Microsoft Earnings Peek: Cash Position And ValueAct Overwhelming Positives

Jan.23.14 | About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) will report its fiscal q2 14 after the closing bell tonight with analyst consensus expecting $0.68 in earnings per share (EPS) on $24.67 billion in revenue for expected year-over-year decline in earnings of 11% and growth in revenues of 10%.

Current full-year 2014 consensus is expecting 1% growth in EPS on 7% revenue growth. (What is interesting is that MSFT Street analysts are expecting faster revenue growth than EPS growth over the next 3–4 years, and the revenue growth is far better than the SP 500 as a whole at 4%-5%.) The consensus estimates for the 2nd quarter have been flat since the last earnings report in October '13.

In MSFT’s fiscal Q4 ’13 (June ’13) the company missed badly, and then in the October ’13 quarter, MSFT beat handily, so if you average the two, MSFT's last two quarters are pretty much in line to be slightly better than consensus. I do like how the company re-configured Surface from a price and promotion perspective. It recognized that problem right away and fixed it, which we view as a positive.

MSFT's stock rose 39% in 2013, excluding the dividend, with just about all of the increase coming around the April '13 earnings report where it was announced that ValueAct had taken a 1%-2% position in the stock, and it was also made public that ValueAct was going to seek a board seat.

At the time the stock was trading at $26-$27 per share and it rose steadily higher from there.

I don't think it is a coincidence that the stock rose with the ValueAct stake, and as long as that activist investor has a stake in MSFT and continues to be a quiet agitator, I do think there is a chance that the $80 billion currently in cash on the balance sheet as of 9/30/13 gets returned to the investor.

ValueAct isn't a Carl Icahn or Bill Ackman "King Kong" like hedge fund. These guys seem to be collaborative activists working with managements behind the scenes to unlock shareholder value. They apparently like to work quietly and without fanfare, which would likely serve them well given the MSFT board, and the continued presence of Gates and Ballmer.

We currently have a 3% position in MSFT within client accounts, but we don’t hold it for any kind of an operational improvement on the part of Mr. Softee. We hold the stake because we are ogling the $80 billion in cash, which grows by about $3 billion every quarter, and eventually will be returned to shareholders in some form or fashion.

On a per-share basis, that $80 billion amounts to a little over $8.00 per share. On a valuation basis, MSFT is trading at 8(x) cash-flow ex-the balance sheet cash.

Why don’t we care about MSFT’s businesses or the new CEO? Well, you’d think these guys were electing a new Pope the way they are going about it, (waiting with bated breath for the white smoke to appear above Seattle that isn’t a collectively-exhaled bong hit), but MSFT’s core businesses should grow mid-single digits on a secular basis going forward, with the wrapping of emerging technologies like the Cloud around the core Windows and Enterprise franchises.

Since 2008, MSFT’s average operating income growth per our internal spreadsheet has been 4%.

The other element to MSFT’s $80 billion in cash that isn’t discussed much, is that a 1% rise in money market rates, amounts to about $0.10 per share to MSFT’s EPS. A change in Fed policy unlocks a lot of EPS value for MSFT, which is technically non-operating, but shareholders will take it. ($80 billon * 1% is $800,000,000 divided by 8.4 billion shares outstanding is $0.095 per share.)

We are hoping that ValueAct can urge the current or future MSFT board to return that $80 billion in cash in some form or fashion to shareholders, despite the fact that 70%-75% is custodied overseas.

There remains a tremendous amount of value in MSFT but we don’t think a new CEO is a huge catalyst for the stock. We’ll wait for the $80 billion in cash to be returned to shareholders to really drive the stock at some point. It may take a while too.

Here is an earlier article we wrote on SeekingAlpha comparing shareholder activism efforts between MSFT and APPL, and our January ’13 earnings preview.

Disclosure: Long MSFT and AAPL