Valuing Microsoft

By Mike Sandrik - January 22, 2012 | Tickers: GOOG, MSFT, ORCL | 0 Comments

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The trick to valuing Microsoft (NASDAQ: MSFT) is figuring out what its transition to a cloud computing paradigm will ultimately look like. The gist of the cloud transition for Microsoft is that margins will almost certainly trend down. The reason for this is that when you support cloud software you're not only paying to develop and support the software, you're also paying for the infrastructure to run the software. In the classic software sales model you just sell the customer software and then the customer goes out and buys the hardware to run it.

So right now Microsoft has some nice, lofty margins. The 5 and 10 year average operating margin is almost 37%. Most of that super-high margin comes from the two divisions that sell Windows and Microsoft Office (the Windows and Windows Live and Microsoft Business Divisions, respectively), both of which have division-level operating margins of roughly 65%. The Entertainment and Devices and Online Services divisions are lower margin and wouldn't be greatly affected by the move to the cloud (Online Services is of course "cloud-based" already). Lastly, the Server and Tools Division would likely be helped, as larger and more complex servers are installed to support cloud computing).

So when I value Microsoft I have to bring the margins down. But to where? I think a good start is looking at Google (NASDAQ: GOOG), which gets primarily all its revenue from software that it supports with its own infrastructure. Google's operating margin is around 33%. I also like to look at Oracle (NASDAQ: ORCL), since cloud computing will increase the importance of the Servers and Tools Division, which competes directly with Oracle. Oracle's long term operating margins are also in the low to mid 30% range.

Using that, I trend Microsoft's margins down from 36% to 30% over the next few years, shooting below Google's current 33%. I also assume that at some point in the next few years the Online Services segment stops losing money and at least breaks even. If you don't believe that then prune another 2.5% off of that 30% operating margin estimate. 2.5% is the difference I get when I remove the operating loss from the Online Services Division from the year-end 2011 income statement.

I also trend Microsoft's capex (defined in my valuations as capex plus acquisition costs) up to take into account the additional infrastructure needed to run cloud software. I boost capex up to 12% of revenue going forward (from its current 5 year average of 10%) and keep d&a expense where it currently is at about 4% of revenue. Thing is, this type of capex (infrastructure buildout) can actually get depreciated/amortized unlike most of Microsoft's acquisitions, which largely can't. Most of Microsoft's acquisition costs are composed of unamortizable goodwill, a pretty typical thing in the tech company acquisition space and doubly so for Microsoft, which tends to pay some pretty rich premiums. I'm keeping d&a cost where it is in my valuation to be conservative.

I have revenue growth at 5% going forward for the next 10 years, about half the growth rate of the previous five years. I think this is conservative. Cloud buildout should be a big boost to Server and Tools sales and Microsoft will still be selling cloud versions of Office and Windows. Discounting this back at 10% gives me a share valuation estimate of around $38 a share.

At this point a lot of it is thinking how low the margin will fall. Keeping everything else the same, a 22% margin gives me a share price about even with the $30 price the shares are trading at today, but I think this is too pessimistic and too far below both Google's and Oracle's current operating margins. Assuming margins land somewhere between 22% and 30%, I get a value of between $30 and $38 a share for Mr. Softy.

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