Business Description & Segments:

    MSFT is in the midst of multiple transformations, moving from PC to devices (i.e. mobile and tablet), transaction to subscription and on-premises to the cloud.  The company operated through FY 2015 in the following segments: Devices & Consumer Licensing; Computing & Gaming Hardware; Phone Hardware; Devices & Consumer Other; Commercial Licensing; and Commercial Other.  In June 2015 the company decided to change its reporting structure to the following segments: Productivity & Business Processes (29% of sales); Intelligent Cloud (26%); and More Personal Computing (45%).   

Revenue can be broken down into the following product/services:

Recent Segment Trends:

Productivity and Business Processes- (29% of sales / 46% of segment profit) – This segment includes Office Consumer and Commercial licensing, Office 365 Consumer and Commercial, and Dynamics licensing and CRM online.  This segment has seen revenues decline 3.8% in recent periods (looking at TTM through Q1 2016 v. TTM through Q1 2015), while operating income has declined 8%.  There have been large declines seen in the Office Consumer business, with sales declining 17% in the FYE June 2015, this is driven by weakness in Japan (which is a market where Office is pre-installed, so computer sales are highly correlated to office sales, PC sales in the prior year were influenced by a boost in the VAT) and weakness in global consumer PC’s.  Office Commercial is holding up better than consumer, with sales down 1% in FY 2015.  Commercial was impacted in 2015 due to difficult comparisons in 2014, which was driven by MSFT deciding to end support for Windows XP, which prompted an upgrade cycle at businesses. Lastly MSFT Dynamics (ERP & CRM businesses) grew sales 12%.

Operating income declined 6% in this segment in FY 2015.

Intelligent Cloud- (26% of sales / 36% of segment profit)-  This segment includes server products and services, and enterprise services.   The segment in the TTM period ending Q1 2016 grew sales 8%, with segment income growing 17%.  Intelligent Cloud sales increased 9% in FY 2015, this was driven by higher product and service sales.  SQL Server and Azure drove sales growth.  Operating income increased 17%, gross profit expanded 10% (no leverage due to cloud infrastructure spending), and operating expense was contained at just 2% growth.

Personal Computing- (45% of sales / 18% of segment profit)- This segment includes Windows (both commercial PC, consumer PC, and phone), devices (Surface and phones), Gaming and search (which includes both search and display).  Sales in this segment in the TTM period ending Q1 2016 declined 2.3%, while segment profit declined 18%.   Sales declined entirely due to the accounting of Windows 10, which requires a portion of the revenue to be deferred and earned over the next 2 to 4 years.  Excluding this accounting change (which began impacting results in Q1 2016) sales would have expanded 0.8% in the TTM period ending Q1 2016.

In the FYE June 2015 sales in the Personal Computing segment grew 12%.  Devices provided the biggest portion of the growth, most of which was due to Nokia.  Ex phones, sales decreased 2.5%.  Surface revenues increased 65% due to Surface Pro 3 (June 2014 release).  Gaming and search expanded but aren’t huge businesses for MSFT.  Windows sales declined 16%.  PC OEM sales declined 15%, due to business and personal declines.  Business was impacted by the difficult XP support change comparison in the prior year, but consumer was primarily impacted by poor trends in the PC market generally.  MSFT is also focusing on lower price point PCs, which hurts consumer Windows sales.

Operating income for the Personal Computing segment declined 16%.  This was driven primarily by mix.

Balance Sheet:

Microsoft’s balance sheet is solid.  The company is currently (Q1 2016) sitting on net cash of $8.95 per share.   Free cash flow was $23.1 billion last year (FCF to EV yield of 6.5%).  Maturity structure is very good, with 76% of the debt outstanding as of FYE 2015 maturing later than five years.

The company issued $13 billion of debt on 10/29/2015 at varying maturities.  The notes due in 2055 (40-year paper), yielded 4.75%.  A lot of the proceeds will be used to retire stock.  The company has committed to completing its $40 billion share repurchase authorization by 12/31/2016.  As of 9/30, there was $17.9 billion remaining (which implies MSFT will be buying back 4% of its stock in calendar 2015).

Valuation:

On an ex-cash basis the shares look attractive, I would also argue that the FCF yield is too high for this caliber of company.  Ex-cash P/E using consensus FY 2016 EPS is 16.0x.  This can be compared to the market at 18.1x June 2016 EPS.

Management & Board of Directors & Capital Allocation:

Satya Nadella took over from Steve Ballmer in February 2014.  Prior to his appointment as CEO he was the EVP, Cloud and Enterprise since July 2013, from 2011 through 2013 he was President of Server and Tools, 2009 through 2011 SVP, Online Services Division.  Satya has been with the company since 1992.  What I have heard and witnessed so far from Satya is encouraging, he is only interested in playing where MSFT has a differentiated offering, i.e. productivity and Azure, which can be seen by his dramatic restructuring of Nokia’s NDS business shortly after MSFT acquired it.

Mason Morfit, President of ValueAct Capital Management is on the Board of Directors.  I hold ValueAct in high regard and view their presence on the board as a positive.

Capital Allocation has been a mixed bag.  Satya has not made any mistakes yet (though still early).  Ballmer made a handful.  Over the past decade, MSFT has generated $246 billion in CFO, and it has spent that money on share repurchases (45% of total capital used); dividends (26%); capital expenditure (15%); and acquisitions (14%).  

Major acquisitions include the April 2014 (announced in September 2013) acquisition of Nokia NDS for $9.4 billion, and the October 2011 acquisition of Skype for $8.6 billion.   Nokia was a complete flop, after trying to build out a hardware business, MSFT is now going to focus on selling/manufacturing its premium phone lines, a strategy implemented by Nadella.

Major Trends/Themes Impacting the Business

Office Transaction -> Subscription- Office 365 is Microsoft’s newest version of Office.  It is subscription based ($100/year, or $70 for one user), its applications (Word, Excel, etc.) are downloaded onto your PC.  Office 365 does have online components, such as updates, OneDrive, Lync, but can be operated offline.  Importantly Office 2016 can still be purchased on a transaction basis for $150.  Office 365 is always up to date with the latest version of Office, while Office 2016 requires a new software purchase to upgrade.  Eventually I wouldn’t be surprised if Office 2016 gets priced higher to push more users to 365.   As of Q1 2016 there were 18 million consumer Office 365 accounts, and 60 million commercial Office 365 accounts.

This shift is important because users under the subscription plan have a far superior lifetime value (LTV) than users under the transaction model.  This occurs for two reasons: 1) under the prior model a user would upgrade their Office every 5-7 years, which means $25 per year ($150/6), now they will be paying $100; 2) Office 365 users add on more premium services than transactional users  The following was presented at MSFT’s recent investor day:

The beautiful thing (from a shareholder point of view, not an Office user) is the following

Here are some charts showing the Consumer and Commercial Office outlooks:

(Source: Company Reports)

Shift From On-Premises to Cloud-  MSFT has a huge server OS business.  This entire shift will be captured in the Intelligent Cloud segment (as it includes both servers and Azure revenues).  Microsoft has a unique position in cloud, since it is the only large player (large players= MSFT, GOOG, and AMZN) with an existing installed base at enterprises.  Familiarity with Microsoft, and the ability to maintain a hybrid cloud is important.  Microsoft is the only cloud operator that can be a one stop shop for an enterprise looking to manage their network on premises and in the cloud, others can only offer one solution.

Credit Suisse explains why MSFT may be the better option for existing enterprise customers:

Windows Likely to Continue Decline- According to Gartner, PC’s shipments (units) declined 3.5% in 2012, 10% in 2013, 0.2% in 2014 (aided by the XP refresh) in Q3 2015 global PC shipments declined 7.7%.  This is a problem for MSFT, since Windows has approximately 90% of desktop share, 2% tablet share and 4% mobile share.  

This will continue to be an issue for MSFT.  They still get close to 20% of sales from Windows (which are high margin sales) and this continued grind lower is likely to continue in my opinion, particularly at consumer, while business Windows licensing could prove resilient.

I don’t have high hopes for Windows 10 to grab meaningful tablet/mobile share at this point, but that is not a concern from an investment perspective, as investors are giving little weight to this outcome (i.e. only upside risk).

Recommendation:

I like Microsoft a fair amount.  The stock trades at a reasonable multiple, I think Office 365 has a lot of potential to drive high margin revenue, while the Intelligent Cloud segment should continue to expand given businesses familiarity with MSFT network products.  With 82% of EBIT coming from advantaged categories, this should be more than enough to offset declining Windows profits over time, all at an attractive valuation.