These 3 Strategies Could Drive Growth For Microsoft

Jun. 8.14 | About: Microsoft Corporation (MSFT)


Shares may be slightly undervalued on a DCF basis but are trading well above historic price multiples.

A strong balance sheet and cash flow support an increase in dividends and buybacks.

Three strategies in particular; Cloud and Saas, Competition in Tablets, and the potential for Skype could drive faster growth.

Shares of Microsoft (NASDAQ:MSFT) have surged over the last year but are trading well above historic price multiples. Sentiment has improved as the company looks to a new CEO for a new era of growth. While it may take a while to turn the $342 billion tech giant, there are three areas that could help lead to stronger growth. Investors can feel comfortable with the current valuation and sustainable dividend while waiting for faster sales growth over the next several years.

New CEO, New Growth

Satya Nadella took over as CEO from Steve Ballmer this year and will be tasked with a tough road ahead to turn the tech giant back into a growth leader in the space. Sales grew at a 5.6% pace in 2013, below the 7.7% pace over the last decade. Shares have advanced 14% so far this year off of a 35% gain last year but investors are now looking for the growth that will support a price of 15.5 times trailing earnings. Founder Bill Gates is spending about a third of his time with the new CEO and told CNBC that the software behemoth is, "re-examining all its strategies," and rethinking how Microsoft can move faster.

While most of the company's diverse line-up of products and services could contribute to growth, there are three areas in particular that look to be especially attractive.

CEO Nadella is focusing much of his time on what he calls the "gold rush" in cloud and SaaS markets, which he believes Microsoft is one of just a couple of companies positioned to capitalize on the dual opportunities. Microsoft's transition from software for a specific device, especially the PC, to providing software through the cloud and as a service is extremely important. The company's devices, some successful and some not-so-much, can help boost growth, but its competitive strength is in software and that is where the driver needs to be.

Microsoft is also trying to become more competitive in the tablet space with its decision to offer Windows for free to OEMs making devices that are 9-inches or smaller. The decision could allow the company to take a decisive share of the mobile market which could save it from slower PC growth in the future. Microsoft is increasing its focus in the phone and tablet space, lowering prices to compete against Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) products. Microsoft recently told the Wall Street Journal that prices would come down to between $100 and $300 from $300 to $500 for the 7,8 and 10-inch devices. While specs differ and brand will always command a premium, Microsoft's tablets are generally at the high-end of the field. The Google Nexus 7 starts around $200 with the Amazon (NASDAQ:AMZN) Kindle Fire the cheapest alternative around $139 for the seven-inch version. The decision to compete on price is probably a good one against Apple and Google but will come at the expense of margin pressure. Still, the potential for growth from a low market share is significant.

One catalyst that I don't think has been given much attention is the company's Skype service. Skype now accounts for a third of all international calls made globally and booked 40% growth in 2012, more than twice the combined volume growth made by all other phone companies in the world. Rates are relatively low against other options and I think there is an opportunity to expand the product into enterprise services.

Strong fundamentals even without faster growth

The company may be looking to faster growth in the future, but there is really nothing wrong with its current financial health. While sales only grew 5.5% last year, operating expenses fell by more than 10% and sales are expected 10% higher this year.

Cash on the balance sheet has ballooned to more than $88 billion in the last quarter against long-term debt of just $21 billion. The company is financed with just 20.6% of its capital structure in debt and issues ten-year bonds at just 3.1%, half percent above the Treasury debt of the United States. With operating income topping $26 billion, Microsoft covers its interest expense by more than 62 times and could easily leverage up its returns by taking on more debt.

Free cash flow fell last year to $24.6 billion on a doubling of capital expenditures to $4.3 billion. The company has spent $5.9 billion over the last twelve months and the increased expenditures should come through with higher sales down the road. Even against the lower free cash flow, no one can deny that the company is a huge cash generator with FCF increasing at an annualized 6.2% over the last decade.

The shares' current yield of 2.8% is lower than some of the other tech giants but still higher than the market average and the 38% payout ratio leaves plenty of room for increasing the dividend. Dividends per share have increased by more than 16% on a five-year annualized basis and the company has made a clear commitment to cash returns with nearly $41 billion in dividends and buybacks over the last three years. As balance sheet cash increases, Microsoft will likely need to increase its return of cash or face the same push by activist investors that has made Apple increase its dividend.

Still some upside but approaching fair value

Shares trade at 15.5 times trailing earnings, above the five-year average of 13.4 times but well below the industry average of 17.2 times earnings. The shares spent more than three years struggling with $30 per share until finally breaking higher in April of last year. The price has jumped since then and may need faster growth to justify the higher multiple.

The shares may be slightly undervalued on a discounted cash flow basis with a fair value of $43.75 per share. With cash building up on the balance sheet and the company significantly under-leveraged, the company should be able to support strong dividend growth but may need to spend more on growth projects. A dividend growth rate of 15% over the near term should be sustainable with growth dropping to 10% over the longer term and a terminal rate of 5.5% used in the model below.

To calculate the company's cost of capital, I used a blended cost of debt from the company's bond statistics provided by Morningstar. The equity cost of capital is an estimate based on the rate of ten-year treasuries, the market rate and volatility in shares of Microsoft.

Click to enlarge

While there may not be much room for the shares to grow over the near term, catalysts for growth should drive sales in the future. Microsoft has a solid balance sheet and could actually increase financial leverage a little to boost returns. The new CEO has his work cut out for him but is focusing on three areas that should pay off. While short-term investors may not be able to wait for growth project to pay off, long-term investors can be comfortable with the current valuation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.