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Analysis: Nadella An Excellent, Evolutionary Choice for Microsoft


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By Norman Young 02-04-14 11:00 AM
Satya Nadella's insider status has given him the experience to continue reinventing the software giant for the post-PC world, says Morningstar's Norm Young.
As had been widely expected, Microsoft (MSFT) has named Satya Nadella as its next CEO. Additionally, Bill Gates has stepped down from his role as chairman of the board and now holds the title of founder and technology advisor, while independent director John Thompson will assume the role of chairman of the board. We remain comfortable with our $39 fair value estimate and wide moat rating.

The selection of Nadella was hardly a surprise, given the constant leaks from insiders throughout the process. Nevertheless, we view Nadella as an excellent choice, given his vast experience, specifically with what has been the growth and profit drivers of the firm--the enterprise business. The selection of Nadella is also a signal that Microsoft understands the critical importance of the cloud and the commercial business to its future. Activist investor ValueAct was involved in the search process and gave its stamp of approval.

Although some were calling for an outsider, we believe the selection of an insider brings some advantages. First, the transition period should be brief and relatively smooth, given Nadella's long tenure and familiarity with the firm. Second, the reorganization begun last year will likely continue with few disruptions--not an insignificant point considering Microsoft is about to take on an additional 30,000 employees when the Nokia acquisition closes later this quarter. Finally, we believe that as a "known quantity" the selection of Nadella ends much of the uncertainty both inside and outside the organization.

In our opinion, the changes to the board of directors are also an incremental positive. John Thompson as chairman will likely bring a more investor-friendly voice to the board--a part of the job that Gates did not relish. However, Gates' new role as a technology advisor has the potential to introduce friction in the product and management workflows given the high level of respect he holds in the organization, should his views clash with Nadella's.

Additional questions remain. We suspect any changes will be more evolutionary and less revolutionary, given Nadella's insider status. However, there are short-term moves that he could make to placate some members of the investor community. For example, since 2009, Bing has lost approximately $16 billion, collectively, $10 billion excluding write-downs. Even though shutting down search could yield instant profitability improvements, we believe its importance as a platform for the longer-term competitive position of the company will likely keep it as an important investment. Furthermore, Microsoft held approximately $61 billion in net cash and investments as of the end of the second quarter; Nadella could elect to disburse more cash to shareholders given the strong cash position and free cash flow of the firm.

With the sudden changes over the past six months (re-organization, Ballmer's resignation, purchase of Nokia, Nadella as CEO, Thompson as chairman/Gates' move to advisor role), we think Microsoft is still re-inventing itself to better compete in the world of cloud and devices. Throughout these changes, financial results have remained strong, especially in the commercial business, with some signs of life in the devices and consumer business. Certainly, Microsoft has formidable competitors and is still playing catch-up in the consumer side of the business, however, we believe the Microsoft franchise--Office, Xbox, Windows OS and Windows Server OS, Azure, and data center products--remain well-positioned and help keep Microsoft's wide moat intact.

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