Microsoft: The Undervalued Giant Makes a Comeback

| About: Microsoft Corporation (MSFT)

by Melvin Pasternak

When Microsoft (Nasdaq: MSFT) stock underwent its IPO in 1986, four of the company's employees became instant billionaires and 12 thousand of the firm's employees were millionaires.

The share price continued to soar.

But the tech bubble of the early 2000s, combined with increased competition and failure to quickly innovate has pushed this tech giant from a split-adjusted peak of nearly $50 a share to a little more than half its value today.

Hovering not far above $25, things are once again looking bright for this tech giant. The company is cheap as measured by several standards such as trailing price-to-earnings (P/E) ratio and the PEG ratio (P/E-to earnings growth). In addition, it has several innovative products just launched and in its pipeline. As a result, it could be one of tech's biggest turn-around stories this year.

Helping drive the tech giant back into a growth mode are three major breakthroughs:

1) Its Kinect video game technology for the X-Box gaming platform
2) The Windows 7 smartphone
3) A new Windows system for netbooks and tablets

Kinect's far-reaching implications
By far, Microsoft's most "game-changing" product is its Kinect. The wireless technology enables audiences to control video games using just their body movement -- without any remote control. More than 8 million Kinect units sold within the first two months on the market.

Sales are expected to remain strong into 2011, since Microsoft plans to make sure the technology is applied beyond gaming. In the near future, audiences should be able to use Kinect to control Netflix's (NYSE: NFLX) movie service and Hulu's TV service to pause or start a show through voice and gestures, without using a remote control.

Further down the road, Microsoft may license the Kinect software to TV and cable companies to push its version of integrated Internet TV, similar to Apple's (Nasdaq: AAPL) or Google's (Nasdaq: GOOG) Internet TV.

Success in smartphones... finally...
From the standpoint of smartphone technology, Microsoft's Windows Phone 7 has lagged behind competing systems like Apple's iPhone or Google's Android platform. However, the Windows Phone 7 is well-designed and attractive. It will likely gain traction as consumers become disillusioned with the ongoing reception and programming problems reportedly plaguing the iPhone.

Its growth projects will be further enhanced as Microsoft solidifies deals in-progress with phone carriers like Verizon (NYSE: VZ) and Sprint (NYSE: S).

For now, Microsoft is doing well just selling apps, such as its OneNote office software, for a range of smartphone platforms, including the iPhone.

Netbooks and tablet PCs
Further propelling the company is anticipation of its new Windows system optimized for low-powered devices like tablets and netbooks. Likely to be released next year, the system will run on ARM Holdings' (Nasdaq: ARMH) processor, instead of the traditional Wintel (Windows-Intel) chip. Some speculate the system could be a potential needle mover in the tablet and netbook market.

All the buzz surrounding Microsoft's new products should translate into growing revenue and earnings.

Analysts' expect full year 2011 revenue will increase 9.8% to $68.6 billion from $62.4 billion last year. By 2012, analysts project revenue will rise a further 6.9% to $73.3 billion.

The earnings outlook is equally robust. The 34 analysts following the company estimate 2011 earnings will increase 16.7% to $2.45 a share, from $2.10 in 2010. By 2012, earnings are expected to rise another 9.8% to $2.69.

This earnings growth should help jumpstart the share price, since Microsoft is currently attractively valued, with a trailing P/E ratio of just over 12. In contrast, the trailing P/E of the S&P 500 is more than 50% higher at almost 19.

And finally, as I mentioned earlier, there's the stock's PEG ratio. The PEG ratio is a key way to measure value. The one-year version of this measure is calculated by dividing the trailing P/E ratio by the projected earnings growth rate. Any number less than one indicates that a stock is cheap and the share price could rise. Right now with a P/E of just over 12 and expected 2011 earnings growth of 16.7%, the PEG ratio is 0.72 (12/16.7 = 0.72), making Microsoft a definite bargain.

While investors wait for the market to recognize value, they get paid to sit. MSFT's dividend yield is about 2.3% right now, more than 50% higher than the 1.55% yield of the average S&P 500 stock. The dividend is in no danger either, since the stock's current payout ratio is 23.1%. With more than $43 million in cash on the balance sheet and a history of dividend increases, another dividend boost should not be ruled out, either.

With exciting products recently launched and in development, strong earnings growth and a low valuation Microsoft looks attractive right now. In my mind, the stock is a worthwhile core addition to any investor's portfolio.

Original Post

Disclosure: Neither Melvin Pasternak nor StreetAuthority, LLC hold positions in any securities mentioned in this article.