If financial data wasn't available, and all of my information on Microsoft Corporation (NASDAQ:MSFT) was obtained through news stories and articles, I'd believe that the former tech-darling has gone extinct, or at least is on its last legs. The reality is that the stock has gone nowhere for the last decade, alienating a generation of technology investors that had been waiting for the re-emergence of gains that seemed so easy in previous decades. This negative stigma and exhaustion at poor stock performance, has pressured the valuation far beyond levels that are warranted based on the fundamentals of the business. While many market participants would acknowledge the stock is cheap, there are a million excuses not to invest, but in my experience I've found that my most successful investments are when I look only at the facts, and ignore all of the noise and preconceptions that don't matter. On this basis, Microsoft is an extremely compelling long-term buy that I expect to produce very strong total returns to investors.
Microsoft ended its fiscal 2013 2nd quarter with $68.312 billion of cash and investments, versus long-term debt of $11.947 billion, so the net cash position is approximately $56.365 billion. Based on 8.444 billion diluted shares outstanding, the net cash per share is about $6.68. At a recent price of $28.25, Mr. Market is valuing Microsoft's business at roughly $21.57 per share. In the last twelve months, Microsoft generated $27.631 billion in free cash flow, which is about $3.27 per diluted share. At $28.25, Microsoft trades at 8.64 times trailing twelve month free cash flow. If you back out the net cash position, the multiple is 6.59 times. Now it should be said that most of Microsoft's cash is held outside the United States, and should be discounted for likely taxes, but this valuation is impossible to justify, unless you believe that Microsoft's earnings and free cash flow are likely to decline rapidly.
Microsoft trades at roughly 3.3 times its book value of $72.576 billion. Despite the huge surplus cash balance that the company carries, Microsoft has generated returns on invested capital greater than 18.6%, and returns on equity greater than 22.5%, every year since 2006. The numbers are usually quite a bit better on average, but the impact of the non-cash write-downs that Microsoft has been forced to take flow down to these ratios in the most recent fiscal year. Microsoft's return on assets is generally greater than 15%, which is truly sensational. Unlike other former tech-titans that have been left for dead, such as Hewlett-Packard (NYSE:HPQ) and Dell (NASDAQ:DELL), Microsoft has invested heavily in R&D. Over the last five years, MSFT has spent just under $9 billion on average in R&D per year, which has been greater than 13% of annual revenue. R&D is expensed and is not capitalized; therefore, I would argue that Microsoft is even cheaper than it first looks, when you account for its deep technology pipeline.
From 2003-2012, Microsoft grew revenue from $32.187 billion to $73.723 billion. Unlike a company like Salesforce.com (NYSE:CRM), which trades at a rich multiple to non-existent earnings, Microsoft grew net income from $9.93 billion to $17 billion during the same time period. Once again, earnings were depressed due to the non-cash charge, so normalized earnings are well in excess of $20 billion. The diluted share count has dropped from 10.882 billion in 2003, to 8.444 billion diluted shares as of the most recent quarter. Earnings per share have grown from $0.93 to $2.02, and I believe Microsoft should earn between $2.80-3.00 in 2013. Microsoft has accomplished these strong business results because of its durable competitive advantage providing software and services in PC's and Servers. The company is dominant in the Enterprise and is an integral IT component in just about every large business across the globe. Clearly, competition is increasing with the shift to mobile, and with the rise of Apple (NASDAQ:AAPL) and Google's (NASDAQ:GOOG) operating systems. Microsoft has made sizable investments in ventures with Nokia and with its Surface platform, to compete on these newer form-factors, and there is no doubt the company has some serious catching up to do. In the Enterprise, businesses are still converting to Windows 7 from XP, and Windows 8 is slowly being adopted as well.
I'm not particularly surprised that the Windows 8 adoption has been slower than many projected, because it represents such a substantial change from previous Windows versions. Due to the adoption of touchscreen technologies, Microsoft had to take aggressive action to introduce an operating system, which can work on PC's, tablets and smartphones. While the consumer might be more willing to work with a Google or Apple operating system, I believe that in Enterprise Microsoft will remain dominant. The same hesitancy Windows XP or Windows 7 using companies have towards shifting to Windows 8, is likely even greater when it comes to shifting to a competing operating system. If Windows 8 does become heavily adopted by Enterprise, then the familiarity with the operating system could potentially spur sales to other form-factors. All of this is highly uncertain and I don't believe that I could make a living predicting technology trends. Fortunately, Microsoft doesn't need to be as dominant as it once was to make money for an investor at current prices, because the stock is just way too cheap. Market participants and analysts seem far too focused on Microsoft's misfires, that they are now losing sight of the embedded value in the business.
In 2012, Microsoft took a goodwill impairment charge of $6.2 billion related to its Online Services Division. This is just the latest in a string of unsuccessful M&A activity under the leadership of CEO Steve Ballmer, and I believe that the large cash balance, combined with the distrust in Ballmer's capital allocation is a primary reason why the stock trades so inexpensively. Microsoft has been late to the game in many instances, paying extremely rich prices for Skype and a small stake in Facebook (NASDAQ:FB). Microsoft got extremely lucky that its nearly $30 per share bid for Yahoo (NASDAQ:YHOO) got rejected, but Ballmer's record of capital allocation has been extremely disappointing. I believe that Microsoft's stock would rally significantly if Ballmer stepped down as CEO, or if the company announced a much more sizeable stock buyback. I believe the plan to repatriate cash and buy back stock that has gained so much attention with the prospective Dell privatization, is a wonderful template for Microsoft to execute on a smaller scale. By issuing debt, it is likely Microsoft could avoid paying taxes on repatriated funds, and with the dividend exceeding 3%, I wouldn't be shocked to see higher interest costs merely offsetting dividend savings from the shares returned to the treasury. A $20 billion buyback at $30 per share would reduce the share count by about 666MM, putting diluted shares outstanding at roughly 7.78 billion. Based on the trailing twelve months free cash flow of $27.631 billion, free cash flow per share would be about $3.55 per share, and obviously any growth would be highly accretive. Clearly the interest income would be lower, and the interest costs would be higher, but I also believe free cash flow should be improved in 2013, so I'd expect it to be somewhat of a wash. I'm not aware of an acquisition in the tech-space, which would be more highly accretive to earnings than Microsoft buying its own stake where it doesn't need to pay a control premium or anything like that.
Microsoft has three extremely strong businesses and two businesses, which have significant room for improvement.
The Windows & Windows Live Division is extremely profitable, but is in the midst of some major changes. Windows 8 and Windows 7 have to remain dominant in the Enterprise space, and Microsoft must continue to spend aggressively to become more competitive in both phones and tablets. It is very possible that earnings in this division are likely to stay flat to slightly negative over the short term, which is disappointing since the company normally sees a nice jolt when a new operating system is released. I believe that the emergence of other tablets and smartphones outside of Apple's iOS is a net positive for Microsoft. I believe that Apple and Google's first-mover advantage in the tablet space is the primary reason that Windows lags behind in the operating system front. All 3 companies have large R&D budgets, and it seems very likely that competition will be much more significant than it is on PC's, but Microsoft has come from behind successfully many times in its history. The positive is that there are increasing amounts of devices, which can serve as a potential platform for Microsoft to win market share.
The Server and Tools division is highly underrated for Microsoft, and is growing rapidly. While margins aren't as strong as they are in the Windows Business divisions, Microsoft is continuing to pick up market share against its competition. I believe that this is an area where Microsoft will see continued growth and will help improve both the top and bottom lines, albeit at lesser margins.
The Online Services Division has been Microsoft's albatross, despite Bing being the number two search engine. Microsoft has made poor, overpriced acquisitions in display advertising, which have further exasperated the situation. If Windows 8 becomes a more viable mobile platform, it seems very likely that Bing and Microsoft's adCenter can pick up valuable market share. I believe that the stock would likely rally if this division was sold but I believe Microsoft can be competitive here. The company needs to continue to invest in its technology here, without spending outrageously on overpriced acquisitions, that don't move the needle on the bottom line. Display advertising, applications, and to a lesser extent search, are too important for Microsoft not to be a major player.
Microsoft's Business Division is its bread and butter and should continue to grow nicely. This division includes Office, Exchange, SharePoint, Lync among other products. These are core components to just about every IT budget, and while there is obviously heavy competition, I'd expect Microsoft's moat to hold steady.
The Entertainment and Devices Division is somewhat similar to the Online Services Division, in that for years it has toiled away, posting heavy losses. Now it has become moderately profitable, but it has produced the leading gaming console in the world with the Xbox. Kinect represents top of the line innovation that gave Xbox a significant advantage against the competition. While the next generation of gaming consoles could prove to be very challenging with increased competition, I look at this division as being a key for Microsoft's presence in having multiple form-factors in the homes of its customers. I also believe it positions the company very well with younger demographics. I believe that there is tremendous appeal to Xbox and Skype, and I believe that a Microsoft TV offering could be just as appealing as an Apple TV. There are very little expectations for either the Online Services Division or the Entertainment and Devices Division, so if there are any positive catalysts at all, the stock could really benefit.
On January 24th, Microsoft reported 2nd quarter earnings that were quite strong, with revenue of $22 billion, and record EPS of $0.81. It was an important quarter for the company due to the releases of Windows 8 and the Windows 8 phone. By the end of the quarter, Microsoft had sold 60MM licenses of Windows 8 and the number should continue to grow. Both operating income and EPS were up 4%, to $8.3 billion and $0.81, respectively. The company saw very strong demand in Enterprise where it has been gaining share with annuity-like, multi-year licensing deals. Multi-year licensing revenue grew 15% and unearned revenue grew 13%, to $17.4 billion. Microsoft is growing in the mid-teens in emerging markets, while obviously Europe has been very weak. Windows revenue grew 11% in the quarter, while Server & Tools grew 9%. The Microsoft Business Division revenue grew 3%, while consumer revenue declined by 2%. Productivity server offerings performed quite well with Exchange, SharePoint, and Lync collectively growing by double digits. Lync led the way with revenue growth of 35%, as customers enjoy the enhanced productivity and strong economics of these Enterprise offerings. The Online Services division grew revenue by 15%. In the Entertainment & Devices division, revenue declined by 2%. Widows Phone Sales were over four times higher than they were last year. Microsoft returned $3.5 billion to shareholders in buybacks and dividends.
Microsoft is very strong in the cloud where it has invested aggressively. The Cloud OS Roadmap provides a flexible platform for CIO's to manage their infrastructure, applications and data. Microsoft competes aggressively with VMware (NYSE:VMW) in the virtualization space. The company continues to innovate with its successful Windows Azure, which includes virtual machines, media services, website and mobile services. Management Product System Center grew revenue by 18%. SQL Server revenue grew 16% driven by strength in SQL Server premium. I believe that Microsoft's cloud businesses are severely underrated by the market, particularly when you look at other comparable companies' valuations in the area.
While there are a million excuses not to buy the stock, I believe Microsoft offers one of the best risk-adjusted opportunities in the tech sector, and possibly the market as a whole. Microsoft still has one of the most desirable businesses in the world, yet the company can be had for a single-digit multiple on earnings and more importantly free cash flow. The media latched on to the Dell take-under by Michael Dell, yet market participants are missing the much more obvious misvaluation of the high-margin, high-return on invested capital, Microsoft Corporation. With a current dividend yield in excess of 3%, the investor will get paid to wait for the catalyst to occur, which ultimately will drive value. It could be a significant increase to its dividend or share buybacks, or possibly the exodus of Steve Ballmer for a more highly-motivated and effective Chief Executive. While Microsoft is playing some defense in key product areas, which are more than discounted in the stock valuation, it is also waging an aggressive offense on mobile, which I believe will allow it to gain a substantial market share. I believe the stock should be trading between $35-40 quite comfortably.