Microsoft’s Refocus Will Yield Outsized Returns for MSFT Investors

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In February, Microsoft (MSFT) appointed Satya Nadella, the former executive vice president of its Cloud division called Azure, as its new CEO. Nadella, who had headed Microsoft’ s Cloud platform since 2011, has promised to re-engineer the company from a PC-based software provider to an organization focused on cloud and mobile devices. To do this, he plans to divest underperforming business segments and cut costs to free up resources.

Refocusing any organization will take time, and in business time is money. Luckily for Microsoft, they have a lot of it. And in the end, this transition will make for a stronger company — and a healthier stock.

MSFT: Capital and Cash Flow

It’s hard to talk about Microsoft and not mention its gigantic cash hoard. According to Microsoft’s most recent 10K it held $87 billion in cash, up from $77 billion the previous year. This is balanced with $21 billion in long-term debt, up from $13 billion the previous year.

With the growth of the tablet and mobile devices (on which Microsoft clearly missed the boat until recently), net margins have declined from about 32% in 2005 to about 25% in 2014. Margin erosion has been driven by a shift to more hardware-based sales, which carry lower margins, as well as a general increase in the overall use of tablets and smartphones being used as productivity devices, most of which do not use Microsoft Windows operating system or Microsoft’s Internet Explorer. Since almost 60% of Microsoft’s revenue is tied to either commercial or consumer licensing of its software, lower licensing sales have a more significant financial impact on net margin than any other category.

What does this money and cash flow afford Microsoft? Time! The reason Microsoft needs time is that with any reorganization that seeks to re-focus a company as large and as embedded in the way things used to be as Microsoft there will inevitably be mistakes.

MSFT: What’s Changing

Microsoft introduced Office 365 in March, purchased Nokia in April, had a mass layoff of 18,000 employees in July and is rumored to be shopping its Xbox Entertainment division to potential buyers.

Office 365 has proved very lucrative. With a subscription price of $99 a year, it has opened up Microsoft’s products to a user group that had previously been unable to afford it. With virtually no incremental costs to deploy, subscription revenue is almost all profit. The transition to a cloud-based, lower-priced subscription model has cost Microsoft some short-term revenue of its standard software licensing, but with cloud-based software growing increasingly dominant this is a sacrifice that Microsoft looks willing make in order to win in the long term.

Microsoft currently holds about 2.5% of the market for smartphones. The acquisition of Nokia will provide Microsoft a needed edge in this growing market. Globally, Nokia has an 11.5% market share of the mobile market, with a significant presence in emerging markets. This boost will help Microsoft attain its goal of achieving 15% market share by 2018. Of the 18,000 employees Microsoft cut in April, 12,500 were related to the Nokia acquisition, which should help margins the increasingly price-competitive business of smartphones.

In July, Microsoft closed its Xbox Entertainment Studio, which was established in 2012 as a way for Microsoft to generate original TV content, popularize its games and push its Xbox hardware. It also helped to position the Xbox as an entertainment platform that could provide not just video games, but also streaming video, satellite and cable television. Selling a hardware-focused business to focus on cloud-based and licensing would make sense as part of the refocusing of Microsoft — and it’s something MSFT stock investors should anticipate happening sometime in the future.

MSFT: How Has This Shift Affected Stock Performance?

MSFT 1-year Growth
Source: www.nasdaq.com

As of this writing, Kenneth Fick did not hold a position in any of the aforementioned securities. Email him at kfick@piercethefog.com or follow him at www.piercethefog.com.


Article printed from InvestorPlace Media, https://investorplace.com/2014/09/microsoft-msft/.

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