Microsoft: A Solid Investment in Technology

Reasons to buy

Microsoft (MSFT) is a cash generating powerhouse. The company prints over a billion dollars of cash flow per month. Moreover, Microsoft has a ttm profit margin of 28%, an operating margin of 39%, and a return on equity of 54%.

In addition to those very attractive profitability ratios, Microsoft has very little chance of declaring bankruptcy in the foreseeable future – zero chance, in my opinion – which is very important given current market conditions. With a debt/equity ratio of .06 and a current ratio of 1.52, Microsoft is about as solvent as water! This software giant also has 20 billion in cash and only 2 billion in debt. The large cash position is great because it gives Microsoft the option to acquire other companies or buy back their stock at depressed levels. You always have other options, right?* Tell that to Jerry Yang!

In addition to sound solvency ratios, Microsoft is currently yielding 2.7% and sports a trailing twelve-month price/earnings multiple of 10.1, compared to an industry average multiple of 14.1.

Aside from strong fundamentals, Microsoft also has a several interesting prospects. Firstly, Microsfot has signed a deal with major health insurer Aetna (AET) that will allow patients to access their health record via Microsoft’s HealthVault platform. Microsoft is also looking to expand their exposure to the rapidly growing search advertising field – either organically with Live or by the acquisition of a search platform such as Yahoo’s (YHOO).

Reasons to be wary

A large portion of Microsoft’s revenues come from selling software such as the Windows OS and Office suite. This software is typically sold when someone buys a new PC. The global slowdown will indubitably mean slowing PC sales growth even when we consider emerging market growth. Moreover, piracy is a huge risk for Microsoft going forward. In China, Most Windows OSs (90%, according to one study) are pirated. Everyone knows the Chinese do not fully grasp the concept of intellectual property rights. If you want evidence of this, just take a stroll down Canal Street - “Gucci!, Prada!, Gucci!, Prada!”. I foresee the relative ease at which programs can be pirated becoming a bigger and bigger problem as Microsoft expands its software business into the poorer emerging markets.

Another risk is that posed by search giant Google (GOOG). Not only does GOOG control about 70% of the search market, but it is also starting to infringe upon Microsoft’s territory via browser based applications such as Google Spreadsheet (which is like Microsoft’s Excel). Though these browser based applications are not a real threat yet, they could become one in the future.

Despite the risks, I like MSFT because of its strong cash position, ability to generate additional cash and strong product pipeline.

*Yahoo! is commonly mistaken to be an acronym for "You Always Have Other Options" – when really it is an acronym for "Yet Another Hierarchical Officious Oracle".

Disclosures: None

Comments

[Josh Thompson:]

Until GOOG lifts its self imposed restriction of all their software running all in the cloud, they will not be able to offer a quality product to compete with MSFT Office. They probably cannot lift this restriction or they'll be competing with MSFT on MSFT's playing field.

2008 Dec 31 10:58 AM

[nakedjaybird:]

Does anyone know why Steve Ballmers MSFT holdings don't show up as a major insider holding anylonger??

2008 Dec 31 12:15 PM

[Bobco23:]

MSFT is a cash machine. The problem is that management is enamored with developing the next giant hit and pisses the cash hord away. Shareholder distributions from this cash machine are miniscule. As competitors and pirates eventually erode MSFTs profitability, shareholders suffer further as management burns cash in an attempt to find "the next big thing." Replicating the financial home run of "Windows" and the associated "Office Suite" will be next to impossible, even if tens of billions of dollars go out in pursuit of this elusive fantasy.

The stock has gone from $90 to $20, after all kinds of buy recommendations at $35. Mr. market agrees with me that a cash cow is no good if the cash doesn't flow out to the shareholder, but instead is wasted tilting at windmills. If the YHOO fiasco doesn't give one pause to consider the quality and intent of MSFT management, nothing will.

Strong sell.

2008 Dec 31 08:45 PM

[Tom B:]

Agreed. And they keep falling further behind technologically with Windows. All the $$$ they put into Vista and, in addition to all its other faults, it hasn't even made the leap to UNIX yet.


On Dec 31 08:45 PM Bobco23 wrote:

> MSFT is a cash machine. The problem is that management is enamored
> with developing the next giant hit and pisses the cash hord away.
> Shareholder distributions from this cash machine are miniscule.
> As competitors and pirates eventually erode MSFTs profitability,
> shareholders suffer further as management burns cash in an attempt
> to find "the next big thing." Replicating the financial home run
> of "Windows" and the associated "Office Suite" will be next to impossible,
> even if tens of billions of dollars go out in pursuit of this elusive
> fantasy.
>
> The stock has gone from $90 to $20, after all kinds of buy recommendations
> at $35. Mr. market agrees with me that a cash cow is no good if
> the cash doesn't flow out to the shareholder, but instead is wasted
> tilting at windmills. If the YHOO fiasco doesn't give one pause
> to consider the quality and intent of MSFT management, nothing will.

>
>
> Strong sell.

2008 Dec 31 10:36 PM

[Ricard:]

What are MSFT's successes?

1) MS-DOS - a program it bought for around $50k, which it used to gain exclusive rights as the OS of choice on PCs.

2) Windows - an OS concept it "borrowed" from AAPL while it was floundering. It utilized this type of platform in a market that had no competition - the PC OS market.

3) Internet Explorer - MSFT's entry into web browsing, pioneered by Marc Andreeson and Netscape. MSFT essentially (and legally) applied monopolistic powers against Netscape, giving away IE, and forcing Netscape into bankruptcy.

4) MS Office - Utilizing its OS monopoly as a springboard, it essentially copied concepts utilized by smaller, less capitalized companies like Lotus and WordPerfect and outspent its competition.

What are its failures?

1) XBox - Instead of scrappy tech startups, the XBox pitted MSFT against Sony and Nintendo. Although it continues to make inroads, the deep pockets and innovations of its competitors have ensured deep red for MSFT

2) Zune - AAPL was a resurgent company by the time MSFT tried to compete with it on consumer electronics. A complete failure.

3) Vista - Wow, when MSFT tries to innovate, it fails hard. Nothing is on Vista that hasn't been seen elsewhere, and the myriad of issues...my IE crashed while I was writing this. I still can't get Flash Player to work. My Canon printer is incompatible with Vista (no backwards compatibility).


My conclusion is that whenever MSFT has to compete against companies that are sufficiently big enough to withstand the flood of cash from the OS cow, it fails miserably to profitably adapt and face its competition through innovation. It amazes me how Gates can brag about finding "supersmart" people and then have them produce next to nothing that can be credibly "new".

The only way this company will find that next big hit is if it finds an industry that is sufficiently small enough to muscle, and yet sufficiently game-changing enough to make a dent in its cash flow. In every effort in the last 10 years, it has failed in this regard.

Like a sheep led to the slaughter, or a dairy cow being milked for every drop, so will go MSFT. It will take time though for us to eat enough of the carcass before that last bit of value disappears.

Jan 01 03:36 PM