Over the last 30 years, there have been very few periods where you could buy exceptionally cash-rich businesses, with reasonable growth prospects, at a 12% forward earnings yield. When you consider that investors have been buying 10-year Treasury bonds at a 1.64% yield, that are almost guaranteeing negative returns after inflation, the fact that this same high quality business offers a dividend yield greater than 3% makes it just too attractive to pass up. Microsoft (MSFT) is yesteryear's Apple (AAPL) in that during the late 80's and through the 1990's, the company could do little wrong. Through the leadership of former CEO Bill Gates, the company rose to truly historic heights. Like many stocks that became inflated during the Tech Bubble, Microsoft stock has been a dismal performer over the last 13 years despite very strong business performance. In the late 90's market participants were more than willing to extrapolate past growth rates far into the future, and when reality hit many paid the price. Moving forward the valuation and business prospects of Microsoft are very attractive, and I believe there is much more upside than downside moving forward, making for a great risk-adjusted investment opportunity.
Source Yahoo Finance MSFT Chart
Over the last 13 years Microsoft's stock price has dropped approximately 43.65% excluding dividend payments. While the stock has been a loser, business performance has been well above average. For Fiscal Year 2000, Microsoft had revenue of $22.956 billion and net income of $9.421 billion. Over the last 12 months Microsoft has generated $72.359 billion in revenue and about $21 billion in net income, adjusted for the $6.2 billion non-cash write down over the aQuantive deal. Obviously the growth rate has slowed down tremendously from some of the most explosive long-term growth any business in America had ever experienced; this was almost assured because when company's reach a tremendous size they must attain larger and larger increases in actual earnings to maintain the same growth rate. While the past should serve as data inputs in assessing the merits of an investment, what is far more important is assessing what the future could look like versus the price of the business.
Microsoft derives the majority of its profitability from its Office and Windows franchises. Both of these businesses have been completely dominant and intertwined with the personal computer infrastructure. Concerns have lingered in terms of how these businesses would be affected by the cloud, where applications are accessed through the web as opposed to traditional software offerings. Microsoft has done a reasonable job fighting off this threat thus far, through making services such as Exchange, SharePoint, and Lync available in a subscription-based model on a hosted platform. Microsoft was fairly early to embrace the cloud with its Azure platform, which is likely to continue to gain market share and increase profitability.
Once again, these two major profit centers are under additional pressure as the technology has shifted towards mobile, and the new sources of accessing information are through smartphones and tablets. These are not the first times Microsoft was late to a hot technology (just ask Netscape) but the consequences could be quite significant. Apple and Google (GOOG) have dominant positions in providing the operating systems on this shift to mobile. Microsoft is betting on a radical transition to its recently launched Windows 8 program to bridge the gap with iOS and Android. Legacy PC heavyweights Hewlett-Packard (HPQ) and Dell (DELL) are trying desperately to catch up on the innovation curve as far as creating the tablets, ultra-books, laptops and touch screen PC's that people now desire. Microsoft has even jumped into the fray by producing its own tablet, which they call the Surface. It is my opinion that hardware is steadily becoming more and more commoditized reducing the first mover advantage that Apple and Samsung had, and now the much more important issue will be the operating system.
Windows 8 seems to be a rather transformative product introduction in that it's made for touch technologies, but the risk is that its traditional user base might feel alienated by the rather dramatic changes that have been made. The product is clearly made for the mobile world, and is designed so that the Windows smartphone, tablet and PC platforms can all be run through a universal operating system. Microsoft has aligned itself with Nokia (NOK), HTC and numerous other handset and tablet manufactures to try and pick up operating system market share. Typically these types of businesses are such that the top 1 or 2 companies make all or most of the profits, so Microsoft is in the battle of its life with both Apple and Google moving forward.
The company is very strong with commercial clients who are the most reluctant to switch from their traditional Windows and Office systems. I believe that Microsoft should be meeting with every CIO possible to try and win Enterprise business for their mobile platforms that can be intertwined with the legacy business offerings, which ultimately will hopefully be upgraded to Windows 8. I believe that if Microsoft can win in the Enterprise, than they can afford to grow more slowly on the consumer side, which I'd expect to be much more difficult to infiltrate. I believe that a Microsoft and Research in Motion (RIMM) collaboration or merger, if technologically practical, could be a potential game-changer in winning with corporate customers. The Blackberry 10 offering seems quite compelling and if CIOs knew that it had Microsoft's financial backing, and that a future integration with Windows and Office compatibility was in the works, there would be a considerable incentive to go with the potential combined entity's operating system. I know this idea isn't very popular with Blackberry haters, but a key to my argument is that the valuation of RIMM is extremely attractive. The stock trades just above the value of its net cash and patent value, meaning that any future earnings are pretty much acquirable at no cost whatsoever. A merger between the two in my estimation would significantly enhance the likelihood of tremendous profitability from the BB10 platform, even if it took several years for a formal collaboration between the two companies.
I really don't enjoy speaking negatively about people when they seem to be decent in nature, but I do believe that the Steve Ballmer era has run its course. This was a man that was given the 1927 Yankees or 2000 Los Angeles Lakers, where all he had to do to win was not mess things up horribly. Just about every acquisition or attempted acquisition has been a complete disaster, and it is obvious he has no concept of obtaining value for the price paid. If Microsoft would have successfully acquired Yahoo (YHOO) at approximately $30 a share, a tremendous amount of shareholder value would have been destroyed and I don't think I really need to go into the disastrous $6.2 billion write-down of aQuantive. Prodigious free cash flows have been funneled into non-productive businesses including Bing. I'm probably in the minority but I do believe that Bing can win market share in Search, but Microsoft has to take more aggressive steps. Whether this is a deeper partnership in handling the Search functions with Facebook (FB) and other social networking sites, or acquiring better content related websites to improve its display advertising businesses, Microsoft needs to make some moves. If they can't come to a deal that makes financial and strategic sense, then Bing should be sold so that it is not the overwhelming cash drain it has been up until now. Xbox is a great product that has now become the market leader in game consoles, but Ballmer has poured many billions of dollars into it without any real economic returns.
When "successful" innovation such as Xbox leads to terrible returns on capital, management needs to be reassessed, especially when they have been given the time and resources that Ballmer has been blessed with. Capital allocation has truly been embarrassing in much of tech-land, as companies like Microsoft and Apple hoard absurd amounts of cash earning less than 2% on the money. This is about as logical as if a modern day political leader was to have a pyramid built for the simple reason that they can afford to do so, despite the fact that the money can be used in much more productive ways. At less than 9 times forward earnings with a 3%+ dividend yield, Microsoft should be aggressively reducing the outstanding share count. If Microsoft wants to emulate Apple and Google in terms of controlling the hardware in addition to the software, there are plentiful opportunities in out of favor but profitable device-makers, which can be acquired at all-time low valuations. Ballmer has yet to articulate a truly innovative or transformative plan, but the fact I still believe Microsoft is a wonderful investment opportunity is based largely on its wonderful business, and any slightly positive management change could result in stellar returns for the common stock.
On October 18th, Microsoft reported reasonably strong earnings before the highly anticipated release of Windows 8. Results were somewhat skewed by the deferral of $1.36 billion of revenue and $0.13 of diluted earnings per share, due to the Windows Upgrade Offer, which relates to pre-sales of Windows 8 to OEMs prior to general availability. GAAP revenue of $16.008 billion was down 8%, while operating income of $5.308 billion was down 26% YoY. Diluted EPS in the quarter was $0.53, but adjusted for revenue deferral non-GAAP EPS was actually $0.65, which was down only 4% YoY.
The Server & Tools business reported an 8% revenue increase to $4.55 billion YoY, driven by double-digit growth in SQL Server and more than 20% growth in System Center revenue. Microsoft continues to invest in this growing business with the September release of Windows Server 2012. The Microsoft Business Division saw revenue decline 2% YoY to $5.5 billion. Adjusted for the impact of the deferred revenue, revenue would have been up 1%. Microsoft's productivity server offerings including Lync, SharePoint, and Exchange saw double-digit revenue growth. The Windows & Windows Live Division saw a 33% decrease in revenue to $3.24 billion. Adjusted for the impact of the Windows Upgrade Offer and pre-sales of Windows 8 to OEMs, the division's non-GAAP revenue declined by 9%. The Online Services Division reported a 9% increase in revenue to $697MM, while online advertising grew 15% driven primarily by an increase in revenue per search. Lastly, the Entertainment and Devices Division experienced a 1% decrease in revenue to $1.95 billion. The Xbox continues to be the leading console in the United States with a 49% market share, and the launch of Windows Phone 8 and continued growth of Skype should portend to revenue growth in the future. Microsoft also reaffirmed its estimates for 2013 operating expenses to be between $30.3 billion-$30.9 billion.
Microsoft 1Q 2013 Earnings Press Release
Microsoft's balance sheet is exceptionally strong with a total of $66.644 billion in cash and investments, versus $9.714 billion in long-term debt. With net cash of $56.93 billion on 8.494 billion shares outstanding, Microsoft has net cash per share of $6.70. At around $27 a share Microsoft has an enterprise value per share of roughly $20.30, or $172.4 billion and a market capitalization of approximately $229 billion. This is remarkably cheap for a business that generated free cash flow of $29 billion over the last 12 months, and over $20 billion in free cash flow over each of the last 3 years.
On November 2nd, MSFT issued $600MM of 0.875% notes due Nov. 15, 2017, $750MM of 2.125% notes due Nov. 15, 2022 and $900MM of 3.5% notes due Nov. 15, 2042. With money being so cheap and the stock price being so low, any astute capital allocator would be issuing even more debt given the capital structure, and buying back the common. I regularly bring up International Business Machines (IBM) as the ultimate model of capital allocation for a mature technology company. The market tends to reward good stewards of capital and I would bet a significant amount of money that if Microsoft bought back $10-$20 billion of stock, and announced a long-term plan to optimize margins and returns on invested capital so that it could continue returning cash to shareholders, the company would receive a much higher earnings multiple. Right now there is a Ballmer discount, as the percentages are high that the company will pay huge prices for the next Skype, when for years it could have been acquired at a much cheaper valuation.
The adoption of Windows 8 will take some time as companies have very little incentive to rush the process. Significant progress in mobile and tablets that would show CIOs that Microsoft is capable of winning market share in those areas would likely be seen as a large positive for the Windows and Office legacy franchises. I like Microsoft's server and cloud based businesses and feel that they are underrated aspects of the company, overshadowed by the money-losing Online Services business. I don't believe it is impossible for Microsoft to become the most valuable company in the world again over the next decade, but management change, innovation, and better capital allocation are needed. If Microsoft were to take the aggressive steps of buying back $10-$20 billion of stock, offloading or increasing the scale of the Online Services business and if it can succeed in winning 30-40% of mobile market share, I believe the stock could trade between$40-$45 within the next 3-5 years. Even if Microsoft continues to trudge along in the same pattern that it has, I believe the stock is worth at least $35 when you factor in the cash on the balance sheet and normalized earnings power.
Microsoft's returns on invested capital have consistently been greater than 20% and have generally been higher than 30% over the last 5 years. The company has spent aggressively on R&D, averaging more than $9 billion per year since 2008. Paying about 3.3 times book value on a business that averages a greater than 30% return on capital is highly attractive, and I believe it is quite obvious the company is materially underleveraged. Within 3 years I don't see why Microsoft shouldn't be earning $4 per share, particularly if they were aggressively buying back stock. For the patient investors I believe now is a wonderful time to buy Microsoft for the long-term.