Microsoft (NASDAQ:MSFT) is famous for its operating system Windows and the Microsoft Office Suite of programs, both of which dominate the PC market. At approximately 90% market share, Windows is the defacto operating system for the world market of PCs. Microsoft has a market cap of approximately $241 billion. I have read several articles claiming Microsoft's valuation is historically cheap. My research on Microsoft shows me there is a great bit of value in this stock and a lot of potential for continued growth in earnings, which we will go through later in the article, but Microsoft is not cheap as I define it. In June Microsoft had a P/E multiple of 10.6 but on July 5th that multiple jumped to 15.35 and stayed about 14 until today which it is at approximately 16. The 5-year P/E average for Microsoft is 12.76 so a P/E of 16 is significantly above that metric.
Now for the industry these numbers are low and the argument could be made that Microsoft is cheap relative to its competitors. The Software Industry's average P/E is 35, more than double Microsoft's current P/E; Price/Sales for Microsoft is 3.32 while the industry's is 8.11; and Price/Book is 3.5 for Microsoft and 4.92 for the industry. A case certainly could be made that Microsoft is cheap for the industry. I would not disagree, but it is not cheap for Microsoft which I think is more important. It might be that Microsoft is 20 times the size of the average in the industry that suppresses its valuation metrics compared to the average of the industry. I would doubt Microsoft will ever earn a P/E multiple as high as 35, so I exclude this comparison from my thought process. Microsoft is not cheap, but does it provide value to shareholders through potential earnings growth and dividends?
The simply answer is yes. FY 2009 (June 2008 - June 2009) was the only year Microsoft saw lower revenues, net income, and ultimately earnings per share. This timeframe was right in the middle of the US financial meltdown and makes sense that revenues were affected during this period. Every year after this period shows increases in revenues and EPS for Microsoft. Even with a recession and a shift from PC to mobile devices, Microsoft has been able to grow revenue and earnings showing the resilience of this company. The expansion into smartphones has been slow to date but now is starting to take off for the company with market share doubling in Britain, Australia, and Italy and now representing 4% of the global shipments (Bailleul, Motley Fool). The majority of this jump in market share came at the expense of Blackberry bringing the Windows Phone solidly in third place for the smartphone market. Sales are starting to increase with ABI Research predicting 45 million Windows phones shipped in 2013 and these revenues will be strong for Microsoft for the future as it continues to gain acceptance from consumers and garners a greater market share. I read that Portio Research forecasts Windows phones to grow to 138 million in 2016 effectively tripling over three years (Cellular News). This is strong revenue growth for the smartphone segment of Microsoft, but the real jewel in my mind is tablet and ultrabook sales.
Sales of the Surface tablet have been slow since its initial launch and the forecast by analysts has been reduced to approximately 600,000 for the quarter, but the Surface Pro tablet hit 400,000 this quarter already (CNet). The estimated profit margin is just north of 45% (USAToday) so the $500 Surface is worth $135 million in gross profit and the Pro for the quarter has already added $162 million in gross profit. These are pretty good numbers for the tablets launch that is perceived as "shaky" by some analysts. Not to mention other vendors have tablets based on the Windows OS that continues to add earnings to the Microsoft ecosystem. The Windows OS is in my mind the operating system that will ultimately win the battle for tablets. This is a personal opinion, but I believe consumers ultimately want a tablet device that can do everything including offer most typical PC tasks. This opinion drives me to the belief that as Microsoft creates versions of Windows and the Office Suite for less expensive tablets with most of the core functionality it will provide a competitive edge for that operating system. The value of the features from the iOS (NASDAQ:AAPL) and Android OS (NASDAQ:GOOG) will continue to dominate this industry in terms of market share for the next few years; however, Windows will see stellar growth in the tablet industry leading it to capture over 10% of the market by 2017 (IDC). As vendors develop smaller tablets based on Windows to take advantage of that growth we may see Windows far exceed the International Data Corporation (IDC) estimates and possibly capturing 15% by the end of the forecast period.
The new technology being developed by Microsoft will also help it grow market share in the mobile market. The technology to make any LCD screen a touch screen or to be able to project touch screen abilities on other surfaces are two technologies that I find absolutely interesting and will in my mind create tremendous value in smartphones and tablets as well as other embedded devices. Microsoft pours a great deal of money into research and development that will ultimately turn into fantastic products for consumers.
PC sales have been showing major declines in the past two quarters but are due to recover with IDC predicting near flat growth for 2013 but then growth in later years mostly due to emerging markets. PCs are not dead and businesses will continue to need them for the foreseeable future. The form factor may change to more mobile solutions but the PC is here to stay. I do not disagree that the PC market is mature and we will most likely not see double digit growth anymore, but my point is the companies that dominate the PC market will still derive a lot of revenue and earnings from it while expanding the portfolio to different segments. Microsoft has not been caught flat-footed with this movement toward mobile devices. The company derives almost the same amount of revenue from server software than it does from Windows. This server market will see tremendous growth over the next several years as the requirements for cloud computing explodes under the pressure of mobile devices.
Microsoft is also on the forefront of embedded devices and the development of intelligent systems. I wrote an article for Intel (NASDAQ:INTC) on this subject and am excited to note that Microsoft sees the potential of this market as we move to Internet of Things (IOT) systems. Microsoft already has software for embedded devices in the surveillance systems, health, industrial, and retail markets. The high growth rates of the intelligent systems market will drive additional revenue to Microsoft outside of the traditional PC market. Microsoft has an operating system Windows Embedded 8 which allows manufacturers to develop embedded devices that can be connected into the traditional business networks.
"By building with Windows Embedded 8, manufacturers can ensure their devices are optimized for intelligence systems. Microsoft delivers seamless enterprise identity and access management. Specialized devices can be efficiently managed alongside Windows PCs and connect to Windows Azure and Windows Server to ensure their customer's data translates into unique competitive advantage." (Microsoft website)
Microsoft is the dominant player in the PC market with both the Windows and Office Suite software programs which will continue to dominate in this maturing market. PC sales are expected to level off soon and begin a low growth period again allowing Microsoft to earn revenues from this segment for years to come. This dominance and the new technology Microsoft is investing in will develop a competitive edge of the company in the mobile markets and allow it to earn market share and becoming the powerful third OS. The profit margins Microsoft enjoys on its Surface products are high at just above 45% and will create tremendous profits for the company as its tablet sales continue their march to 10% - 15% of the market. Microsoft is well positioned in the server and embedded devices markets which will allow it to develop tremendous earnings in these high growth areas. While Microsoft is not cheap in terms of P/E based on its historic 5-year average, I still see tremendous upside potential for this company is the coming years.
Disclosure: I am long INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.