Microsoft reported a solid fiscal second quarter on Thursday with revenue and earnings that were generally above consensus estimates.  However, concerns over relatively tepid growth in the Windows segment overshadowed positive results elsewhere in the eyes of market participants leading to a nearly 4 percent drop in the stock price today.

Since there are numerous articles already published detailing Microsoft’s results for the quarter, we will focus the majority of our attention toward an examination of some of the business issues that are most often cited by those who are bearish on the company’s outlook.  For more background on the investment thesis for Microsoft, please read our article from August 2010.

Fear of Tablets Overshadows Positive Results

The general market sentiment toward Microsoft appears to be based on fears that the company’s longstanding moat in Windows will be rapidly eroded by the entry of new tablet devices led by Apple’s iPad.  This concern has largely overshadowed positive developments that have emerged in recent quarters including significantly higher overall operating margins, shipment of over 8 million Kinect units in the final sixty days of last year, strong performance in the Business Division led by Office 2010, and continued positive results in Server & Tools led by products such as the SQL Server database.  In addition, the company repurchased $5 billion in stock and recently increased the regular dividend.

The tepid growth in the Windows segment reflects an overall slowdown in PC unit shipments with a more pronounced slowdown in PC sales to consumers.  According to the company, business PC shipments grew more quickly than consumer shipments as companies continued to combine hardware refreshes with adoption of Windows 7.  In absolute terms, PC shipments of 90 million globally was still a record high, but lower end netbooks are in decline.  Netbooks sold to consumers are in direct competition with tablets such as the iPad and often serve as secondary devices in addition to a main PC.

Focus on the Enterprise

There is no doubt that in the consumer market, low end netbooks are subject to significant competition from the iPad and other tablets.  Consumers often purchase netbooks as secondary devices and may prefer the lighter and more compact form factor offered by tablets depending on expected usage patterns.  However, with all of the scrutiny of the consumer, we should not forget that Microsoft’s success is largely tied to what happens in the enterprise.

According to Microsoft’s conference call presentation, 300 million Windows 7 licenses have  been sold over the past year and 90 percent of enterprise customers have started their formal migration to Windows 7.  At this point, Microsoft reports than over 20 percent of PCs are running Windows 7 which obviously means that the refresh cycle for Windows 7 is not over and enterprise customers intend to move forward with migration in the coming months.

We can validate the continued prevalence of Windows in the enterprise by observing the fact that Microsoft’s Server & Tools and Business Divisions continue to turn in very strong results.  The Business division in particular is worth examining because it is actually Microsoft’s largest segment both in terms of revenues and operating income.  Office 2010 appears to be a major hit both in the consumer and business markets and this trend should accelerate as companies adopt Windows 7 and combine the operating system migration with an upgrade to the new office suite.

Microsoft’s Consumer vs. Enterprise Moat

It is obvious that Microsoft enjoys a powerful moat in both the consumer and business markets, but there is no denying the fact that the moat is under major attack in the lower end netbook market and this will impact results if the trend persists and Microsoft fails to adapt to the tablet form factor.  However, Microsoft’s moat in the enterprise does not appear to be at nearly as much risk.  While Apple is making great headway in enterprise adoption of the iPad, there is limited evidence to suggest that the device is a substitute for PCs within the enterprise or that Microsoft’s powerful moat in Server & Tools or Office is at imminent risk.

Enterprise Inertia and Risk Aversion

To understand why Microsoft’s moat in the enterprise is so strong, one needs to examine the nature of software in business environments. An enthralled consumer can set aside his PC and head for the Apple store to wait in line when the new iPad comes out this spring, but for grizzled and skeptical IT managers, the situation is more complex and perilous.

In many organizations, Microsoft has long supplied the operating system and business software used to run critical systems and is deeply embedded in the corporate DNA.  Much media attention today focuses on threats from cloud computing and the opportunities for Google or Salesforce.com to take share from Microsoft, but analysts typically ignore the depth and volume of customized software that is built into the Microsoft ecosystem.

Business software takes on a life of its own over many years and becomes embedded into critical processes.  Microsoft products have long allowed for customization through extensible architectures that permit programmers to leverage the operating system, productivity applications such as Word and Excel, business applications such as Microsoft CRM, and server tools such as SQL Server to facilitate unique processes.  In many organizations, two decades of custom code may exist within the Microsoft ecosystem.

When faced with the decision of whether to move to the cloud, which often provides very legitimate benefits to organizations, companies will naturally first look at their current investment in software and attempt to determine whether any of it can be leveraged.  Since Microsoft has not ceded the cloud to competitors without a fight, a decision facing information technology executives becomes whether to leverage some of  their existing investment by utilizing Microsoft’s cloud solutions or scrapping the existing code and starting from scratch entirely.

Moat May Take Years to Breach

No moat is immune from attack by superior products offering significant advantages to those who make a switch.  If Microsoft’s competitors offer businesses compelling choices that provide either cost advantages or customer service benefits, eventually market share will be lost as  companies determine that the costs of staying with legacy software outweigh the massive costs of making a switch.  However, contrary to popular belief, Microsoft is not simply sitting still and passively waiting for competitors to take market share.

Based on actual data, it is not possible to make a compelling argument that Microsoft’s moat has already been breached.  The company continues to turn in very strong results by nearly any measure, including expansion of operating and net margins.  Few companies without a moat can turn in net margins in excess of 30 percent.  Lacking data to make the case, bears need to present a compelling case that Microsoft’s moat will be breached in the near enough future to justify a P/E ratio of approximately 10 when excess cash is excluded from the calculation.

The bullish investment thesis for Microsoft does not need to make heroic assumptions to be correct.  For example, we need not assume anything spectacular for the Kinect device going forward even though it appears that Microsoft has likely grown Entertainment & Devices into another division that could deliver $2 billion or more in operating income annually.

At the current valuation, the investment thesis must focus on whether Microsoft’s moat is not only likely to be breached but largely destroyed over the next three to five years. If such an outcome occurs, Microsoft’s margins will plummet and today’s valuation may look rich based on future earnings.  While anything is within the realm of possibility however remote, the weight of all the evidence is that Microsoft’s moat, even without much technological progress, will remain intact for at least the next five to seven years and most likely much longer.

Microsoft Fiscal Q2 2011 Resources:

Form 10-Q Filing
Press Release
Conference Call Transcript
Conference Call Presentation (PowerPoint)

Disclosure:  The author of this article owns shares of Microsoft Corporation.  From 1995 to 2009, the author was involved in building business applications primarily within the Microsoft ecosystem.

Microsoft Bears Underestimate the ‘Enterprise Moat’
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3 thoughts on “Microsoft Bears Underestimate the ‘Enterprise Moat’

  • January 30, 2011 at 9:30 am
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    My gripe with MSFT is not valuation, it is more of a philosophical difference.

    First of all, if an investor is looking for an actual bargain, they need to look at companies with less than 32 analysts. The smaller and more obscure the company, the more likely it is to be mispriced.

    If, on the other hand, an investor is looking for a reasonable return (and not a bargain), then they are best served investing in a simple business that they can easily keep tabs on and for the most part just ignore.

    To quote Buffett:
    \Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.\

    And here’s my problem with a stock like MSFT: There is no telling what to expect in 20 years. A Buffett-style company like Coke, Burlington, P&G, etc, is likely to offer an identical or very similar product in 20 years. Microsoft, on the other hand, will have to re-invent its core products multiple times over in a 20 year period.

    This means that
    1) It is harder to evaluate MSFT’s prospects than a simpler company, since it is quickly changing, and involves many qualitative variables.
    2) Even if the near-term prospects can be accurately judged, a company like this will require regular attention and evaluation.

    Just my 3 cents.
    Thanks for blogging, I enjoy your site.

    • January 30, 2011 at 9:41 am
      Permalink

      I definitely agree that Microsoft’s business is not one as resistant to change as Coca Cola, Burlington Northern, etc. The real question is how long Microsoft’s moat may last under various assumptions. I don’t think elaborate discounted cash flow assumptions reaching years into the future are useful, but we can look at some broad brush scenarios:

      Scenario One: “Microsoft is Really Clueless”. Microsoft utterly fails at every initiative from Windows to Office to Server Tools, Phone, etc, and even manages to kill the hit Kinect. Under this scenario, Microsoft’s moat will *still* be formidable for at least three to five years simply due to the factors mentioned in the article. Once this shows up in earnings and cash flow, the company would have to painfully retrench but would likely still be profitable as run-off business continues for years. Outcome for shareholders: Continued high cash flows for three to five years, then perhaps halving of cash flow for another three to five years, followed by a fire sale? It’s unknowable how the precise scenario would unfold, but returns would probably be mediocre at best.

      Scenario 2: “Microsoft Muddles Along”. The company fails to really innovate but does enough to keep inertia bound customers on board over the next decade despite encroachment, but not a full breach, of the moat. Record high profits and cash flow probably continues for five years followed by a gradual decline as margins compress. Scenario for shareholders would be fine particularly if the company continues to dispense free cash flow through buybacks and/or hiking the dividend. I would argue that shareholders will at least achieve market returns, and probably higher given the valuation discrepancy that exists today.

      Scenario 3: “The Moat Lives”. Obviously if Microsoft has anywhere near today’s moat in place in 2020, shareholders will do very well from current levels particularly with buybacks and dividends.

      So I do acknowledge that this is probably not a situation Warren Buffett would get involved with, although I would not entirely rule it out. In my opinion, any price below $35 does not adequately recognize Microsoft’s moat in spite of the potential risks.

  • January 30, 2011 at 10:08 am
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    Rational, insightful, unusually well written MSFT analysis. JK

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