Growing a Google every year...for 4 years

Google recorded revenues of $3.2B last year, and will record over $5B this year. Microsoft has grown revenues by $4B every year for the past 3 years and is likely to grow by another $4B for the fiscal year that ends June 2006. Microsoft has grown a Google every year yet the stock price remains flat. Google has a market cap of over $100B. Some of this is due to the "law of large numbers" and some is due to stock market dynamics.

Google growing from $3B to $6B is only $3B of growth compared to Microsoft's $4B, but it represents 100% year over year growth, while Microsoft is more like 10% year over year. This is a perfect example of the law of large numbers. Growth that is impressive, even extraordinary, compared to the rest of the industry, is considered "flat" compared to yourself. The law of large numbers applies to all large companies. It happened to IBM and Microsoft, and it will eventually happen to Google. They can't continue to grow 100% per year for very long.

Lets look at other examples of current annualized revenues for high profile companies. Yahoo is at about $4.8B total revenue and has a market cap of $58B. Ebay has annualized revenues of about $4.2B and a market cap of $63B. Microsoft has grown a Yahoo or an eBay every year too, yet has added virtually nothing to its market cap. You could also add a Siebel ($1.4B), an Adobe ($1.9B) and a Salesforce.com ($237M) combined total revenues and still not equal the growth at Microsoft. These companies have a combined market cap of about $26B, don't suffer the law of large numbers, yet don't have the growth rates of Google or Yahoo.

So, is the stock market being unfair to Microsoft and under valuing the company? No, not really. For many years Microsoft's stock price enjoyed this same premium valuation reserved for only the highest growth stars. The stock market, comprised of millions of independent investors, sets the price on every company every day based on news, trends, and expectations. All non-dividend stocks, or low dividend stock, are valued based on future expectations. Investors are willing to pay more for 100% growth than they are for 10% growth. The key question is what happens when that 100% growth becomes 50% growth, and then 25% growth, or even lower?

Microsoft is really comprised of many different business segments, combined in one company, and traded under one stock symbol. But, the stock market can only place one valuation on all of these businesses. The businesses are very different, have different competitors, and different growth rates. Lets take a look at each segment.

For the fiscal year that ended June 30th 2005 Microsoft had revenues of about $40B broken down as follows;

• Client Software (Windows desktop OS) - $12.2B
• Information Worker (MS Office) - $11.0B
• Servers & Tools (Windows Server, SQL Server, .Net development tools) - $9.9B
• Home & Entertainment (xBox) - $3.3B
• MSN (MSN sites, Search) - $2.3B
• Business Solutions (Great Plains, SMB business) - $0.8B
• Mobile/Embedded (Windows Mobile) - $0.3B

There are basically three massive $10B plus businesses that are highly profitable. These businesses generate excellent profits and cash flow. They grow along at the rate of normal IT spending at a fairly predictable rates. These three businesses are each comparable in size and growth to an Oracle which has about $12B in revenues and a market cap of $65B. However, the Client and Information Worker businesses have Operating Margins of over 70% compared to Oracle's 40% margins.  The Server and Tools business is more comparable to Oracle with a 33% Operating Margin. So, you could place a value of about $100B each for the Client and Information Worker businesses, and about $60B on the Servers &Tools business for a combined market value of about $260B.  Today, Microsoft has a total market cap of about $300B, so that means all the remaining businesses are valued by the market at around $40B.

MSN includes the various MSN sites and networks as well as the Search business. MSN had revenues of $2.3B for the year ended June 30, 2005. This business has tremendous growth prospects, very different from the traditional software business. MSN is just starting to build out and optimize its advertising network, particularly in the search space. Today, MSN is about half the size of Yahoo ($4.8B revenue and $58B market cap) but could match, or even exceed, Yahoos growth rates over the next several years. Indeed, MSN is one of the big four known as GYMA; Google, Yahoo, Microsoft, AOL. In the next five years MSN could emerge as a top player in this space and rival the revenues and market cap valuations of Google and Yahoo. I would guess that MSN is worth about $30B today and could be worth over $100B in a few years.

Home and Entertainment is a $3.3B business today. The gaming division with the new xBox 360 is the poster child for this group. This is another high growth business with huge potential profits. The home set top box could become the computing center for the home, and the software as a service delivery mechanism for much of the world. Windows Media Center transforms the TV into a multi-media center for video, music, photos, games, and all forms of digital content. This is an exciting business with huge potential. From a stock market point of view it is hard to find "pure play" comparables. Sony is of course a competitor, but like Microsoft it includes many other businesses that make it hard to value just the game or media business. I would guess that the Home and Entertainment business has a stock market valuation of about $20B today and could be worth over $100B in a few years.

That leaves the Microsoft Business Solutions segment ($800M) and the Mobile Embedded segment ($300M). Again, these businesses have great growth prospects and are building up from small revenue bases. What value should the market place on these businesses?

Lets review the estimated comparable value of each business segment;

• Client Software (Windows OS) - $100B
• Information Worker (Office) - $100B
• Servers & Tools (Windows & SQL & .Net) - $60B
• MSN (Sites plus Search) - $30B
• Home & Entertainment - $20B
• Business Solutions - $5B
• Mobile/Embedded - $2B

So, is the stock market valuing Microsoft fairly? Are each of the business segments being valued by the right metrics? The stock market answers those questions every day. Most days they are probably right. Today my guesses total about $317B, while the market values all the pieces at about $300B. Probably close enough for rough guesses.

The real key to Microsoft's growth, and value, over the next several years will be the MSN, Home &Entertainment, Business Solutions, and Mobile Embedded businesses. All great businesses with great growth prospects. These businesses could easily add $150B in market cap over todays valuations.  Once the stock market believes this is possible the stock price will move up in anticipation. Now it is all about execution.

Comments

[W Cargill]

Well, a nice analysis of the MSFT business segments, but mis-guided on several fronts. First, the stock market values profits not revenues (or in the case of "pre-profit" businesses it's the potential for profits). Walmart grows a Microsoft every year (almost anyway) and yet doesn't merit a MSFT sized increase in valuation. So, you should do the same analysis comparing MSFT segment profits to GYMA profits.

Second, you seem to assume that the market believes MSFT's existing business segments will continue to generate the same level of profits and growth, thus giving your "undervaluation" of the new, unprofitable segments like MSN and XBOX. I think that may not be true. Perhaps the market is saying it doesn't believe those extremely high profits are sustainable, in which case, your sum of the parts equation could be different.

And finally, look at the difference between what MSFT and GOOG are doing with their extra cash. GOOG is reinvesting its excess cash in potentially blockbuster businesses, while MSFT is sitting on $40b, giving $40b back to shareholders as a dividend. Not that MSFT isn't investing in big businesses, but the market probably is willing to bet more on a newcomer with radical ideas than a monopolistic incumbent that protecting the crown jewels with perpetually money losing ventures like MSN, XBOX, etc... It is ironic that the market values a company that burns cash more than one that generates AND distributes it back to shareholders, but again, it's all about the potential.

Also, you should subtract the $40B in cash from the market cap to get the true enterprise value of MSFT.

In the end, I'm not saying your conclusion is wrong. MSFT may indeed be undervalued. And execution will be critical for the company. I just think the interpretation of the stock market is a bit off the mark.