Microsoft Offers Real Value for Investors

This from Toro points out the selling that is taking place in a number of well capitalized tech companies without regard to valuation. In particular, he points out Microsoft (MSFT) and its 10% free cash flow yield as something "nobody cares" about.

Microsoft is a company that gets knocked quite often, without any seeming appreciation for what they have been able to accomplish. While Microsoft might not be anyone's idea of a classic value stock, I think there are many positives that make the company one of the better stocks to own now.

In short, Microsoft has demonstrated itself to be a survivor in the tech sector, and its excellent balance sheet strength and cash flows give the company plenty of flexibility going forward.

A while back, I said that I liked what Microsoft was doing with its core businesses, but the extremely overpriced bid for Yahoo (YHOO) made me wary – there have been too many good companies led astray by overpriced acquisitions. Now that it has more or less been established that Yahoo is worth more to Microsoft than anyone else (how does that $10 stock price feel, Mr. Yang?), Microsoft could return and make a bid at a substantial discount from when talks began. An offer in the $15-19 range would be reasonable, and I think there would be immense pressure on Yahoo's board to agree to make a deal.

But ignoring that for the moment, focusing on Microsoft's internal performance gives some impressive figures worth considering. With Microsoft's substantial cash position, working the balance sheet a bit helps tease out a cleaner idea of economic performance.

Below is a graph of profits relative to adjusted equity, which is simply traditional equity adjusted for the excess cash the company holds. For argument's sake, I tried to be conservative and said excess cash was any amount above three months sales. Excess cash has declined, albeit largely because Microsoft has doubled sales since 2003 while paying out $50 billion in dividends and doing an additional $55 billion in stock repurchases. And, lest this be perceived as a sign Microsoft is running out of financial firepower, cash and short-term investments totaled $20.7 billion last quarter.

For some idea of incremental return on capital, adjusted equity has increased by 75% in the past ten years, while net income has risen more than 125%.

So as Microsoft has consistently shown great profitability, how has the market reacted in terms of valuation? As you might be able to guess, not so favorably. I'll offer two metrics: adjusted price to adjusted book, and adjusted price to sales. P/B is useful but not perfect, and what I wanted to see was how the market has valued Microsoft without the excess cash (which I assume is dollar-for-dollar) over time. To do this, I subtracted excess cash from market cap to arrive at adjusted price (a stricter form of enterprise value, if you will), and also subtracted excess cash from equity. Adjusted price to sales uses the prior established metric as well, only with total revenues.

To try to give additional color to valuation versus profitability over time, I also added in return on adjusted equity, which is just like ROE only using the equity value less excess cash.

Essentially, even as profitability has increased over time, the extreme multiple compression since the bursting of the tech bubble has meant that has done little good for shareholders. Keeping the perspective that it matters more where the stocks are going than where they've been, consider the following graph, which shows the adjusted ROE divided by the adjusted price-to-book (a ballpark for future returns that I like) relative to 5-Year Treasury yields, as well as the spread between the figures for that point in time. You'll note that during the height of the tech boom years, the implied returns for MSFT were in the 1.5% range, and sharply negative compared to bond yields. Now, implied future returns are north of 10%, with a spread of 8% relative to intermediate bonds.

Of course, not all is wonderful. The lack of enthusiasm for pretty much any equities of late might not reverse for some time, and Microsoft could be pushed even lower – and I'll even say there's plenty of bad news that needs to work through the tech sector. Intel (INTC) and Cisco (CSCO) have given extremely gloomy outlooks of late, and observers suggest the worst is yet to come.

But in terms of relative value, I think Microsoft is better positioned than almost any other large cap tech company. It has a large buyback authorization in place and the cash flow to back it, and consensus suggests that a Yahoo deal will occur at a much lower price than originally thought. Microsoft seems to have a sense of urgency about competing online, and building out search is a priority that comes backed with a budget in the tens of billions if necessary. I've also seen suggestions that the threats to Microsoft's OS dominance are exaggerated by things such as cloud computing and Software-as-a-Service, and actually present an opportunity to cut down on costly product piracy (estimated to be 65% for Office).

The ultimate course of Microsoft's online strategy remains to be seen, but the underlying theme is that the risks appear overblown both in terms of media attention and stock price discounting. Adding to equities right now might seem devoid of preservation instinct, but this well-capitalized leader (the ratings agencies will go out on a limb to say Microsoft is AAA/Aaa) with rich cash flow at a reasonable valuation fits the bill for portfolio management moves in a down cycle.

Stock position: None.

Comments

[Did U Think...:]

Microsoft is a mature company which pays a paltry 2.60% annual dividend and that is after having dropped below $20. Until it pays at least 6% on a regular basis with inflation less than 3% I cannot see why anyone would want to own it. If we are all going to move away from speculative investing back to dividend investing then let's see the dividends before we figure out who is a good buy as opposed to a good bye.

2008 Nov 18 10:52 PM

[prairiedog555:]

I hear what the tech community says and that is that Microsoft is steadily losing its most profitable products.
Vista is a bust, Apple and Linux are gaining ground
Open Office is free oppenoffice.org )and works with Word.

There are many other examples. their greed and lack of innovation has tarnished the brand. Sure they have tons of cash, but people hate them

2008 Nov 19 08:19 AM