Despite Disruptive Forces, Micros' Long-Term Position Remains Attractive

 Micros  recently lowered its full-year forecast and provided a fiscal 2014 outlook that underwhelmed the market. The overarching factor behind this change in sentiment lies with the macroeconomic climate and Micros' proportionately high exposure to the North American and European markets. However, macroeconomic issues aside, we also think the investment community is concerned with other disruptive forces. We've broken down Micros' key business segments and analyzed the disruptive forces, and we think the investment community is overly discounting this market-leading company.

Micros' narrow economic moat is derived from its entrenched position in the hospitality and retail segments. Although the company's shares have risen considerably in recent weeks, we believe there is still 9% upside to our current fair value estimate of $50 per share. Our favorable outlook is reinforced by high customer switching costs, scale-related cost advantages, and considerable free cash flow generation.

Diversified Operations Should Ensure Micros' Longevity
Micros is a market-leading provider of enterprise application software, hardware, and services to the hospitality and retail industries. The company helps its customers conduct their daily operations by providing a broad range of products such as property management systems, central reservation systems, point-of-sale, and enterprise resource planning. Additionally, Micros' customers rely on it for services such as installation labor, custom software development, consulting, maintenance, helpdesk, and software upgrades.

The firm has operations in more than 180 countries, yet its financial results are largely dependent on the health of the North American and European markets. Going forward we think the company will look to expand further into the faster-growing Asia Pacific and Latin American markets via mergers and acquisitions. About 45% of the company's revenue is recurring, and we expect this recurring share to grow over time as the shift to SaaS & Hosting increases. We think the lower total cost of ownership will be the primary reason behind this shift. As a result, we expect improved earnings visibility compared with the past.

Although the company faces disruption from new technology and emerging competitors in the restaurant and retail industries over the long term, we think Micros' foreseeable future remains healthy. We believe Micros' narrow economic moat is supported by high customer switching costs and scale-related cost advantages, and there are numerous opportunities for the company to extend its leadership position and gain market share.

Restaurant Segment: Entrenched Yet Facing Long-Term Disruption

Micros Restaurants (37% group revenue)

Emerging threats at the low end of the market will not affect Micros' dominant position for the foreseeable future. Micros first made its name in the restaurant industry. Recognizing a secular shift to electronic systems in the mid- to late 1970s, Micros was able to carve out a competitive position in the electronic point-of-sale niche. Today, the company has a market-leading installed base of more than 350,000 restaurant systems throughout the world, and it provides hardware, software, and services across the value chain, from large resorts and casinos to small table-service restaurants and quick-service restaurants. While the restaurant business faces the most disruption from both a competitive and a macroeconomic standpoint, we believe these disruptive forces will not change the underlying strength of the business for at least the medium term. We think the company will be able to withstand the disruptive climate given its imbedded position in the restaurant market, a newly developed hardware strategy, and compelling Restaurant Enterprise Series, or RES, and Simphony platforms. Notably, we are encouraged by recent interest from large chains such as  Tim Hortons  and  Ruby Tuesday .

The answer to the question, "are iPads going to put Micros out of business?" is a resounding no. The purchasing decision for most clients is not based solely on the cheapest hardware alternatives, but often also on what software and services are available. Fortunately for Micros, it has both market-leading software and services with which to sway customers. Comprehensive mission critical functions--such as labor, product, and financial management, as well as loss prevention, business intelligence, and e-commerce--are a significant contributing factor in the purchasing decision. Additionally, Micros' broad support network is able to provide timely service in case of emergency, which is something many competitors can't guarantee. We believe such software and services implant Micros within a restaurant's ecosystem and create meaningful switching costs, which reinforce the restaurant segment's narrow economic moat.

Although Micros' hardware business faces disruption from the proliferation of tablet substitutes over the long term, we think the company's recent foray into the mobile space will curtail the potential for accelerated hardware sales deterioration. We still forecast a modest slowing in hardware sales growth, yet we don't think Micros' hardware solutions will become irrelevant. Notably, Micros has started to produce its own purpose-built tablet. The recently announced mTablet and mStation represent Micros' entrance into the tablet market and a shift away from its traditional POS workstations. The overall financial impact from customers' choosing either the tablet or the traditional workstation is expected to be negligible, with costs and margins similar.

Much has been made of the potential impact on Micros' business from the emergence of mobile payment providers, such as Square, as they move further into the POS ecosystem. However, we do not think there is a significant risk to Micros' core restaurant business for at least the medium term. Square has created a basic platform for small merchants and might still be able to move further up the value chain over time, yet at this stage, it's disrupting the low-end electronic cash register market--a place Micros has never targeted. Additionally, Square provides only basic functionality, and its fees (2.75%) are too exorbitant for larger enterprises, which hinders its appeal.

Of the 7 million restaurants globally, 2 million are deemed "sophisticated" sites, worthy of Micros' attention. With less than 20% share of this segment, the company has the opportunity to expand further into the sophisticated sphere, in our opinion. We also believe the sophisticated market can expand, since restaurateurs have an increasing need to keep up with advances in consumer behavior. In our view, the higher end of the market is becoming a two-horse race between Micros and  NCR (NCR) (thanks to Micros' acquisition of Radiant), which could act as another tailwind for the firm. Based on Micros' market data, competitors such as  PAR (PAR) and Squirrel Systems are losing share in this segment of the market.

We believe Micros' Restaurant Enterprise Series and Simphony solutions will allow the company to penetrate the faster-growing casual and quick-service restaurant markets. While Micros has primarily targeted the higher-end chains in the restaurant industry, we think the company will look to take these scalable platforms downmarket over the coming years in response to an emerging trend toward lighter-casual and quick-service restaurants. People are trading down to restaurants with smaller check sizes owing to a lackluster economic recovery and a shift toward speed and convenience. We expect Micros to follow this growing market segment with its new tablet and Simphony offerings.

Hotel Segment: Dominant Position Expected to Be Extended

Micros Hotels (38% group revenue)

We believe Micros has a wide moat in the hotel segment, and we expect it to continue to dominate over the long term. Micros started its foray into hotels with its acquisition of Fidelio in 1993. Since then, Micros has grown to become the dominant global platform in hotels (particularly in large chains) with an estimated 30% share of this market. Importantly, Micros continues to extend its market leadership in the hotel segment, and recent deals with premier hoteliers such as  Marriott (MAR) and  Starwood  exemplify the relevance, technological expertise, and value of Micros' offerings. Over the midterm we think Micros has the ability to increase its market share in the hotel industry given its compelling solutions and ability to execute. Additionally, thanks to the company's large customer base and high switching costs, we believe the hotel segment has the strongest and most stable moat out of all Micros' business segments. Therefore, we forecast the hotel segment as the company's backbone for the foreseeable future.

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Micros provides a comprehensive suite of software and services predominantly under the OPERA brand name. Micros' OPERA solutions provide hotel operators with a highly scalable and flexible platform. The suite includes property management systems, central reservation systems, customer relationship management, and many other solutions tailored specifically for the hotel industry. Micros offers both on-premise and cloud-based deployment. Over time we expect Micros' customers to gradually shift to more-hosted solutions, as the total cost of ownership is lowered under such a model. Importantly, the firm's next-generation OPERA 9 platform is web-based only, and it highlights the increasing appeal of hosted solutions for the hotel industry.

Micros recently signed a multiyear deal with Marriott to provide a customized version of the OPERA 9 property management system across all Marriott brands in North America. It is a significant win for Micros as roughly 3,200 properties and more than 500,000 hotel rooms are included in the agreement. The next 18-24 months will be characterized by specific product customization for Marriott, and then starting in the summer of 2015, Micros will start to displace Marriott's internal platform; this entire process is expected to take four to five years. The tail end of this deal (2019) is expected to contribute roughly $45 million in recurring revenue per year. We believe the Marriott agreement is a crucial indicator of Micros' competitive position in the hotel market, particularly within large chains.

While the hotel market is viewed as fairly mature with only moderate growth prospects, we think there are opportunities for Micros to grow its market share and outperform the broader market. Within the hotel segment, internal platforms are actually Micros' biggest competitor, and notably, a number of high-profile chains are still using Windows platforms made in the mid-1990s. These aging internal platforms are now becoming redundant because of significant advances in consumer platforms and interaction. We think this tailwind will provide Micros with the ability to take further market share. Significantly, a possible deal with Hilton may emerge over the next six to 12 months, which could be a meaningful growth catalyst over the medium term. Additionally, we believe there are four other large chains that are in a similar position to Hilton, and Micros is in a very good competitive position to lure them onto its OPERA platform. Any additional wins could lead to further upside for the company.

Although large chains will remain the core focus of the hotel group, the firm's scalable cloud platform will enable it to grow downmarket too. With only a small share of the nonchain market, Micros expects to leverage its technical expertise in large chains and provide lighter, easy-to-use cloud solutions for smaller hoteliers. Such products as Opera Xpress, Opera Lite, and Operetta are currently being promoted to this segment of the industry. The company aims to grow its hotel salesforce to penetrate the lower end of the market, and we think it stands a good chance to gain greater adoption against internal platforms and smaller competitors.

Retail Segment: Micros' Expansion Will Be Moderated by Competition

Micros Retail (25% group revenue)

With the acquisition of Torex, Micros now has the required scale to compete in the highly fragmented and very competitive retail industry. Micros entered the retail business in 2003, when it purchased Datavantage for approximately $52 million. The acquisition allowed Micros to extend its product suite and diversify its revenue base. Recently, the company made a further push into the retail market with the acquisition of Torex for £165 million--its largest acquisition ever. The acquisition now provides Micros with a critical mass in both North America and Europe. By bringing in Torex, Micros now has a comprehensive retailing platform, which we think will gain adoption due to the increasing popularity of omni-channel retailing and growing consumer sophistication. In our view, while Micros has the opportunity to increase its small market share, the highly fragmented and competitive nature of this industry will moderate any long-term dominance.

The company's broad array of solutions is a deciding factor for customers who wish to have a consistent experience across every point of the business. Today, Micros retail covers everything from e-commerce to customer relationship management, POS, order brokering, managed services, social media, and more. While omni-channel retailing is growing rapidly, there seems to be a lack of effective implementation and awareness on the behalf of retailers; this is where we think Micros has an opportunity to develop its business. Through its well-established salesforce, we think Micros has the ability to demonstrate its value to potential customers by offering an end-to-end solution, in contrast to smaller competitors who have a narrower breadth of products. To that end, Micros recently signed omni-channel agreements with Steve Madden, Modell's, and Charlotte Russe. Furthermore, recent deals for Micros' Xstore platform, whereby the company is displacing internal platforms and third-party competitors, support our conviction.

Overall, we believe the company's sales, software, and global support services will differentiate it from the competition and create an opportunity to gain share in the industry in the near term. However, we also think emerging mobile competitors will erode any significant long-term competitive position. Moreover, these emerging mobile competitors pose the long-term risk of moving further up the value chain and encroaching on Micros' traditional large-format retailing segment. Therefore, we are taking a conservative long-term outlook for the retail segment.

So What Does This All Mean? Micros' Outlook and Valuation
The macroeconomic climate remains lackluster. Despite a weak economic backdrop (as highlighted in the company's most recent financial quarter), we think Micros remains an attractive midterm investment. From a macroeconomic standpoint, the company has seen a slowdown in spending and new unit expansion. Owing to the long-lived nature of Micros' platforms (eight to 10 years), the company's customers have the luxury to defer their purchase and upgrade decisions. In theory, roughly 10% of Micros' customers should be upgrading to new systems every year; however, this rate has slowed. Activity and client interaction is good, yet it isn't translating into signed deals. As a result, we think pent-up demand is building, which is likely to lead to higher-than-average upgrade rates once economic conditions in North America and Europe improve. As to the timing of such improvement, we are expecting this dynamic to play out over the medium term owing to the long sales cycle.

Our valuation reflects Micros' attractive position in the hospitality and retail segments. Our fair value estimate for Micros is $50 per share, which implies forward fiscal-year price/earnings of 21 times, an enterprise value/EBITDA of 13 times, and a free cash flow yield of 5.4%. While macroeconomic issues will suppress Micros' short-term performance, we think the company is well positioned to increase its revenue in the high-single digits over the medium term. The firm's competitive position remains attractive, and we believe all three key segments are ripe for market share expansion. While Micros faces disruption from hardware substitutes and low-level POS competitors, we believe these developments are long-term in nature and will not have a meaningful financial impact on Micros for the foreseeable future. Our revenue growth forecast assumes a moderate improvement in the North American and European markets whereby new system demand returns. We also expect Micros to start recognizing the Marriott sales contribution as OPERA begins to be implemented across the hotel group in North America. Additionally, Micros anticipates it will increase maintenance rates by about 2%-3% per year for the foreseeable future, which will benefit the company's top line.

On the margin front, we expect Torex to be fully integrated by the second half of 2014 and expect to see operating margins return to fiscal 2012 levels in fiscal 2015. Additionally, we believe the company's growing scale will allow for a modest improvement in operating leverage, and we think Micros' software and services revenue growth will outpace the company's hardware growth. As a result, the overall group margin will naturally increase given the smaller-hardware (lower-margin) contribution. The company will continue to invest in its salesforce in order to extend its market leadership, and we expect the company to use surplus funds to pursue further M&A opportunities. The company is actively looking to extend its business, and we think the higher-growth regions of Asia Pacific and S. America could be attractive. While we are not explicitly forecasting a contribution from such a deal in our growth outlook for the company, we do think this is a distinct possibility.