For over 25 years, Microsoft (MSFT) has been a dominant force in the computer software market – from DOS in the 80’s, Windows and Office in the 90’s, to Internet Explorer at the turn of the century. With each successive wave of emerging technologies, Microsoft has demonstrated the ability to outlast its competitors. Curiously, Microsoft has never been the innovator or first to market in any of the areas in which it dominates today. It has, however, been a master of network effects – generating the critical mass that makes their software so indispensable.
In the last five years, Microsoft has appeared less than superhuman. Missteps with Windows Vista and poor adoption of Zune and Windows Mobile have tarnished its reputation of technological leadership. Meanwhile, the emergence of Google (GOOG) and the resurgence of Apple (AAPL) have stolen the spotlight and captured the hearts of the consumers. As they set the standard for what is now new and innovative, internet services and ultra-mobile devices have become all the rage. Suddenly, Microsoft has become the underdog, bombarded with criticism for its lack of imagination and old-world thinking.
This is all great news for a value investor. Companies that have fallen out of favour present great buying opportunities; and Microsoft is certainly unloved in today’s market. But not every cheap stock is a bargain. Sometimes they are discounted for good reason – a company with a failed business model will never make you any money. Let’s examine Microsoft closer to see what kind of animal it is.
Financial Overview
Microsoft is a hugely profitable company. It enjoys an 80% gross margin, a 30% net margin, and a 40% return on capital. Few companies can claim such lofty ratios. In terms of sustainability, Microsoft spends over $8B annually on R&D (Research and Development) and holds a cash reserve of over $36B to capitalize on future opportunities. Furthermore, it now pays a dividend of 16 cents per quarter, which at yesterday’s closing price of $24.53 (10/7/2010) provides a dividend yield of 2.6%.
Building Intuition around Value
Like any good value investor, we first look at book value to gain a feel for economic reality. Since assets and liabilities are far more concrete than discounted cash flows, a stock that trades at a low price-to-book (P/B) ratio is typically more defensible and thus more resilient in uncertain economic times. Book value can also give us an idea of what a company is worth at a minimum.
Microsoft’s reported book value per share last June was $5.17. Capitalizing a few years worth of R&D and marketing expenses easily bring this figure up to $14. This adjusted book value is our back-of-the-envelope estimate of reproduction cost. Finally, substituting reproduction cost for book value, we get a P/B ratio of 1.75 and the implication that 43% of Microsoft’s stock price is attributable to a sustainable competitive advantage. How reasonable is this?
I’d say it is quite reasonable. Microsoft’s sustainable competitive advantage is nothing to scoff at. It has been able to generate sizeable switching costs for its consumers who are helplessly attached to its Windows and Office franchises. The large number of other people utilizing Microsoft products makes collaboration difficult with anything but Microsoft products. This is what we referred to earlier as the network effect – a phenomenon so cunningly perpetuated by Microsoft’s OEM (Original Equipment Manufacturer) distribution channel strategy.
The Last Decade
To get a good sense of where Microsoft might be headed in the future, I’ve plotted some key performance metrics over the last decade. Microsoft’s chart (below) paints the picture of a solid company – all measures of revenue, earnings, and cash flow have been growing strongly and steadily for an extended period of time.
Overlaid on the plots are exponential curves that I’ve fitted using Excel’s “trend line” feature. The useful characteristic of equations in exponential form is that I can isolate from it the continuously compounded rate of interest. (For those less quantitatively-inclined, the annual rate of interest is approximately the power to which the “e” is raised to.) Revenue and net income have been growing on average at 10.5% y/y, while operating cash flow has been growing at 5.5% and FCF (Free Cash Flow) has been growing at 4.5%.
From here we take a look at FCF over the last decade. This gives us a good sense of what a “normal” cash flow should look like for Microsoft today. The details of my calculation can be seen in the figure below, but the end result is a normalized cash flow of $18.6B. This is in comparison to the $22.1B in actual cash flow reported last June, and thus incorporates a reasonable discount for the cyclical surge in earnings due to both the business PC (Personal Computer) and Windows 7 refresh cycles.
Discounted Cash Flow Analysis – No Growth Scenario
For my DCF (Discounted Cash Flow) analysis, I have opted to keep things simple. Sometimes it’s best to focus on the basics so as not to obfuscate the conclusions with more speculative elements. Using only my normalized cash flow estimate, a 0% growth rate, and a 10% cost of capital, I have calculated an intrinsic value of $24.28 per share. (My 10% cost of capital is based on the value found in Trefis and Bloomberg.)
The calculated intrinsic value is essentially Microsoft’s stock price today. In other words, Microsoft is priced in the market for no growth whatsoever from now until eternity – not one ounce of growth while still spending billions of dollars on R&D each year. Despite all the naysayers who say growth is dead at Microsoft, I have to say that this is an unlikely scenario. Recall the unmistakable upward sloping trends we saw earlier. Even companies in mature markets exhibit some kind of growth.
Discounted Cash Flow Analysis – Status Quo Scenario
From another angle, it can be argued that Microsoft will continue to grow as per usual by shifting its portfolio of businesses from declining markets to new growth markets. One promising area of new growth for Microsoft is in the area of cloud computing. To this end, Microsoft has been pouring billions of R&D dollars into datacentres and evolving Windows and Office for connected scenarios.
To model what I have called the status quo scenario, I have assumed 5 years of 4.5% FCF growth y/y (based on the trend analysis we looked at earlier), which drops off to 2% in the long run. Note that 4.5% is not exactly a high-flying growth figure – it fits a company with one foot in a maturing market. Recall furthermore that historical net income growth was 10% y/y. Since, theoretically, cash flow and earnings must eventually converge, 4.5% FCF growth is potentially an underestimate.
For my DCF calculation, I am projecting free cash flow only. Greyed-out values show implied values for other line items, but are only present for illustrative purposes. The result of the calculation is a substantial $32.97 per share.
Discounted Cash Flow Analysis – Declining Margins Scenario
To take into account impending shifts in the computing landscape, I’ve attempted to generate a convincing scenario that effectively captures the downside risk for Microsoft. It is commonly publicized in the press that the two major threats to Microsoft’s dominance are cloud computing and the tablet PC.
Cloud computing, in my opinion, is the lesser of the threats. Despite being dubbed as “The Two Words Bill Gates Doesn’t Want You to Hear” (one year ago by the Motley Fool), cloud computing has actually become an area that Microsoft stands to compete strongly in. Microsoft’s Windows Azure can easily become the preferred cloud platform for large enterprises whose IT (Information Technology) personnel are already knowledgeable in Microsoft Server technologies and whose developers are already experienced in .NET programming. What I expect to see is another example of Microsoft’s network effect in action. The downside, of course, is that cloud computing cannibalizes on Microsoft’s core desktop offerings, such as its very profitable cash cows: Windows and Office.
Tablets, on the other hand, are an area in which Microsoft currently has no presence in. The rise of the iPad has really shaken things up in the laptop PC market, as it has substantially cannibalized the tail-end netbook category. iPad and iPad-inspired tablets are based on the ARM architecture, which is incompatible with Windows 7. This means that for every netbook substituted with a tablet, one less Windows licence is sold. Fortunately for Microsoft, the types of computers that are vulnerable to cannibalization from the tablet are limited to those designed to primarily surf the internet – my best estimate is 12% of the overall PC market. Moreover, Steve Ballmer, Chief Executive of Microsoft, remains hopeful that his own version of the tablet PC, scheduled to be released this Christmas, will recapture its lost Windows market.
For the sake of argument, let’s assume for a moment that the PC market does decline significantly; that the use of cloud computing does become widespread; that tablets do supersede laptop computers. This is basically Google’s vision of the future. Computers that are no more than web browsers with all computing capability reassigned to the internet. The loser here would be Microsoft’s traditional Windows platform. Gone are the complexities of managing local computing devices. In its place would arise Windows Azure or an equivalent – a virtualized computing platform better known as PaaS (Platform-as-a-Service). Taking it a step further, we realize that computing resources haven’t really disappeared after all. They have just been outsourced to data centres, where Microsoft Sever technologies have the opportunity to take center stage. The likely scenario would see a substitution of platforms: Traditional Windows to Windows Azure. The irreversible downside, however, is a decline in pricing power for Microsoft. The cloud computing market is a busy space and if all current incumbents survive, there will be plenty of choice for consumers. The inevitable is thus a substitution from high margin revenue to low margin revenue.
In contrast, on the Microsoft Office front, Microsoft actually stands a good chance of preserving its valuable franchise despite the advent of these disruptive technologies. Unlike Windows, Office is not tied to the survival of the PC market. Office as a web application is as valuable as Office as a PC application. The switching cost, the network effect – everything that forms Office’s sustainable competitive advantage – is preserved. Currently, the only credible competitor to Microsoft Office is Google Apps. But think about the entrenchment of Microsoft Office in large enterprises. The productivity penalty for switching from Office is far too high. Google Apps has been selling well with small and medium-sized businesses, but Microsoft has already begun to respond with Office Web Apps. Ultimately, it is of my opinion that the familiar look and feel of Office Web Apps will win over long-time Office users. Finally, the most telling sign that Office is probably here to stay is the fact that 80% of Office revenues are from sales to business – a segment where switching costs are highest.
The scenario I have depicted is captured in the DCF calculation below. I have carried over the revenue numbers from the status quo scenario, but have decreased Microsoft’s net margin from 28% to 21% over the next 3 years. The degree of margin shrinkage was determined as follows. First, Microsoft’s Windows Division contributed to 40% of total operating income; Its Business Division (including Office) contributed to another 40%. Next, the gross margin of both these divisions is 68%; Microsoft’s Services Division (including Azure) has a gross margin of only 34%. Therefore the simplifying assumption would be a 50% reduction of margins in 50% of Microsoft’s total operating income, or equivalently a 25% reduction in overall margins. This is consistent with a decline in net margin from 28% to 21%.
Intrinsic value under these circumstances comes out to $26.19 per share.
An Upside Worth Considering
At this point, let’s review our intrinsic value estimates. Adjusted book value is $14 per share, and in a world where Microsoft is incapable of growing, it is still worth $24.28 per share. Both of these estimates define lower bounds albeit with varying levels of substance. Nevertheless, with yesterday’s close at $24.53, they give us confidence that Microsoft's true intrinsic value is north of its price in the market. Our final two intrinsic value estimates revolve around the longevity and resilience of the PC industry. If the PC industry is relatively untouched, then Microsoft is worth $32.97 per share. On the other hand, if the PC industry is completely overhauled, then Microsoft is worth $26.19 per share. The important take-away is not which way the PC industry is evolving, but that Microsoft is undervalued in either case. Depending on how it plays out, you are looking at a 7% to 34% upside.
Data Sources: Morningstar, SEC Filings
Disclosure: No Positions
