BernsteinResearch analyst Mark L. Moerdler rate Microsoft Corporation (NASDAQ:MSFT) as Outperform.

Microsoft

Microsoft bear case

One leg of the Microsoft Corporation (NASDAQ:MSFT) bear case has been the belief that the decline in consumer Windows will destroy the Office franchise starting with consumer Office revenue. This note discusses the move of consumers to subscription Office and how 2M subscribers generate the equivalent of 5% of consumer Office revenue.

Microsoft Corporation (NASDAQ:MSFT) has been able to signup 2M+ consumer subscribers of the Office Home Premium Edition (Word, Excel, PowerPoint etc) which is 0.6% to 0.8% of the overall consumers Office paid user base.

Consumer Office revenues

Consumer Office revenue accounted for only 15% of Microsoft Business Division revenue or $3.7B in FY 2013. It was down 15% YoY from FY 2012, when it was ~ $4.4B, driven by decreased consumer Windows PC sales combined with the move of consumers from perpetual licenses to subscription.

There are over 1B users of Office including both paid licensed users and those that are pirating the software. Given that over 50% of Office users pirate the software we estimate there are between 420M and 518M paid users world-wide.

Microsoft Office licenses purchase

Analysts estimate that in FY 2013 between 27.5M to 41.2M consumers purchased Office licenses which given a 5 to 7+ year purchase cycle gives us 250M to 331M paid consumer Office users world-wide or 60% to 64% of overall paid Office users are consumers.

As of September 2013 there were 2M+ Consumer Home Premium subscribers that generate enough revenue to replace 5% of overall consumer Office revenue with subscription revenue. If Microsoft Corporation (NASDAQ:MSFT) can migrate 11% to 15% of paid consumers, or 37M users, the company can replace all of its FY 2013 consumer Office revenue with subscription revenue. Analysts do not expect Microsoft to migrate that many consumers to subscription but each additional million subscribers will improve the value and stability of the consumer Office franchise.

 – Analysts believe, the consumer signup rate is accelerating and Microsoft Corporation (NASDAQ:MSFT) will continue to offer more incentives to consumers to sign-up for subscription including Office for the iPad.

The move of consumers to the Office Home Premium subscription offering and how it protects both the consumer Office business and consumer Office revenue is in-line with Bernstein’s thesis on Microsoft and how the move to Cloud and subscription, especially within the company’s enterprise business will drive revenue and EPS growth.

Investment Conclusion

Analysts believe the current share price embeds an unrealistically bad scenario of no to negative perpetual growth, billions of dollars of annual cash drain from Search and Mobile into perpetuity, and tens of billions of dollars of additional value destruction through ill-fated acquisitions and investments. Instead, they believe that the move of Microsoft Corporation (NASDAQ:MSFT)’s enterprise business to the Cloud will generate significant revenue and EPS upside and will more than replace, over time, weakness or problems with Windows.