News Analysis date published New: 
Thursday, February 14, 2013 - 11:30
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Thursday, February 14, 2013 - 11:30

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Thursday, February 14, 2013 - 11:30am

During the past 18 months, Microsoft's (Nasdaq: MSFT) army of software engineers worked feverishly to prepare for the tablet revolution. The company's newest version of Windows was aimed at taking back lost market share from the likes of Apple (Nasdaq: AAPL) and Google (Nasdaq: GOOG). Yet as I noted in this article, the launch for Windows 8 has been underwhelming. Nearly three months later, this view still holds.

Still, Microsoft has many other core strengths outside of operating software. Management should shift focus and ensure that each of these divisions has the right growth drivers to take market share. With more than $60 billion in net cash just sitting in the bank, it's foolhardy to stand back and do nothing.

Here's a look at three Microsoft niches and how the company can strengthen them through acquisitions of young, fast-growing firms that are gaining relevant traction. History has shown that the fast-changing technology landscape often produces tomorrow's top-performing investments. And these are the kind of opportunities no investor should ignore.

Server and tools
It's easy to overlook this division as it has little exposure to the consumer end of the technology world. Yet it's a $20 billion (in annual sales) division that is a key player in the management of many corporate networks. Microsoft has an especially strong presence in business intelligence and structured databases (with its SQL server platform).
But in recent years, the hottest growth areas have been in a field known as "Big Data," which is the ability to log, classify and analyze massive reams of data in real-time. And the most dominant entrant in the field of independent vendors is Splunk (Nasdaq: SPLK), which closed on its first day of trading in April 2012 at $35.50 a share and is now a few dollars cheaper. Microsoft would likely have to pay north of $4.5 billion to acquire Splunk, which seems pretty rich for a company on track for just $260 million in sales in fiscal (January) 2014.
But using Splunk as a beach head for a move into the Big Data niche would likely yield major benefits for Microsoft down the road as it goes head to head with Oracle (Nasdaq: ORCL) and others. Microsoft could also look to make a smaller purchase in the field: Privately-held firms include Sumo Logic and Loggly.
Online services
If Microsoft wants to be seen as a serious challenger to Apple and Google in the consumer space, then it will have to beef up this division, which is home to the Bing search engine, the MSN portal, the Hotmail email service and the company's SkyDrive data-storage service.
It's this last service could serve to be a Trojan Horse for the company's other consumer initiatives. Hosting personal data and media content in the cloud is a key goal for Apple, and it should be for Microsoft as well. After all, consumers tend to remain clients once they have all of their important files on a particular platform.
To boost market share in the data-storage segment, Microsoft may look to acquire Carbonite (Nasdaq: CARB), which is growing at a 20% annual clip and is on pace to exceed $100 million in sales this year. The company is valued at about $265 million, and even assuming a 30% buyout premium, this would still barely make a ripple in Microsoft's balance sheet. Privately-held Dropbox, which may look to pull off an IPO this year, is also a potential target for Microsoft.
Entertainment services
In the entertainment space, Microsoft's biggest challenge is a simple one: Attract new customers to its platform (which includes Skype, MSN, Bing, Hotmail and its various gaming efforts), and figure out ways to keep these customers' eyeballs glued to the company's properties. Outside of video games, the company is lacking compelling forms of entertainment and popular online services (such as dating sites).
That's where IAC/Interactive (Nasdaq: IACI) comes in. The company operates a range of online dating sites (such as Match.com), media and humor sties (such as Vimeo.com and CollegeHumor.com) and has also invested heavily in mobile apps, which is a big part of Microsoft's revamped smartphone efforts.
IAC/Interactive brings more than just a $3 billion revenue base: It also brings an army of tech-savvy developers who have shown a willingness to make bold moves, a personality trait Microsoft sorely lacks. Back out IAC/Interactive's net $700 million in cash, and the company is currently valued at less than $3 billion. Chairman Barry Diller is now in his 70s and may be willing to take an offer from Microsoft -- for the right price.

Risks to Consider: It's never wise to load up on stocks simply because they may become buyout fodder. Instead, think of it as just another virtue among the many investment merits you assess.

Action to Take --> One year ago, investors were looking ahead to Microsoft's looming Windows upgrade, and shares were moving above the $30 mark. A year later, shares have lost momentum and are back in the $20s, exactly where they stood five years ago. Apple and Google's share prices are up 200%, and 50%, respectively, in the same period.

It's increasingly apparent that Microsoft will have to keep stepping on the gas to get its share price moving again. Its cash-rich balance sheet means that deal-making will most likely be part of the strategy. The buyout targets I mentioned here are a good starting point for further research as you refresh your understanding of the technology landscape. While some of these young companies will be buyout targets, others some will prove to be winning investments on their own merit. The 2013 IPO calendar is chock-a-block full of these high-growth tech companies, which you can read about here.

P.S. -- It's finally here... our Top 10 Stocks for 2013. Since we first began publishing this annual report in 2003, our picks have beaten the market 7 out of the past 9 years... including average annual gains of up to 38.7% in a single year. Go here to learn more.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.