Microsoft's Transition To The Subscription-Based Economy

Helena Leathers

Growth, long-term horizon, growth at reasonable price, Ph.D Strategic Business

Helena Leathers

Summary

MSFT's transition to SaaS has a positive outlook.

Huge potential earnings from subscriptions should not be ignored when valuing.

P/E ratio at 26.81 is incredibly high: is that value realistic?

Microsoft (MSFT) is of key interest to those within the technological and software industry. A number of key recent occurrences have instigated a lot of controversial opinions regarding the ethical viewpoint of making the software that it provides into monthly paid subscriptions. However, from a stock valuation perspective this would be a very positive move, which is reflected in its current valuation.

This article will go over four main recent reports, and will conclude with a discussion on the overall value of those. They will be the Netflix-like subscriptions to video games, Office and Windows becoming monthly subscriptions, and the HoloLens.

MSFT is a company that specialises in technology. It creates operating systems, servers, phones and devices connected to the IoT. It was incorporated in 1975, and has 124,000 employees.

Its main segments are productivity and business segments (accounts for 28% of sales), intelligent cloud (accounts for 25% of sales), personal computing (accounts for 46% of sales). This is a slow growth company.

Stock overview

With a P/E of 26.81, this is higher than 40% of Standard & Poor’s 500 average stocks. This is not a cheap stock by any means; however, can the recent moves to create subscription-style products (that, let’s be honest, everyone uses) increase the revenue of the company and improve this figure? For the longer-term investor, it is highly likely that this move will deem effective; however, for the short term, this stock seems too expensive.

To get some perspective, Windows is used by 1.5 billion people, and Office is used by 1.2 billion people.

That means that there are more Windows users than the following countries as of 2015, according to the United Nations;

The Russian Federation (143 million)

Japan (1.2 billion)

The UK (63 million)

So it’s quite a lot of users that will transition from one-time sales to subscriptions.

In 1989, Warren Buffett said,

it is far better to buy a wonderful company as a fair price than a fair company at a wonderful price

According to the forward P/E, MSFT is valued at 22.5, which is still higher when compared to the S&P 500 (at 20.4) which is still roughly 10% above the average. This could indicate that it is reasonably priced, given the premium for the quality of the company. However, I would probably prefer it to be closer to this average.

The PB ratio shows MSFT at 7.73 (industry average 5.91). This indicates that MSFT investors are content in paying $7.73 for each dollar of net assets. Because the industry average is 5.91, this indicates that the investors are either happier to pay more for MSFT or the stock is overvalued. This indicates that the stock could be too highly priced right now for effective value.

The PS ratio is currently at 6.33 compared to an industry average of 5.78. O’Shaughnessy in 1996 found that stocks aimed at growth that were selling for one and a half times the sales or less generally did better.

This figure is clearly a lot higher than can reap value (according to O’Shaughnessy’s findings). However, compared to the industry average, this seems to be somewhat close to the norm.

These industries don’t come without immense investment into R&D. Movement is so fast that this is vital for companies to stay ahead.

The following image is MSFT’s investment into R&D over the last 5 years (quarterly). You can see the overall increase in investment.

Within accounting, R&D is shown as an expense rather than an investment; and although this is generally argued, these expenses are subtracted from revenues annually. This means that it is increasingly important to determine whether the research budget is an investment that will be lucrative, or whether it is just another cost resulting in lower revenues.

The following sections will go over what some of these projects have been, and their capability of being successful.

Netflix-like subscription to Video games

Netflix (NASDAQ:NFLX) provides a subscription to streaming television at low prices, and its business model has been successful in the long and short term, and potentially even revolutionary within tech. It has had strong financial performance, and the model has been used by Sony Corp (SNE) with PlayStation Now, as well as MSFT with the launch of the $10 monthly gaming subscription for Xbox One. This is not a streaming service, however, and allows for downloading popular games like Halo 5. The game is removed if they stop their subscription.

The Xbox has been hailed in itself as the ‘world’s most powerful console.’

This product and the subscription are directed at only the most enthusiastic gamers (the Xbox is $499). But this is not a niche market, finding more than 50 million users, with the Xbox Live business generating over $2 billion in annual revenues. This is only 8% of the company’s revenue so this won’t change the company dramatically; but it does open opportunities for increased market share as Sony’s margins are small.

This may not be a game changer; however, to tap into this market would be beneficial from a competitive perspective as well as increasing capabilities.

Office and Windows a monthly subscription

Office (Word, Excel, all that good stuff) will be (and actually already is) sold on a subscription basis. This means annual payments of $99 for five users, or $69 for a single license. This means long-term, perpetual revenue for all the users (this is considered the Productivity and Business Processes division, which was up 10% and led by a 22% increase in consumer Office revenue, coincidentally).

MSFT’s Cloud Azure is also an area of importance; however, this probably warrants its own article.

For those who already own a copy of Office, this will not be detrimental, which could affect initial sales revenue. So it would now be MSFT’s job to make the subscription version a requirement to achieve anything through office (almost like Google (GOOG) (NASDAQ:GOOGL) did with Google Drive).

The HoloLens

The HoloLens is a holographic computer, which is designed to let those from all walks of life engage more fully with the content that they are working with. If that is education, such as medical analysis, students can see in-depth diagrams of the human anatomy, interact and process this with more ease than ever before. A secondary use is for industry, where those with highly skilled jobs can use this technology to have a formed guideline on how to do their own jobs; for example, within manufacturing of electrical engineering this could signal the decline in the need for workers to have trained so extensively for specific aspects of work, as the HoloLens can be their real-time guideline.

A third potential use is commercial sales for people in their homes. Blank walls can be covered in computerised information that individuals would see when they wear the HoloLens.

This project is certainly pushing boundaries, and with the purchase of LinkedIn, MSFT is turning around what was once considered an outdated business model. The integration of LinkedIn continues to support MSFT’s position within the practical business world, from consumers’ professional image and network to the productivity tools needed in their profession.

Now the kit costs $3000, so it is not used by anyone except developers today. However, MSFT did report ‘thousands of sales,’ indicating that either the developer base is growing or people are becoming happier to fork out more money for MSFT products (which was actually similar to what we found in the PB ratio, interestingly).

Summary

Overall, MSFT is a good company with the drive to succeed. It has revolutionised its business model (albeit, copied Netflix, adapting to the new age economy) and it continues to invest in itself and its products, which is always something that I personally like to see in a technology company. If a company that is product-dependent is not investing revenues into research, I suggest to stay far, far away, as although its revenues and profit margin may be seen to be higher, there is no long-term strategy there. We see this behaviour a lot in the pharmaceutical market.

There is a 14.41 price/cash flow ratio, which should improve with the transition to subscriptions. This is better than the industry average of 15.38, which seems like it should be becoming even stronger overall.

MSFT has a lot of positive projects underway, and I would actually say that while it is expensive, it’s a quality company that moves strategically and has a lot of potential. I would say that MSFT is a buy (or a hold if you are so lucky and the price doesn’t keep going up!) but it is certainly a buy and hold worthy company.

Disclosure: I am/we are long MSFT, GOOG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.