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Microsoft Corporation (MSFT): A Look At Underappreciated Core Enterprise Strength

 June 28, 2013 02:18 PM

(By Mani) The valuation of Microsoft Corporation (NASDAQ: MSFT) has been pressured by too much investor focus on PCs; however, not enough attention has been paid to the strength and durability of its enterprise and small medium businesses (SMB) which accounts for nearly two-thirds of Microsoft's revenue.

Unearned revenue has grown double digits for eight quarters now. In key enterprise segments like Server and Tools, Microsoft has had 11 quarters in a row of mid-to-high teens unearned revenue growth.

The Windows software maker has able to achieve this growth rate despite stiff competition with heavyweights like Oracle Corporation (NASDAQ:ORCL), International Business Machines Corp. (NYSE:IBM) and VMware, Inc. (NYSE:VMW).

[Related -Microsoft Corporation (MSFT) Earnings Preview: What To Watch In Q2 Results?]

"There are consistent signs that customers are committing to MSFT for the long haul. MSFT's enterprise agreements are typically 3 years in length, but the company bills annually, so years 2-3 of that contract go into "Contracted not billed" (first year goes on BS and MSFT collects the cash, years 2-3 off BS "not billed")," UBS analyst Brent Thill said in a client note.

Microsoft's contracted not-billed balance in the most recent quarter was over $21 billion, up more than 10 percent from last year and up nearly 60 percent in just 3 years. So, the argument that Microsoft is a client/server era success story-only and can't make the transition as enterprises and SMBs move to the cloud is not backed-up by the numbers.

[Related -Microsoft Corporation (MSFT): Good Buy or Good-Bye?]

Still, some investors have stated that the Windows division should be modeled down into perpetuity given some of the dire predictions for PCs. The fact is that the PC market doesn't have to grow for MSFT's stock to work.

"In our recent meeting with the company we came away reassured that MSFT's Windows strategy is pivoted around the thesis that future device growth is in mobile," Thill noted.

Though analysts predict negative PC unit growth for the next 5 years, the PC market would stabilize at some point given the importance of the PC in corporate settings, and the PC install base has only penetrated 20 percent of the worldwide population.

In the first quarter, PC units were down 14 percent, yet Microsoft's Windows business was flat with last year, driven by non-OEM revenue growth of 40 percent, which included Surface where MSFT is expected to have sold 800k units, and commercial sales of Windows.

Clearly, PCs do matter there are some potential catalysts to make the PC market 'less bad' in the second half of 2013. First things first, Microsoft's Windows 8.1 release is expected to address key Windows 8 deficiencies and should open up the small screen opportunity.

Windows 8.1 offers usability enhancements to flatten the W8 learning curve gleaned from telemetry data and user feedback, which should help lower adoption barriers, add differentiated new functionality, and enable a new class of smaller-screen devices.

"Touch penetration in aggregate is only ~15% of PC shipments today which has been a W8 PC sales drag given its ‘touch-first' design. MSFT is working with OEM partners on more concise roadmaps and is targeting 50% touch penetration for consumer developed markets by Holiday 2013," Thill noted.

In addition, Intel's Haswell chip released in the second quarter enables ultrabooks to have the battery life and price points of tablets. Microsoft also recognizes its Windows retail experience is not acceptable and may shift marketing dollars from advertising to improve the retail experience.

The above catalysts are expected to revive the Windows division performance and these are the potential positives for the PC market too. In addition, the success of Windows would also sustain the ongoing enterprise and the SMB demand.

"We expect non-OEM revenue to remain strong on continued strength in commercial demand with XP extended support expiring April 2014 and more competitive next-generation Surface hardware expected in a wider range of form factors," Thill added.



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