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Commentary

We’re Boosting Our Fair Value as Microsoft Becomes a More Focused Operation

Management's cost-cutting, restructuring, and strategic moves should help Microsoft regain lost ground in the mobile devices and the cloud, says Morningstar’s Norm Young.

 Microsoft's (MSFT) typically strong commercial businesses led the way for the company, but the recently completed Nokia acquisition weighed on profitability for the fiscal fourth quarter. Aside from the generally positive results for the quarter, management's cost-cutting, restructuring, and strategic moves should make Microsoft a leaner, more focused organization as it hopes to regain lost ground in the mobile devices and the cloud. We are raising our fair value estimate to $46 per share from $42 and maintaining our wide moat rating.

For the quarter, revenue increased 18% to $23.4 billion as the inclusion of Nokia added $2 billion. Excluding the acquisition and other one-time items, revenue growth would have been 22%. Device and consumer licensing revenue increased 9% on strong Office and Windows Phone licensing revenue. Phone revenue included $382 million from the recognition of the conclusion of the former commercial agreement with Nokia. Computing and gaming hardware grew 23% to $1.4 billion on improved sales of Xbox and Surface tablets, while D&C other increased 20% year over year to $1.9 billion as Bing and Office 365 drove the improved result. Total commercial revenue increased 11% as refreshed on-premise server products, cloud products and services, and a PC refresh cycle more than made up for weaker commercial Office revenue.

Profitability was dragged down by the new phone hardware business (Nokia), as operating income of $6.5 billion would have been $692 million higher excluding Nokia. Operating expense control was solid, as revenue growth (ex Nokia) of 9% for the year was matched by 4% growth in operating expenses.

Although the Nokia numbers muddied this quarter's results, Microsoft's commercial business remained resilient and its cloud products showed impressive growth, once again. The big news was the restructuring announced last week, which should make Microsoft a leaner, more agile competitor.

The results for the quarter were mostly lost in a combination of last week's restructuring announcement and the drag from the completed Nokia acquisition. Nevertheless, there were some important data points in the quarter that point to Microsoft's continued strengths and ongoing challenges.

For the most part, the commercial business remains a bright spot for the company. Accounting for roughly 58% of total revenue for the quarter, selling to the enterprise and especially the data center is still Microsoft's growth driver. A refreshed lineup of SQL Server combined with newer on-premise server products drove server product revenue 14% year over year. Microsoft's virtualization product, Hyper-V, continues to gain share, ending the quarter with approximately 30% of the market. The cloud businesses (a combination of Azure and commercial Office 365) were another bright spot for the firm, as revenue for commercial cloud services increased 147%, hitting an annualized run rate of more than $4.4 billion.

The recent improvement in PC demand was largely confined to the commercial business as enterprises refreshed their PCs due partly to the ending of XP support. This improvement in PC demand is only temporary, in our view, and we expect the refresh cycle to fade over the next quarter or two.

The devices and consumer business segments showed some signs of life, as Surface tablet and Xbox sales were slightly ahead of expectation and consumer Office 365 was a pleasant surprise. Bing continued to gain market share, reaching 19.2% share in the fourth quarter, and perhaps the biggest surprise was that management expects Bing to be profitable in fiscal 2016.

Microsoft's challenges remain its mobile hardware business, that is, its phone and tablet businesses. The announced restructuring will help rationalize the massive Nokia business, but Microsoft will probably still struggle to gain smartphone market share. However, investing resources in the more popular, lower-end smartphones seems a prudent strategy for now. We do not expect overnight improvement for the firm's travails in mobile devices, but the move to shutter extraneous projects and rationalize the structure should quicken the pace of improvement.

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