Writing about stocks and investments is as much an exercise in convincing oneself of the idea, as it is an exercise in explaining it to others. I have always found it helpful to articulate the idea to someone as a way to hear yourself think and see if you sound foolish making that argument. The theory goes that as I write it down, if I cannot convince myself of the reasons I hold a stock, I will finish the article with a sell recommendation and get out of the investment. This analysis will be fairly simple and will be based on historic data that indicates the strength of management to maintain profitability, identifying a "moat" of sorts that protects the company from falling off a cliff, and a focus on the future markets that is some indication of continued growth and profitability. It will also focus on current valuation with respect to assets in relation to the markets it serves.
Let me start with my favorite holding -- Microsoft (NASDAQ:MSFT).
About a year back I was on the fence on this one. The launch of Windows was a complete PR disaster and MSFT seemed to be kicking around with no direction. By that time I had held MSFT for over a decade, very painfully I might add, and seen no return on my investment. The only reason I held on to it was the sheer value that it represented for the trailing and forward earnings that they had on its Income statement. So what is this value that I talk about?
Let's review historical data to understand the past and current strengths of the organization. The source of the data here is predominantly from the MSFT investor site.
The historic data for revenue growth in MSFT has been consistent if nothing else. The individual segments have fluctuated, but the overall revenue growth of this company has been incredible considering the revenue base that it is working off. In 2007 the company had revenue of 54 billion and seven years later (through all the market churn) it has grown its revenue all the way to 87 billion with just one blip in 2009 in terms of a dip in revenue. This is over 60% revenue growth in 7 years! All this while every report out there was calling for the demise of this company and its irrelevance in today's technology market given the proliferation of smartphones and tablets.
Income and Earnings:
The operating income over the same period of time has grown by 50% ($18.48 billion-$27.75 billion) and the diluted EPS has grown 85% ($1.42-$2.63). The diluted EPS has been more choppy than people would have liked it to be, but then again when you consider that this company has been fighting to reshape itself over this period of time, with acquisitions (arguably ill-fated in some cases) such as Skype, Aquantive, Nokia, etc., it is remarkable that none of these moves have created more than a blip in the bigger picture. What is notable in this is the continued ability of the company to grow its earnings faster than its revenue.
Cash and RoE:
If there were no Apple (NASDAQ:AAPL) in the market today, the cash pile that MSFT holds would be legendary. It is only AAPL that makes this pile look small. But to Microsoft's credit it did pay a one-time $3 dividend out to investors about 12 years back and at the end of the day an $85 billion+ war chest is nothing to scoff at. With explosive retained earnings and the bias towards equity, MSFT has a pristine balance sheet that every stockholder will be happy to see. MSFT has also managed to maintain a very high RoE of over 25% that reflects on the management's focus on shareholders.
A strong dividend yield on the stock also works in favor of this holding. At current levels, the yield may not be eye popping, but if you were to look at it in the near past, it had a handsome yield for a technology company. The company also has a good history of periodic increase in this payout. The current yield is at 2.7% and any pull back will only make this much more attractive to hold.
So knowing what we know so far about the company and discounting any forward-looking guidance, what would we pay reasonably for this stock? The calculation is fairly simply. For a rough annual growth of 10%, we pay 10 times earnings. So with a $2.65 EPS, we get to $26.50 a share. Add in the 65 billion in cash (after discounting for the 20 billion in debt), which amounts to about $7 per share, we get to $33.50. So fundamentally I would like to think that this stock is worth $33.50 based on what it has done.
Now that we have got to the base value, let's review what the company has to offer for the future. By future, I refer to the next five years rather than an unbounded time because I believe that for a company the size of MSFT it usually takes about 3-5 years to fundamentally change the execution path it has embarked on.
The product cycle:
Five years ago, the products coming out of MSFT were looking stale. The Vista debacle, the Zune and Kin experiments, the onslaught of mobile computing, the rise of cloud computing and the ageing XP were all contributing to an image that MSFT has lost its way for good and would go the route of IBM as it gets slaughtered by the likes of Google and Amazon.
Admittedly, Windows 8 has not been the best of launches in Windows history. But with that launch, the subsequent 8.1 launch and the rumors about Windows 9, MSFT has shown the ability to learn from its mistakes and learn quickly. Assuming for a moment that it is not a trivial task to take 90% of the desktop/laptop users with you on a monumental transition into a new mobile strategy, MSFT has shown the propensity to take criticism and change for the better. For this reason, I still believe that MSFT will be the biggest winner in the next PC refresh cycle that will occur in the coming 1-3 years as enterprises start refreshing from their last upgrade of Windows 7. With that upgrade, chances are MSFT will start picking up a greater share in the mobile computing space as well.
The commercial cloud services is a phenomenal driver for MSFT and Azure demonstrates MSFT's ability to leverage its massive customer base to muscle into a new market segment in the Enterprise space even if it is a late entrant. Though this is typically a lower margin product, MSFT has the ability to charge a premium on this service for the vertical integration it can enable for all its enterprise products on this platform. This progressively become a clear differentiator for MSFT in this crowded segment.
Office 365 is another product cycle that demonstrates the deep penetration that MSFT has with its customer base and its ability to introduce software products into the market that address market transitions and yet preserve the existing customer base.
Xbox One is a product that was underwhelming to say the least. But it is a necessary platform that MSFT should build on; to enable it to reach the home user as it expands its cloud services. I believe, the initial setback of Xbox One will be overcome over time, just as Xbox 360 overcame the challenges MSFT faced with its first venture into the console market.
The Nokia division is the one I think MSFT will eventually play down. As the CEO indicated, it would become a showcase product where MSFT demonstrates the ability of its software platform rather than try to make it a serious product line within the company. This I think is also true for its Surface brand of products. Ideally the value here will be to enable OEMs rather than become a devices company.
There is a fundamental shift in how MSFT perceives its role in the world today. This has mostly been forced on it rather than being a visionary change. In the decades gone by, MSFT viewed itself as the master of its domain and built software to enhance its Windows universe. It developed applications and services in this universe in an effort to migrate people away from other ecosystems and bring them into the Windows ecosystem. What changed in the past decade was a shift towards mobile and cloud computing. As MSFT dragged its feet on this transition and was distracted by the happenings in the consumer devices and Internet search space, the competition started getting ahead of it. Over the past 3-4 years, MSFT has recognized this challenge and worked towards steering the ship back towards its core business, which is building software for enterprises and personal users. But what is most heartening about this shift is what occurred in the last couple of quarters, when MSFT has started showing a strategy where its software development is not inherently bound to the Windows world.
This, in my opinion, creates the greatest opportunity for MSFT for the coming five years. With its ubiquitous presence in the enterprise space and the adoption of cloud architecture, the underlying platform on which software runs, is becoming less of a focus and the focus is shifting towards running applications anywhere with minimal user intervention and migrating them based on load factors. The opportunities lie is providing solutions that are mobile and highly available and the more MSFT focuses on that rather than the underlying platform, the more it will succeed. The platform it develops will then be a unique selling point it can pitch to users, for a vertically integrated solution that can provide a greater user experience that could command a higher premium and differentiate them in the low margin IaaS marketplace.
Additionally, the new CEO has shown the ability to act quickly on things that matter most. The quick downsizing of the Nokia division was critical in proving to the market that it is not going to continue building phones across the board with no clear vision on how that fits in with the rest of the company. As sad as it is to see a brand like Nokia fade away, it is essential in keeping the focus at MSFT. This is a good sign that Satya is not someone to drag his feet and with his background in building the cloud business at MSFT, he seems to be the ideal person for the path that MSFT has embarked on.
So what would be a reasonable value now?
Let's start by listing out the positives in the future valuation:
- A growing PC upgrade cycle with a upswing in Windows Licensing in the next few years
- A gain in mobile devices market share - not in terms of physical devices, but increased adoption of the Windows platform
- An acceleration of the cloud strategy and increased monetization of the data center buildout that is currently in progress to support this strategy.
- Increased revenues from productivity software running on non-windows platforms
- An increased capital spending levels from Enterprise customers which has been depressed for over 5 years starting with the great recession in 2008.
- Cost savings on the Income statement once Nokia and Surface is streamlined and the continued monetization of Bing and Xbox One resources.
- Further buybacks and shareholder friendly activities using the cash on balance sheet.
- A growing dividend payout.
Conservatively, assuming all these catalysts is worth 4 times (I am discounting 8 catalysts to 4 percentage points here as a gut call) current earnings we come up with a new P/E of 14 that gives us a price of $37.10. After adding back the $7 of cash we get to $44.10. Based on the catalysts listed above, I believe that this would be a fair value for the stock as it stands today.
The X factor in MSFT is, in my opinion is its CEO. If Satya can execute to a clear vision and generate a buzz around MSFT's future, there is a potential in this stock to meet and handily beat the projections I have made above. This can take the stock a lot higher than the $44 price. And that is truly what excites me about MSFT.
The market is currently hovering around $44 and so I would not call MSFT overvalued, but neither will I call it a steal. As the catalysts play out over the next five years, the expectation is that MSFT will grow into this valuation effortlessly and surprise to the upside while paying a handsome dividend (currently at 2.7%).
At my cost basis of $29, I am even more comfortable holding this through a possibly approaching market correction and might even add to my position if it was to fall below 40 at any point.
This is why I hold MSFT today.
Disclosure: The author is long MSFT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.