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Morningstar | The Growth Mindset: We're Raising Our Microsoft FVE to $130 Due to Azure, Office 365, and LinkedIn

After transferring coverage of Microsoft to a new analyst, we are raising our fair value estimate to $130 per share from $122. We maintain our wide moat, stable trend, and medium uncertainty ratings. We have raised our stewardship rating to Exemplary to reflect CEO Satya Nadella’s ability to radically transform Microsoft’s culture in only a few years. With the shares trading at a discount to our fair value estimate, we still see additional upside for Microsoft and an attractive margin of safety for investors.

After Nadella took the helm, the firm has revitalized itself. In our opinion, Microsoft is increasingly a cloud leader, the business is more user-friendly, the firm is willing to take risks in investing in nascent technologies, and employees have implemented a growth mindset. We see Microsoft’s future as oriented around Office 365, Azure, and LinkedIn, while seeing broad-based contributions from smaller segments such as Xbox, Surface, and Dynamics.

The words "Microsoft" and "monopoly" were embodied in the zeitgeist of the 1990s tech boom. While these two words may not be uttered in the same sentence as frequently now, we firmly believe Microsoft’s offerings maintain monopolistic qualities. Under Nadella, the firm is not reliant on Windows and Office. Today, Microsoft is capitalizing on incremental investments in cloud computing and artificial intelligence, in addition to its purchase of LinkedIn, which gives it exposure to social media and the inherent data and network within the platform. The recent acquisition of GitHub provides another degree of optionality, with access to a premier developer ecosystem. Azure, Microsoft's public cloud offering, capitalizes on workloads moving to the public cloud while serving as a hedge against declines in legacy businesses. These various factors give us confidence in a wide economic moat rating for the aggregate business.

We model modest declines for the Windows operating system. Although Windows 10 takes the title for Microsoft’s fastest-growing OS and we still expect enterprise and consumer growth, the shift to software-as-a-service applications and the rise in new form factors, such as mobile and tablet devices, have eroded Window’s stranglehold on the computing industry. We think Microsoft’s management is very cognizant of the shift away from Windows, as a calendar 2018 restructuring relegated the Windows business to the cloud segment. We believe Microsoft will be squarely focused on Office productivity, cloud computing and Azure, artificial intelligence, and the acquisitions of LinkedIn and GitHub--all wide-moat businesses, in our opinion--which supports our wide moat argument for the aggregate business. We do not expect Windows to be a meaningful contributor to Microsoft’s top line over the next 10 years.

We use a bottom-up valuation approach, modeling each of Microsoft’s subsegments independently. Our five-year revenue compound annual growth rate for the business is 12%, while our 10-year revenue CAGR is 8%. Our valuation is largely driven by confidence in Azure expansion, Office 365 uplift on both the consumer and enterprise side, continued LinkedIn monetization, a renewed focus on Dynamics, and a growing developer ecosystem, which we believe was aided by the GitHub acquisition. We believe this will be contrasted by declines in Windows revenue, cyclical hardware revenue, and cannibalization of on-premises Office and Server revenue from cloud products. We model a 9.5% 10-year revenue CAGR for Microsoft’s productivity and business processes segment (Office, Dynamics, and LinkedIn), a 12% 10-year revenue CAGR for the firm’s intelligent cloud segment (Azure, server products, consulting and support), and a 2% 10-year revenue CAGR for the more personal computing segment (Windows, gaming, advertising, Surface, and other).

Our bullishness for Office 365 stems from the long-term margin uplift inherent in a cloud application business model, with Microsoft’s ability to curb Office piracy and breach historically unpenetrated markets that could not afford the up-front server costs to support on-premises software, such as small to medium-size businesses and emerging markets. Microsoft targets that two thirds of Office users will be migrated to Office 365 by the end of fiscal 2019. We model a 24% five-year revenue CAGR and a 15.5% 10-year revenue CAGR for Office 365.

Microsoft’s wide-moat Windows Office tools have remained relevant for decades, a rarity in the fast-paced software world. The firm’s on-premises deployments maintain a monopolistic position, and cloud suite Office 365 is expected to continue Microsoft’s dominance. These applications are utilized by over 1 billion people around the world. Google caught Microsoft flat-footed with its cloud-based Google Docs, Slides, and Sheets tools. However, we think Microsoft has corrected course with Office 365, its cloud application response to Google’s offerings, which is growing robustly. The shift to Office 365 moves Office, which was a business confined to launch cycles, to a recurring subscription business while also quelling piracy risks. Through internal development and acquisitions, Microsoft has added Skype, SharePoint, Yammer, Power BI, OneDrive, and Teams as services available to its client base, protecting Office from SaaS productivity applications and creating upsell opportunities. The 2014 “Office Everywhere” campaign pushed to launch Office on as many devices as possible, allowing Office to grow on iOS and Android devices and decoupling risks that might exist with Office being solely tied to Windows operating systems.

Our modeling for Azure is contingent on double-digit secular growth for infrastructure as a service and platform as a service over the next five years. We still believe the shift in workloads to the cloud is in the early innings and public cloud services have consolidated around a couple of vendors, with Microsoft as the number-two player after Amazon. We model a 43% CAGR for Azure over the next five years and a 24% revenue CAGR over the next 10 years.

Microsoft Azure’s IaaS services benefit from cost advantages as the industry has consolidated around a few vendors with the ability to gain massive scale and high utilization. In terms of scale, Microsoft is responsible for the immense input costs in running a data center, namely the hardware, infrastructure software, power, cooling, networking, and IT staff for management. Global vendors, like Microsoft, need to have worldwide scale, which necessitates infrastructure for redundancies such as backup and recovery. These up-front investments are utilized to drive customers to drive heightened levels of server utilization. Over the years, we have seen prominent tech vendors abandon or alter their cloud efforts such as HP, Cisco, VMware, and IBM. As Microsoft Azure has grown in scale, pricing has actually come down, making it increasingly difficult for a new vendor to enter the space as the incremental investments necessary to price in line with Microsoft and the market leaders would be an immense task.

Secular forces drive enterprises to funnel their IT spending toward SaaS, PaaS, and IaaS, all of which are likely to grow at double-digit CAGRs over the next five years. In terms of IaaS, we have seen the market increasingly consolidate around four hyperscale IaaS vendors: Amazon, Microsoft, Google, and Alibaba. Increasingly, these vendors are generating economies of scale that protect them from new entrants, and the market’s shakeout phase is contributing to smaller competitors jettisoning their public cloud initiatives. We believe that Microsoft’s Azure, after a late start to Amazon Web Services, has caught up significantly in terms of technology and closed the gap with the number-one player. Moreover, we believe the line between PaaS and IaaS has become increasingly blurred, as enterprises seek to purchase both in a comprehensive offering. We have seen this benefit Microsoft and Amazon the most, leading to further consolidation.

We expect Microsoft to benefit from operating margin expansion inherent in a mature, cloud-oriented business. We model gross margins of 71% and operating margins of 43.5% in fiscal 2028, up from 65% and 32%, respectively, in fiscal 2018.