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Stock Strategist

A Closer Look at Microsoft's Wide-Moat Server and Tools Business

This market share leader in data centers can grow at nearly a double-digit rate.

 Microsoft's (MSFT) underappreciated server and tools business has been a crucial moat and growth driver for the firm. Years of incremental product enhancements and pricing discipline have resulted in leading market share in server operating system and database management software. Building out its suite of enterprise data center products has helped create a wide-moat server and tools business with high switching costs for customers who use its mission-critical IT tools. We believe device, data, and cloud trends will continue driving revenue growth for Microsoft's server and tools business over the next five years.

Revenue and profits in the server and tools business have grown at an impressive pace over the past decade. In fiscal 2012, server and tools contributed 25% of total revenue and 34% of operating income. The operating margin improved to 40% in 2012 from 25% in 2002. We believe the segment has additional room to grow, but cloud-related investments and competitive flanking will probably slow margin expansion.

Server and Tools' Moat Is Underappreciated
Discussions of Microsoft invariably turn to the flagship Windows OS business. However, the server and tools business has quietly emerged as an important moat and revenue driver for the firm. Toiling industriously behind the scenes, whether in a basement, a server room, or stadium-size data centers, servers are critical to modern everyday life. From phone call routing to smartphone browsing, media streaming to online commerce, servers are responsible for the heavy lifting behind these tasks. More often than not, these servers run on some form of Microsoft server software and services.

Microsoft has built a formidable server and tools business, with segment revenue and operating income growth outpacing industry growth. Through a combination of competitive positioning, pricing improvements, and key secular consumer and data trends, we believe Microsoft's server and tools business can deliver high-single-digit growth and remain a wide-moat revenue growth and profit driver for the foreseeable future.

Exploding growth in global Internet usage, coupled with the growth of data storage and analytics and the steady improvements in processing power driven by Moore's Law, has been critical to server unit growth over the past decade. As the number of servers increases, customers have placed more importance on servers that are relatively inexpensive and easy to manage. With server OS software priced to undercut rivals and its Windows-based, easy-to-use graphical user interfaces, Microsoft was able to carve out strong positions in the server OS and database management markets over the past decade, supplanting traditional heavyweight UNIX servers.

Microsoft leveraged its position in the server OS market to expand its database management system product, SQL Server. Database management system software is a critical component in a robust enterprise infrastructure suite, and Microsoft attacked the segment with its tried-and true strategy: by undercutting the competition on price and slowly increasing and improving the feature set with each release. With the potent combination of low-priced, well-integrated, easy-to-use server OS and DBMS software, Microsoft was able to erode the market leaders' share over time. Because DBMS holds data that is defined and used by the enterprise, it creates switching costs that increase depending on the mission-critical and time-sensitive nature of the data. The pricing advantage and the ratcheting of customer switching costs, combined with steady improvements in product features, have given Microsoft a dominant position in both the server OS and DBMS markets over the past decade. In 2012, we estimate that the Windows Server OS share of the market reached approximately 70% by unit and SQL Server's market share by device was approximately 50%.

A Decade Later, Secular Shifts and New Products Should Drive Gains
Despite impressive revenue and profit growth and strong share gains over the past decade, there is plenty of room for the server and tools business to grow. Even as Microsoft has established a strong position in the enterprise server market, we believe there is still plenty of room to grow for the server and tools business. Internally, the firm will continue improving its product and service offerings, extending its reach across the enterprise and increasing customer switching costs. Secularly, the growth in smartphones and tablets and the continuing rise in media consumption and creation, data, business intelligence, and big data will drive data center and server growth in the foreseeable future.

Although Microsoft's SQL Server product enjoys a wide market share lead when measured by unit volume, it is just third in market share when measured by revenue. This is the result of Microsoft's years-long strategy of undercutting the competition on price to establish and gain share. The implication is that Microsoft's server and tools products have plenty of room to raise prices. With the introduction of SQL Server 2012, Microsoft began slowly raising its prices to be more in line with comparable products. As the company continues taking share from rivals and slowly raises its prices, we expect revenue and operating income growth and margins to improve for this key product line.

Microsoft also continues to build out its product portfolio. Another critical piece of the enterprise server stack is the tool used to control the information technology infrastructure, assets, and resources. Although Microsoft's offering here is fairly nascent relative to competitors', it has consistently taken share from the top four market share leaders (IBM (IBM), CA , BMC Software , and Hewlett-Packard (HPQ)), recently surpassing the former fourth-place leader, HP.

In addition, we believe several secular trends will help drive revenue growth for Microsoft's server and tools business. The explosion of devices such as smartphones and tablets and the concomitant increase in data accessed and stored by these devices will be a significant driver in the buildout of enterprise data centers. Gartner estimates a 19% compound annual growth rate in the installed base for tablets and smartphones from 2012 to 2017; including PCs, the device installed base CAGR is 10%. In our opinion, the resulting increases in media consumption, data storage, and content creation will spur server and data center growth, which should benefit Microsoft, given its market-leading server OS and database software. Gartner estimates a 4.9% worldwide server unit CAGR from 2012 to 2017.

Cloud Adoption Will Help Drive Growth, but Expect Some Cannibalization
The growing adoption of cloud computing should also play a role in server growth. The ability to offload server workloads (whether infrastructure as a service or platform as a service environments) is likely to reduce the need for on-site servers for many enterprises. This offloading of mission-critical IT functions to a hosted cloud will result in hardware, software, personnel, and infrastructure cost savings for customers. Microsoft's server and tools business could benefit as these data centers are more likely to stay current with software updates and upgrades. Gartner forecasts a 16.8% CAGR for total cloud spending from 2012 through 2017.

A few years ago, Microsoft went on the offensive. Not content with hoping that cloud providers use Microsoft enterprise software products, the firm launched Windows Azure, its cloud application platform, in 2010. By offering IaaS, PaaS, website hosting, and data management--the spectrum of cloud computing services--Azure brings enterprise-class data center products and services to all customers. Customers pay subscription fees for the computing resources and services needed and consumed, helping to eliminate the costly investments needed for an on-site data center and the associated personnel costs. Microsoft would benefit as Azure subscription revenue should more than offset the possible loss of some on-site server OS and database licenses. Finally, offloading some mission-critical data and technology assets to the cloud has the potential to increase some customer switching costs.

As on-premise server shipments may decline as a result of increased cloud adoption, Microsoft looks to offset these revenue losses with predictable subscription revenue from Windows Azure. With its competitively priced, full-featured cloud offering, Microsoft hopes Azure replicates its successes in server OS and SQL Server as it pursues market share leader Amazon Web Services (AMZN).

Given the forecast growth in devices, server unit shipments, and cloud spending, combined with Microsoft's product improvements and modest price increases, we expect the server and tools business' revenue growth to average in the high single digits to low double digits over the next five years. We model a 9.4% five-year revenue CAGR for the business.

Threats Abound, but Open-Source Solutions Are the Primary Challengers
Microsoft has done an admirable job taking share from established rivals such as Oracle (ORCL), IBM, and the former Sun Microsystems in the server and data center marketplaces, while increasing customer switching costs as it embeds deeper into critical customer data and workflows. Nevertheless, while open-source Linux has less market share than Windows Server OS, it is growing faster.

Being open-source, Linux allows for in-house customization and offers some cost advantages over many vendors. However, unless the enterprise is running an internally developed version of Linux, customers must still pay for services and upgrades. The typical data center user is an experienced IT professional, which probably reduces some of the switching costs associated with user training.

The increasing adoption of public cloud services may also be a potential moat-eroding event for Microsoft. By outsourcing the infrastructure or platform, it will largely be the cloud providers that determine the software platforms, although the major providers (Amazon Web Services, Azure) offer a wide variety of Linux- and Windows-based options. Nevertheless, we believe there is some risk to Microsoft's ease-of-use advantage, as small and midsize enterprises that would have traditionally built on-site data centers would have been more likely to deploy Microsoft solutions.

Trends to Watch
The increase of virtual instances is likely to weigh on the number of servers shipped over time. Nevertheless, we believe virtualization is not necessarily a net negative for Microsoft. A combination of improved economies of scale in the public cloud (especially Azure) and license pricing changes are designed to take into account multiple instances.

Microsoft uses its in-house developed business intelligence tools for big data analytics. As such, its offerings are relatively nascent in this rapidly growing market.

The strategy of optimizing storage, servers, networking devices to work together as one cohesive system has the potential to threaten any vendor that dominates several pieces of the data center. We believe it will be important for Microsoft to remain flexible on heterogeneous environments.

Fairly Valued at $35, but Our Assumptions Are Modest
Although Microsoft is currently fairly valued, we do not believe it is expensive, given our relatively modest growth and margin assumptions. At our fair value estimate of $35, the company trades at a reasonable fiscal 2014 price/earnings of 12 times, with a trailing 12-month free cash flow yield of approximately 9.3% and a dividend yield of 2.6%.

We forecast a five-year revenue CAGR of 8%, even taking into account our relatively pessimistic assumptions on PC unit shipments, and a five-year 9.4% CAGR for the server and tools business. We model operating margin declines over the next five years on the assumption that the firm's attempts to maintain its share dominance across multiple markets will eat into profitability. Nevertheless, we still view this wide-moat diversified tech giant as a one that is willing to play the long game with regard to market share and strategy. We would not hesitate to recommend Microsoft's shares, given a modest margin of safety.

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