast enough to handle all the games on the XBox, gaming developers can easily bypass the XBox and sell their titles through Apple's App Store. Why not? There are over 84 million iPads already out there as of June, 2012. As of March, 2012 there were only 65 million Xbox units sold. 

High-quality games are already making the shift: Dead Space, Rage HD, Call of Duty: Black Ops, Zombies and Infinity Blade 2. But don't take it from me. As cited in Reuters, Frank Gibeau, CEO of Electronic Arts says he is eyeing Apple closely:

"When the iPad gets to the processing power that's equal to an Xbox 360 and it connects to a television, that's no big deal to us. We'll put the game through the iPad and have it display through the television."

Not enough for you? As reported by TechLand, Mike Capps, CEO of Epic Games speaks similarly:

”It is quite easy to imagine a world where an iPad is more powerful than a home console, where it wirelessly talks to your TV and wirelessly talks to your controller and becomes your new console.”

6. Windows Phone Division?
Time will tell how well the Windows Phone OS will hold up in the ultra-competitive smart phone market. For now, the Windows Phone OS revenue is too small for its own division; It's simply slapped onto the Entertainment and Devices Division. If Microsoft could just get a small slice of Apple's smartphone profit pie, it would be enough for Microsoft to create its own revenue category for the Windows Phone.

I think Microsoft's arrangements with HTC and Nokia (NYSE: NOK) are a good start for the Windows Phone 8 OS. Nokia's Lumia might not have impressed investors very much, but there are definitely Windows loyalists out there that will be willing to buy the sleek, colorful device just because it runs Windows. But I think it's going to take a Windows-branded phone with disruptive technology to create a stir in this ultra-competitive market.

7. Tablets & Other Windows-Branded, Non-PC Computing Devices?
Windows-branded, non-PC hardware is a no-brainer for Microsoft. Apple continues to sell millions of devices at unbelievable profit margins. The basic laws of economics suggest that these abnormal profit margins will attract new market entrants. Unfortunately, it took Microsoft years to enter the market with a Windows-branded device. Its late entrance with the Surface, nonetheless, is a solid start. But it is definitely tough to forecast how things will go from here.

The bottom line
Microsoft's business divisions are engulfed in uncertainty. Fortunately, its Microsoft Business Division (Microsoft Office) has the least doubt associated with its future, and also happens to represent the company's biggest revenue generator. Much of this uncertainty is definitely already priced into the stock at Microsoft's currently conservative valuation. Still, it's important for investors to understand that an investment in Microsoft today would be based mostly on speculation.

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