Summary

Microsoft’s stock price and actual performance have been growing apart at an unsteady rate.

Nadella’s forward thinking will not rely on the old Windows cash cow as the major revenue source.

The three step solution: aggressive targeting of cloud computing, not a desktop oriented OS company anymore, and a good bye to internet explorer.

Microsoft Speculation

Microsoft’s revenues have been growing; however, their stock price has gone mad bull. After 2009, the company got back on track. Revenues have been steadily increasing from $58.4b (2009) b to $62.4b (2010), $69.9b (2011), $73.7b (2012), $77.8b (2013) and rounding off 2014 with a solid growth to $86.8b. During the period from 2009 to 2012 stock price growth followed nicely with revenue and profit margin growth; however, in 2013 the three indicators started to sharply diverge.

The figure above demonstrates the sharp increase in stock price, with revenues growing at half the rate of the stock price, and profits growing at half the rate of revenue growth. Microsoft missed out on multiple opportunities and were slow to adapt during the last decade. Microsoft was late to web search and social networking, allowing Google (NASDAQ: GOOG) and Facebook (NASDAQ: FB) to become the leaders in these markets. Perhaps the biggest missed opportunity was with touch-screen technology and smart phones, where they had a significant early lead in smart phone technology, but failed to understand its significance and thus fell behind other competitors. Now, people are increasingly using smart phones and tablets to do their internet browsing, and Microsoft has not yet been able to take advantage of this trend. Its Surface tablet has lost more than $1.2 billion, and its smartphone operating system market share pales in comparison to that of rivals Apple’s iOS (NASDAQ: AAPL) and Google’s Android OS. But somehow, the stock price is still strong bullish, and its new CEO Satya Nadella is a major reason why. His new vision attracted us to write the article “Why Nadella Will Lead Microsoft In The Right Direction”, recommending Microsoft in the 1 month and 3 month time horizons. The returns were a staggering 3.32% and 7.53% respectively. Following the successful forecast we published Part II of the same title, which forecast a slowdown which held for about 2 month. On September we re-established our bullish position on the stock in the article “Why Are We Bullish On Microsoft? Algorithmic Analysis”, and after a weak first half to October, the stock shot up to nearly 50$ a share, 36% growth since Nadella’s appointment. As of now the price is about $46.5.

Nadella Will Not Count on Windows as a Cash Cow

Satya Nadella, who was Executive Vice President of Microsoft's Cloud and Enterprise group, was named CEO on February 4th, becoming only the third CEO in the company’s history. Since then he has been extremely successful in getting investors and analysts to buy into his future vision for the company. Nadella has shifted the focus of the company from a “devices and services” company to a “mobile and cloud first” organization. “While the devices and services description was helpful in starting the transformation, we now need to hone our unique strategy,” Nadella said in July. “At our core, Microsoft is the productivity and platform company for the mobile-first and cloud-first world.” By shifting the focus of the company, Nadella has responded to the shrinking PC market, and the growing adoption and prominence of smartphones, tablets, and bring-your-own devices. This change in strategy instilled confidence in investors. So are investors accurately speculating, or are they over estimating Nadella’s ability to get Microsoft back in the game?

First Task, Do What He Does Best: Cloud Computing

Investors bought into Nadella’s vision as a cloud and mobile-first company, and as a company that responds more quickly to the needs of businesses and individual smartphone and PC users. However, he needed to take definitive steps to make this happen. Releasing Office Suite for the iPad was a good start, as it drew notable attention for Office 365, the cloud version of its Microsoft Office software. Reluctant to do so in the past, Microsoft is now trying to get away from the exclusive software offering for its Windows operating system. The apps had more than 12 million downloads in the first week alone, and Office 365 had over 4.4 million subscribers after a year in service. Office 365 grew to more than seven-million subscribers in 4Q14, an increase of 26%. Microsoft hopes to grow this into a subscription-based cloud business.

Microsoft Azure, a cloud computing platform used to manage applications through its own data centers, is also strengthening the company’s place in the cloud. The company has made key acquisitions to help their cloud services. In 2014, Microsoft acquired InMage, GreenButton, Capptain, and Parature. The most recent acquisition was InMage, a start-up that focuses on helping organizations migrate their data between public and private clouds. With InMage, Microsoft aims to strengthen Microsoft Azure and improve hybrid cloud solutions. GreenButton is a high performance cloud-computing company that has worked in close quarters with Microsoft Azure to help solidify its position. The other acquisitions are Capptain, a mobile push analytics provider, and Parature, a provider of cloud-based customer engagement solutions. Microsoft has also announced partnerships with companies such as IBM (NYSE: IBM), Salesforce.com (NYSE: CRM), and SAP (NYSE: SAP). These partnerships of leading players in the industry show increased collaborations in the cloud space, and should help improve the scalability, adoption, and installation of Azure.

Second Task, Break That Old PC Shell: Mobile Services

Microsoft is also working to increase the market share of mobile devices that run Windows and Windows phone operating systems. Smartphone sales in emerging markets are expected to grow at an exponential rate going forward. The International Data Corporation (IDC) reported that they expect emerging markets to grow at a rate of 32.4%, compared to 4.9% for mature markets. The report also states that by 2018, nearly 80% of the smartphones on the planet will be owned by customers in emerging markets. Microsoft’s acquisition of Nokia (NYSE: NOK) is expected to help the company compete in these markets where premium devices will not have the same important position as they do in mature markets. While Nokia’s mobile hardware business does well, the company’s share of the smartphone market has declined in recent quarters. Through its smartphones, Microsoft aims to expand its customer base to use its software, Internet offerings, and mobile apps.

Microsoft’s online service segment is comprised of Bing, which generates revenue through advertising. In 4Q14, Bing advertising revenues grew 40% due to higher revenue per search and higher search volume. Increased adoption of mobile devices with Microsoft’s operating system is expected to lead to more Bing search traffic and additional advertising revenues. Microsoft has rebranded its smartphones to Lumia devices. Its Surface Pro 3 tablet, launched in late June 2014, garnered consumer interest and earned revenue of $908 million, more than double the $400 million it earned in the same quarter the previous year. Surface revenues grew at 127% this quarter, and Microsoft stated that Surface’s gross margins were positive in 1Q15 for the first time. Below is Bing’s current global search market share position.

Third Task, Dump The Junk: Goodbye Explorer, Hello Spartan

Microsoft displayed Windows 10 in the first week of October. This version of the operating system will be key to Microsoft’s growth for a couple of reasons. One is that consumers did not respond favorably to Windows 8. More importantly, Windows 10 will run across desktops, tablets, and phones, blurring the lines between mobile and desktop operating systems. However, the most recent news is Microsoft’s fresh start browser strategy, following recent news of a new internet browser to be released (not explorer).. Reports indicate it will support a minimalist user interface (UI), as well as extensions, sometimes called add-ons, much like Google's Chrome and Mozilla's Firefox. The browser, currently code named “Spartan”, will release alongside the new operating system, Windows 10. After years of trying to flip Internet Explorer’s terrible image, Nadella simply decided to let it rot, showing his forward thinking rather than the old clinging to the past mentality haunting the corporation. To leave the cumbersome legacy support demanding Internet Explorer and replace it with a browser/engine of the future which would be aggressively updated goes against classical Microsoft thinking, showing a true shift for the better.

Third Task, Dump The Junk: Goodbye Explorer, Hello Spartan

I Know First is a financial services firm that utilizes an advanced self-learning algorithm to analyze, model and predict the stock market. The algorithm produces a forecast with a signal and a predictability indicator. For now it is not pointing to buy since the stock leans towards the bearish in January. When a strong enough signal comes from the algorithm, we will release our future forecast in part IV of this series. Microsoft was chosen as one of our best dividend growth stocks in 2014, we believe that by February a clear signal should indicate if in 2015 it will make the list again.

I Know First Research is the analytic branch of I Know First, a financial start up company that specializes in quantitatively predicting the stock market. This article was written by Aaron Tallan and Daniel Hai, two of our interns. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.