Share price of Microsoft (MSFT) has declined by 14.1% over the past 12 months. At $28.04, the stock is trading near its 52-week low of $26.26 and offers a 3.3% dividend yield. The recent price weakness has presented a great opportunity for long-term and income investors to pick up the shares, and there are four compelling reasons backing my view:
1. From a relative valuation perspective, Microsoft shares are priced cheaply based on the company's solid financial performance relative to that of its peers'. Consensus estimates predict Microsoft's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 10.4%, 14.6%, and 34.7%, respectively. Over the longer term, its EPS is forecasted to grow at 9.5%. On last 12 months basis, the company generates healthy double-digit profitability and capital return margins. The firm also takes a limited level of debt as reflected by its low leverage ratios. In terms of liquidity, Microsoft has a 32.9% free cash flow margin. Both its current and quick ratios are above 2.0x, suggesting a very healthy balance sheet condition (see comparable analysis chart below).
Compared with the primary peers in the software sector (see comparable analysis chart below), Microsoft's growth potential is below par. However, the company significantly outperforms its peers in terms of profitability and capital return. Microsoft's leverage is below the peer average and its liquidity metrics are all considerably above par.
Given the above, I believe the stock's fair value should trade at only a modest discount to the peer-average valuation level. Nevertheless, the current price multiples at 5.1x forward EBITDA (next 12 months) and 9.1x forward EPS (next 12 months) together represent an average discount of 54% to the same peer-average trading multiples. After accounting Microsoft's relatively weaker long-term EPS growth estimate, the stock's PEG of 0.96x remains 25% below the peer average at 1.28x, suggesting market has likely not given enough credits to the firm's superior profitability and liquidity performance and hence the stock is modestly undervalued on a relative basis (see chart above).
Taking a large-cap technology peer set as a comparison (see chart below), one would likely draw a similar conclusion. Microsoft's financials outperform the group averages in almost every aspect but yet both of the stock's EV/EBITDA and P/E multiples are 23% below par on average. Its long-term PEG ratio is also 13% below the group average at 1.10x, again indicating an undervaluation.
2. Microsoft's forward P/E multiple is currently trading at 38% below the same multiple of S&P 500 Index, which stands at 14.7x now (see chart below).
This below-market valuation presents an excellent entry opportunity as I believe the stock should trade closer to the market level provided that 1) the market discount averaged at 28% in the past 12 months; 2) Microsoft's long-term EPS growth estimate at 9.5% is above the average estimate of 8.2% for the S&P 500 companies; 3) Microsoft has market-leading profitability and free cash flow margins, and approximately 23% of its current market capitalization is in net cash; and 4) the stock also offers a decent 3.3% dividend yield, which is markedly above the average at about 2.3% for the S&P 500 Index.
3. The stock's dividend growth potential as well as the high dividend yield significantly enhance the investment's margin of safety. Microsoft has a track record of raising dividend. Since 2010, management has raised the dividend per share three times by 23%, 25%, and 15%, consecutively. In the past few years, the company's annual dividend payment only represented a small portion of the total free cash flow generated, suggesting there is likely an ample capacity for future dividend hikes and thus the current pace of the dividend growth can be sustained (see chart below).
Further, as the Fed is expected to continue its easing policy, the persistent low-interest market environment will continue to support a strong demand for high-yield assets and therefore weigh on equity dividend yield. As such, assuming a target dividend yield range from 3.3% to 4.0% (Microsoft's dividend has never reached this level), and supposing that the annualized dividend per share would be raised by just 10% from the current level at $0.92 to $1.01 in November 2013 payment period, this conservative scenario would suggest a stock value range from $25.30 to $30.67, or a fairly balanced return band from -10% to 10% before considering the 3.3% dividend income.
4. Sell-side analysts remain generally bullish on the stock. Of the total 38 stock ratings complied by Thomson One, there are 12 strong buys and 11 buys. In a research note dated March 6, 2013, Norman Young at Morningstar, who has a 4-star rating and $35 target price for the stock, commented on the company's growth prospects, which I tend to agree on (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, and we also expect the already strong server and tools business to continue gaining share in an expanding market."
Bottom line, I believe the market's concern on Microsoft's future growth is exaggerated and the share price is overly penalized. As such, investors should consider buying the shares now in the light of the solid company financials and cheap valuation.
All charts are created by the author and all financial data used in the article and the charts are sourced from S&P Capital IQ unless otherwise specified.
Disclosure: I am long MSFT.