Seeking Alpha
Long/short equity, research analyst
Profile| Send Message|
( followers)  

Shares of Microsoft Corporation (NASDAQ:MSFT) have dropped by 18.6% from their 52-week high of $32.95 achieved in March. At $26.81, the stock is trading just above the 52-week low at $25.44. Is now a good time to acquire the shares? In this article, I will walk you through my value analysis to gauge the margin of safety on this investment.

First, let's look at the relative value analysis (see comparable analysis chart below). Analysts on average predict Microsoft's revenue, EBITDA, and EPS to grow at 3-year CAGRs of 7.5%, 7.5%, and 21.5%, respectively, over the current and next two fiscal years. The revenue and EBITDA consensus growth estimates are largely below the averages of 14.2% and 18.7%, respectively, for a peer group consisting of Microsoft's primary competitors. However, the company's EPS growth projection is considerably above the peer average of only 11.3%. Microsoft's EBITDA margin is forecast to remain flat over the same period, compared to an estimated 5.7% average expansion for the comparables. On the profit side, Microsoft has demonstrated a robust margin performance, as most of the company's profitability and capital return measures are significantly above the par. The firm carries a relatively low level of debt as reflected by its below-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, Microsoft has the highest trailing free cash flow margin at 33.8%. Due to the strong profitability and the lower leverage, the company was able to maintain a healthy interest coverage ratio. Both Microsoft's current and quick ratios are above 2.0, reflecting a very healthy and liquid corporate balance sheet.

(click images to enlarge)

To summarize the financial comparisons, Microsoft's relatively weaker revenue and EBITDA growth prospects should be the primary drag on the stock's valuation. However, given the company's higher EPS growth potential, strong profitability and cash flow performance, as well as its fortress-like balance sheet, I would not expect the stock to trade at a large discount to the peer-average level. Nevertheless, the current stock valuations at 5.1x forward EV/EBITDA, 7.0x trailing EV/FCF, and 8.8x forward P/E represent an average discount of 55.9% to the peer-average trading multiples, suggesting a very cheap valuation level.

Moreover, Microsoft's trailing EV/EBITDA multiple is currently trading at 35.2% discount to the same multiple of the S&P 500 Index (see chart below). I believe this large valuation multiple discount is exaggerated provided that: 1) Microsoft's long-term estimated earnings growth of 9.6% is markedly above the average estimate of 7.9% for S&P 500 companies; 2) the company's profitability and free cash flow margins are significantly above the market average; and 3) its dividend yield of 3.4% is also above the average yield of 2.2% for the S&P 500 companies.

I also performed a DCF analysis to support my above conclusion (see DCF chart below). The DCF model incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2017. In the recent research note, Morningstar's Senior Equity Analyst, Norman Young, elaborated his long-term view on Microsoft, which I believe is fair (sourced from Thomson One, Equity Research):

"With the introduction of Windows 8, the Surface tablet, and Windows phones, Microsoft is trying to change the recent downward trajectory of its Windows OS franchise. These changes complement earlier introductions of Office 365 and Windows Azure, Microsoft's entries into cloud computing. We believe Windows phones and the Surface tablet face strong headwinds and will probably see limited success in the near term, while the cloud offerings are holding their own and should help offset revenue losses as the Windows OS franchise declines. We expect the overall company to continue increasing revenue, although at lower margins given the shift in product mix."

This view appears to have been reflected in the market's consensus estimates, as the revenue growth is likely to experience a downward trajectory, and the EBITDA margin is forecast to compress from 41.0% in fiscal 2013 to 35.8% in 2017.

Other cash flow related items (i.e., tax expense, depreciation and amortization, capital expenditure, and net working capital investment) are forecast based on the historical ratios of their figures relative to the revenues as the ratio trends were fairly stable over time. To be conservative, a company-specific risk premium of 4.0% is applied in the cost of equity calculation to account for the financial projection risk. A normalized risk-free rate of 2.5% is used instead of the current yield of the 10-year U.S. Treasury Bond yield. The cost of debt assumption is also higher than Microsoft's existing debt yield with about 10 years to maturity (see DCF chart above).

As such, the conservative but reasonable DCF model yields a share price of $35.26, representing 31.5% upside from the current market price. Given that this model takes the consensus revenue and EBITDA estimates as inputs, it would be fair to say that the current share price at $26.81 implies a scenario of approximately 13.0% WACC and 0.0% terminal growth rate (see Sensitivity Analysis in the DCF chart above), which I believe is somewhat extreme for Microsoft.

From a dividend perspective, I believe Microsoft's 3.4% dividend yield would also provide some downside price protection. Since 2010, the company has raised the dividend per share by 23.1%, 25.0%, and 15.0%, subsequently. Given the firm's robust free cash flow, I believe the company has an ample capacity to sustain the current pace of the dividend growth. In addition, under the current low-interest environment, I expect that the demand for high-yield quality asset would continue to be strong, and thus an upside for Microsoft's dividend yield would appear to be limited. As such, assuming a dividend yield range between 3.0% and 4.0% and supposing that the stock's annual dividend per share would be raised by only 10.0% from the current $0.92 level to $1.01, these assumption would suggest a stock value range between $25.30 and $33.73, or an attractive price return range between -5.6% and 25.8 even without considering the 3.4% dividend return.

Bottom line, Microsoft's cheap valuations, high dividend yield, and solid dividend growth prospect appear to be strong forces in supporting the current stock price. Given the limited downside and potential room for a valuation correction, I recommend buying the shares now.

The comparable analysis and DCF charts are created by the author. All other tables in the article are sourced from Capital IQ, and all the historical and consensus estimated financial data in the article and the charts are sourced from Capital IQ.

Source: Microsoft: Is The Downside Significant?