This is the sixth in a series of articles covering “unpopular” larger companies. Benjamin Graham believed that such companies may present opportunities for enterprising investors. We discussed the Graham approach in more detail in a recent article.
At the turn of the century, few observers could have possibly foreseen that Microsoft would become a favorite bargain purchase for value investors in 2010. The dot com boom was in the process of peaking and any company even vaguely associated with software or technology traded at stratospheric multiples of earnings.
Microsoft was certainly no exception. The company earned $0.85 per share in fiscal 2000 and traded at well over fifty times earnings when Steve Ballmer assumed the CEO position in January of that year. While the company has increased profits at a moderate clip and reached earnings per share of $2.10 in fiscal 2010, the stock price is now at well under half of the peak levels seen in 2000 and is firmly in “value” territory trading at ten times trailing earnings when adjusted for excess cash on the balance sheet.
Bargain Valuation Not Unnoticed
Microsoft’s bargain valuation has not gone unnoticed among value investors who have flocked to the stock in recent months. Some of the prominent investors with significant positions in Microsoft include Arnold Van Den Berg, Wally Weitz, David Einhorn, Bill Miller, and Whitney Tilson. (For a list of fund managers currently holding Microsoft stock, click on this link to view Dataroma’s database.)
Of course, the fact that many value investors have positions in Microsoft does not mean that it is intelligent to blindly follow but it is intelligent to use the positions of successful investors to generate ideas for further independent research. In the case of Microsoft, the value becomes quickly apparent with a brief review of the key facts.
From Cutting Edge to Stodgy in Ten Years …
We presented much of the bullish case for Microsoft in a recent article regarding Steve Ballmer and will not repeat all of the details here. To sum up the past decade, Microsoft continued to deliver strong results but suffered a downward revision in valuation so extreme as to deliver negative returns for investors who purchased stock a decade ago. Earnings advanced from $0.85 to $2.10 over the ten year period which amounts to a compound annual growth rate of 9.5 percent. During the decade, the company introduced a regular quarterly dividend and paid a one-time $3.00 per share special dividend in 2004. Profit margins have declined over the ten year period but net profit margin of 30 percent in fiscal 2010 still signals the presence of a very strong franchise. (Download Value Line’s report on Microsoft for more useful statistics. The report is one of Value Line’s Free Dow 30 stock reports.)
The main problem facing the company is the inability of management to profitably break into a new line of business beyond the core Windows and Office franchises. Mr. Ballmer is facing a great deal of criticism regarding the failure of Microsoft to break into an entirely new line of business that will deliver new profit streams and potentially mitigate an eventual decline in the core Windows and Office franchises.
One cannot help but compare Microsoft’s performance to Apple Computer particularly given the fact that Apple recently overtook Microsoft in terms of market capitalization. Steve Jobs has succeeded in creating entirely new categories of products such as the iPod and iPad and he revolutionized the mobile phone industry with the iPhone. Meanwhile, Microsoft has introduced lukewarm products like the Zune music player and disastrous products like the Kin mobile phone that was taken off the market only months after its introduction earlier this year. Even successful products like the XBox have not resulted in large sources of profit compared to the company’s core Windows and Office business. Microsoft has obviously failed to break into new areas successfully and, as a result, the company has taken on a stodgy image.
But Count the Cash …
Despite the well publicized difficulties facing Microsoft, the company continues to generate significant cash flow and had approximately $36.8 billion of cash and cash equivalents as of June 30, 2010 ($4.12 per diluted share). The company generated over $22 billion of free cash flow for fiscal 2010, paid $4.6 billion in dividends, and used $11.3 billion for share repurchases. Microsoft is clearly still a cash flow machine. At a recent price of $23.47 and a market capitalization of $203 billion, the overall valuation of the company is clearly depressed.
Microsoft is even cheaper than the “headline” price/earnings ratio suggests when one considers the excess cash on the balance sheet. The exact amount of excess cash is open to debate, but it appears that at least half of the cash on the balance sheet could be safely distributed to shareholders. Adjusted for excess cash, Microsoft trades at ten times trailing earnings and less than nine times estimated fiscal 2011 earnings of $2.40 per share.
If someone had told you in August 2000 that Microsoft would be available for under nine times forward earnings one day, it is unlikely that you would have believed them.
Cloud Risks Are Exaggerated
Cloud computing is a long term threat that could erode Microsoft’s Windows and Office franchises over time. Products such as Google Docs have gained some traction, but Microsoft still controls well over 90 percent of the office market. The slow moving conservative nature of most information technology departments all but guarantees that Microsoft will retain a very large share in both operating system and office sales for many years to come even if cloud based solutions begin to take more share.
While Microsoft was initially slow to respond to the cloud computing threat, the company has not ignored the risks entirely. Office Web Apps and related online services are intended to directly address the threat from solutions like Google Docs. While Microsoft may not be entirely successful in retaining share on the cloud, many risk averse companies could be convinced to stick with a known quantity. Making a move from desktop based Office products to Microsoft’s web solutions could be seen as a more conservative approach for IT managers concerned with career risk issues.
Tablets Beyond iPads
With three million iPads sold through June 30, Apple has proven that the tablet computer has finally arrived, but it would be a mistake to assume that Apple will “own” this market. One very surprising aspect of the iPad’s introduction, apparently even to Apple executives, has been the adoption of the device in business environments. The Wall Street Journal recently reported that businesses are adding the iPad as a rapid clip. Some executives are using the iPad as a substitute for laptop computers for tasks such as email, reading documents, and even giving presentations.
One of the possible reasons behind Microsoft’s recent stock price weakness is the fear that the iPad will erode sales of traditional laptop computers running Windows. However, it is very likely that business users have adopted the iPad as a supplement to their laptops rather than as a replacement. In addition, new tablets running Windows and Android will be released in the very near future.
There are some doubts regarding whether tablets are well suited to run Microsoft’s Windows operating system. Although Windows 7 does have touch screen capabilities, will it provide a good user experience in the tablet form factor? One potential solution may be the upcoming Windows Phone 7 software which is scheduled for release in October. Windows Phone 7 has received some positive reviews (click here for one example) and may be better suited for tablet devices.
While no one can predict the market shares different players will have in tablet devices once the market matures, it is very likely that Microsoft will generate significant market share given the strength of Windows Phone 7 and the relationships the company has with corporate users.
Microsoft is one of the “least loved” companies in America today. Investors have become disillusioned by the company’s failure to break into highly profitable lines of business beyond the core Windows and Office franchises. The emergence of highly successful products such as the iPad have generated fears that Microsoft’s moat in operating system software may be facing a more rapid decline than previously assumed. From an intangible perspective, Microsoft is simply no longer in fashion.
Despite the negative headwinds and many real challenges facing Microsoft, the company does not deserve to trade at current depressed valuations based on its demonstrated earnings power and formidable cash flow. Windows and Office still have dominant markets shares and enjoy high margins that validate the presence of a significant moat. The current corporate refresh cycle will help generate record earnings for fiscal 2011 and the company is not standing still in cloud computing, mobile phones, or tablets. A company with this profile does not deserve to trade for nine times likely fiscal 2011 earnings.
Whitney Tilson summed up the bullish case very well in a recent presentation (pdf). Mr. Tilson assumes fiscal 2011 earnings per share of $2.40 and assigns various multiples to arrive at a valuation (adjusted for cash/share of approximately $4). At a modest 10x multiple, Microsoft should trade at approximately $28 per share which would imply an upside of nearly 20 percent from current levels. A more reasonable 12x multiple would imply a share price of approximately $33 for an upside of 40 percent. In addition, the company has a 2.2 percent dividend. Barring an unprecedented collapse in Microsoft’s earning power over the next few years, the risk of permanent impairment of capital seems remote given the company’s current valuation.
Disclosure: The author of this article initiated a position in Microsoft Corporation today at an average cost $23.67. This article is for entertainment and informational purposes only; do your own research before making any investment decisions.