For the past 10 years, Microsoft’s (NASDAQ:MSFT) stock has traded in a relatively tight range of $20 to $30. According to our estimates, however, Microsoft is currently worth around $41/share, implying a premium of about 40% to the market price. In contrast to our forecasts, we think the market expects Microsoft’s market share for the OS and Office divisions to decline. Our thesis is centered around Microsoft being able to maintain its market leading position, especially for its Office and Windows OS offerings.
Microsoft’s flagship products include the Microsoft Office Suite, Windows Operating Systems and Windows Servers. The company primarily competes with Google (NASDAQ: GOOG) and Apple (NASDAQ:AAPL) in productivity software and OS markets.
New interface with lower costs for consumers
Over the years, Microsoft has been criticized for not innovating its product offerings and taking its dominant market position for granted. However, with its newest offerings, Office 15 and Windows 8, the company is focusing on making its platform more intuitive and putting the focus back on the consumer. We think that this redesign is a step in the right direction and will enhance Microsoft’s ability to retain market share relative to competitors. Additionally, the company is reducing the price for upgrade to its new Windows 8 platform to remain competitive against free open source software such as Linux.
Microsoft has also taken steps to redesign its user experience for its online properties; it is deprecating Hotmail for a sleeker Outlook.com. These interface changes show greater focus on consumer usability, and can help attract users, going forward. You can assess the impact of changes in Office Suite market share on our stock price estimate by using the chart below.
New OS can drive synergies
In our view, the market may be dismissing the chances that a consumer using Windows OS on PC will buy a Windows-based device for tablet or phone. The availability of Windows 8 across all platforms is likely to encourage user adoption on multiple platforms. For example, in the emerging markets, an individual who cannot yet afford a PC can buy a Windows-based phone because it is cheaper. And, if the user saves up for PC in the future, the chances that he will choose a Windows-based PC are higher due to familiarity with the Windows OS. We think the desire to have the same experience across multiple devices and the general reluctance among users to switch operating systems will help Microsoft maintain market share for its flagship products.
Risk: Increased competition and bad acquisitions
As stated above, we expect Microsoft’s market share for its biggest products will stay more or less flat until the end of our forecast period. If Windows 8, Office 15 or a new iteration of these products fail to attract users or, still worse, they leave the Windows platform, we could see a downside to our price estimate. Additionally, if a competing product gains traction relative to the Windows OS and Office suite, we could see a decline in market share, which would consequently drag the company’s value.
Another concern is the company’s history of paying extravagant amounts of money for new acquisitions. Microsoft wrote down aQuantive in the most recent quarter and, if future acquisitions are not successful, they could destroy value for the company by wasting cash.
Overall, we think our $41/share valuation for Microsoft is justified, implying a 40% upside to the market price. We don’t expect the company’s largest segments to go away anytime soon and will likely maintain their market shares till the end of our forecast period. The depressed market valuation could be a result of lack of faith in management or overestimation of the impact that trends in the open-source, free software space will have on Microsoft’s value.