The early part of 2013 has been a mixed bag for Microsoft (MSFT). On the one hand, its mobile platform, Windows Phone, appears to be gaining traction, particularly in emerging markets. On the other hand, its latest desktop operating system, Windows 8, has been much-maligned by critics and users and has seen very sluggish adoption rates judging from its low web traffic usage.
Given this, it's not surprising that while the Dow Jones Industrial Average, of which Microsoft is a component, has climbed by over 11% in the year-to-date, the Redmond, WA based Microsoft's own shares have risen by a relatively sluggish 7.8%. In fact, over the past 5 years, the Dow has added over 15% while Microsoft, even adjusted for the dividends it has paid, has returned just 11% - and if Microsoft hadn't paid any dividends, its performance would've been even more dismal, falling 1.5% for the period.
What's interesting about Microsoft is that it may be a victim of its own success.
With over 90% of the desktop OS and 95% of the office productivity markets, people have come to expect big things out of Redmond. In fact, Windows Mobile, the predecessor of Windows Phone, had a worldwide market share of over 23% in 2004 - and 42% of the U.S. market as recently as 2007. Had Microsoft managed to maintain that share in the U.S., neither Apple (AAPL) nor Google (GOOG) would have as large a market share as they enjoy today and Microsoft might still be the world's most valuable company.
Instead, Microsoft has stumbled - with failed offerings such as Microsoft Kin (a.k.a. "Project Pink"), poor performance from "next gen" software like Windows Vista and the anemic launches of Windows Phone and Windows 8.
These have contributed to the negative mindset among the mainstream media and even technology sites, fomenting questions regarding Microsoft's continued relevance. A cursory Google search for the phrase "Windows 8 poor usability" yields 4.3 million results - this is clearly not how Microsoft would like its 5-month old operating system to be regarded.
Yet the public remains fixated with the Redmond giant - consider, for instance, that reports of an impending Microsoft Office application for Apple's iOS and Google's Android generated a storm of media coverage, with some pundits suggesting that it spelled the end of Microsoft while other suggesting it could mean its rebirth.
THE BUY CASE FOR REDMOND
Despite all of this, Microsoft continues to churn out solid results. In three of the past four quarters, Microsoft has exceeded analysts' expectations by an average of 3%. It seems that the generally lukewarm media coverage of Microsoft has unfairly slanted expectations and contributed to its lackadaisical performance - the media clearly prefers exciting stories as these tend to attract more eyeballs but for investors, the primary concern should be how to extract value from investments. This isn't about being one of the cool kids.
As such, Microsoft should see better days ahead and merits a "buy" for the following reasons:
1. Still Spinning Gold. On April 18th, Microsoft is expected to report earnings of 77 cents/share - 28% higher than the 60 cents it earned in the same period a year earlier and around 3% more than in the previous quarter.
Going forward, Microsoft's earnings are expected to rise by around 8% this fiscal year and the next - which is remarkable considering that PC shipments are expected to fall by 2% in 2013. What's more, it's not as though the company is discounting prices at a significant detriment to its margins. To wit, Microsoft's current gross margins are at nearly 80% -- not much lower than the nearly 83% margin it earned, on average, over the past five years. This compares favorably with the 73% margin earned by its industry peer group, which consists of many big names like Adobe Systems (ADBE), Apple, Cisco (CSCO), Dell (DELL), Google, Hewlett Packard (HPQ), IBM (IBM), Intel (INTC), and Orcale (ORCL). In addition, this is a huge premium to the 47% earned, on average, by other S&P 500 companies. Even if Microsoft's margins were to fall by another 3 to 5% as it evolves its product pricing, its margins would still be notably higher than that of its peer group and the S&P 500.
Other measures are equally impressive: Microsoft's EBIDTA margin is at nearly 40%, compared with 19% for the S&P 500. Meanwhile, its pre-tax profit margins for the past five years, at 36%, are more than triple that of the S&P 500.
Consequently, it is not surprising that Microsoft continues to pay a dividend that, at 3.2%, is 50% more generous than the S&P 500's which is at 2.1%. As we noted earlier, this dividend has been Microsoft's saving grace: absent these payments, it would have given shareholders a slightly negative return over the past five years.
2. Cheap By Many Measures. At a 15.7x P/E, Microsoft trades at a 24% discount to its peer group's P/E of 20.6x - even though, as illustrated above, it expected double digit earnings growth. That's especially odd considering that EPS growth among Microsoft's peer group has been more sluggish at just around 12% compared with the 28% it's expected to report.
It should also be noted that Microsoft has net cash (defined as cash and cash equivalents less short and long-term debt) of approximately $8 per share, meaning that it's being valued at just 3x its net cash. In contrast, a presumably more "exciting" stock, such as Apple's, is at 6.3x net cash.
This is further borne out by the fact that Microsoft's Price-to-Free Cash Flow is at just 13x - or less than 1/3 that of the 45.7x registered by its peer group (which includes Apple). Another measure is equally insightful: Microsoft's Price-to-Tangible Book Value (using its most recent quarterly figures) is at just 4.43x - compared with 11.2x for similar companies.
While this could simply mean that Apple is relatively overvalued, consider a different reading. It could imply that Microsoft's share price has considerable upside potential - even at just 5x net cash, Microsoft would trade at $40 per share - not too distant from what some pundits expect it to trade at.
3. Can't Keep It Down Forever. Despite its lukewarm launch, Microsoft's fortunes in the media-friendly smartphone space appear to be turning around. According to Kantar Research's latest data, Windows phone was the fastest-growing mobile O/S in the early part of 2013, growing by 123% to 6.7%, and it is now third in the smartphone league tables - ahead of BlackBerry (BBRY).
To be fair, BlackBerry's numbers do not yet include its new Z10 and Q10 smartphones and the company has disputed Kantar's numbers. That said, it should be pointed out that Nokia's (NOK) Lumia 920 - essentially the flagship Windows Phone device - had only begun selling at the end of January and that, more importantly, Nokia has not yet launched its latest mid-end Lumia phones in emerging markets, where the company has a strong presence.
This implies that the battle for third in the lucrative smartphone space (Nokia's margins in this space are at 33%, for instance, compared to break-even for its feature phones) is very competitive. BlackBerry's protest says as much and Microsoft could eke out a victory in this space if OEM partners such as Nokia and HTC (OTC:HTCKF) can continue to draw users away from iOS, Android and BlackBerry.
Meanwhile, in something of a similar approach to the way that Microsoft recovered from its Windows Vista debacle by quickly releasing Windows 7 (which has a 45% desktop market share), Microsoft appears to be accelerating the release of Windows 8.1 (codenamed "Blue"), an update to Windows 8 that has garnered some positive feedback for improvements to the usability conundrums affecting Windows 8.
To summarize, Microsoft can provide excellent value to investors at current levels because of its solid earnings potential, cheap valuation and recent moves aimed at addressing holes in its ecosystem of product offerings. Investors who come in at this time can expect an upside of 40%.
Additional disclosure: Black Coral Research is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.