Plenty of Upside Remaining for Microsoft

Imagine a plain-vanilla stock that that trades at a forward P/E of 13 and pays a 2% dividend. Sounds kind of average, right?

Next, I tell you that the company is a software company. It has a 34% operating margin, a 37% return on equity, holds $33 billion in cash, and a history of being one of the leading companies in the world for the last 20 years. Your ears would perk up.

The company is Microsoft (MSFT). If you told somebody in 1998 that the company would some day trade with these kind of metrics, they would swoop in and buy it. Historically, it is very rare for such a blue-chip name with such strong financials to trade at a P/E of 13.

I took a stab at Microsoft in its plunge into the mid-teens, but now I'm buying more. Recently, of course, Microsoft's stock has been perking up on excitement building for Windows 7. It's not too late to get in, if you think that Windows 7 will be a grand success. Microsoft hasn't been growing for a year. Add revenue growth to this formula, and the stock takes off.

Early success with Windows 7 could generate additional upgrades, including big corporate upgrades. Given that many large companies skipped Vista altogether, you could see a huge wave of Windows 7 upgrades. And in 2010, Microsoft will also be upgrading its Office Suite.

Windows sales were down 39% year-over-year from Q1 Fiscal 2009 to Q1 Fiscal 2010 (Microsoft's fiscal year runs from October-July). Part of this was the bad economy. The other part was a bad operating system.

In other words, everything has been a huge disappointment. All Windows 7 has to to do is be reasonably successful to reverse this disappointment.

If Windows sales can go back to fiscal 2009 levels -- or maybe even a bit higher -- that is a $2 billion bump in annual revenue.

Now let's look at Microsoft's numbers over the past three years:

PERIOD ENDING	30-Jun-09	30-Jun-08	30-Jun-07
Total Revenue	58,437,000	60,420,000	51,122,000

Net Income	14,569,000	17,681,000	14,065,000
Preferred Stock And Other Adjustments	-	-	-
Net Income Applicable To Common Shares	$14,569,000	$17,681,000	$14,065,000

Source: Capital IQ

Profits fell about $2 billion from 2008 to 2009. If Microsoft can get revenues back to the $60 billion mark, you could argue that with cost-cutting measures, they could beat 2008 profit levels, when they earned close to $2 per share. Analyst estimates have been rising lately and now the consensus if for $2.05 EPS in 2010.

If you give Microsoft a more generous forward premium P/E of 20 -- a premium it has traditionally had and deserves because of its strong profitability and cash position -- that gives you a stock price of $41. All the while the company is sitting on piles of cash and paying you 2% dividends. Not a bad deal. There is plenty of upside for Microsoft here.

Disclosure: Long MSFT

Comments

[J. Bruun:]

I'm with you on this one. I'd add to that a steady big amount of share buy backs.

Nov 02 04:09 PM

[Josh B Thom...:]

The tone behind MSFT's price is that OS's and Office Suites are the 1990's and the future is the browser. Even though this is false, the investment community clearly embraces it.
The future is probably the 3 screens and a cloud story. MSFT's mobile software has the weakness of having to work on many phones and phone interfaces. AAPL's software has to run on only 1 device and its single interface, that is a short term advantage for AAPL. Because AAPL brags about the quantity of apps available for the iPhone, I would like to see S. Jobs yell: Developers, Developers, Developers. Obviously, both companies see the value of application development; nevertheless, AAPL's system is much more closed than MSFT's.

Nov 02 05:50 PM

[The Drifter:]

Cloud computing has many street pundits sounding the death knell for Microsoft. Cloud computing will hurt MSFT the same way the breakup of Standard Oil "hurt" John Rockefeller. Don't buy the nonsense. MSFT is ready for the cloud, and more importantly, they control the development platform most will use to create cloud apps.

Nov 02 06:36 PM

[Rokjok777:]

Take a look at the BOD sometime: it's a bunch of "yes" men and women (from places like Harvey Mudd College). They've been bullied by Ballmer for years (when they should have fired him years ago for drastic underperformance, the stock closed at $35 bucks ten years ago fer chrissakes, now it's $27). Now that Gates is gone, they've brought in Ray Ozzie to be the startegy guy, and his head is in the cloud (maybe rightly so). So there IS no strategy, it's all tactics. And tactics are driven by Ballmer and Kevin Turner, who came from WalMart. What he learned at WalMart was how to take cost out, turn the box sideways and you can fit three more on the shelf. And that's what they're doing, just taking cost out, firing people, paying at the 66% percentile so they don't get the best and brightest anyhow. No, my friends, this company is not like Google....it's more like GM.

Nov 02 10:55 PM

[Peter Mycro...:]

Here is some additional ammo for your argument.

Froic = Free cash flow return on invested capital

YEAR STOCK FCFPS P/FCF FROIC
1993 $3.82 $0.09 42.44 25%
1994 $3.86 $0.13 29.69 27%
1995 $5.48 $0.13 42.15 23%
1996 $10.32 $0.23 44.87 32%
1997 $16.15 $0.36 44.86 35%
1998 $34.67 $0.52 66.67 31%
1999 $58.38 $0.78 74.85 28%
2000 $21.68 $0.90 24.09 22%
2001 $33.13 $0.99 33.46 22%
2002 $25.85 $1.00 25.85 21%
2003 $27.37 $1.04 26.32 18%
2004 $26.72 $1.05 25.45 15%
2005 $26.27 $1.19 22.08 26%
2006 $29.86 $1.18 25.31 30%
2007 $35.60 $1.41 25.25 43%
2008 $19.44 $1.81 10.74 46%
2009e $28.05 $1.86 15.08 39%
2010e $28.05 $1.93 14.53 35%
2011e $28.05 $2.19 12.81 39%

Disclosure: Long MSFT

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Nov 03 12:50 AM

[Daniel Eskin:]

Well argued but I still think MSFT is too inconsistent year over year to provide solid price appreciation. Dividend stock - maybe, but seems like that's what you're in it for. good luck!

Nov 05 08:35 PM