Microsoft: Potential 30 to 40% Upside

Mar.31.11 | About: Microsoft Corporation (MSFT)
Microsoft (NASDAQ:MSFT) generates revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. The software products and services include operating systems for personal computers, servers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and video games. The company provides consulting and product and solution support services and trains and certifies computer system integrators and developers. It also design and sell hardware, including the Xbox 360 gaming and entertainment console and accessories, and Microsoft PC hardware products. Online offerings and information are delivered to consumers through Bing, Windows Live, Xbox LIVE, Microsoft Office Web Apps, our MSN portals and channels, and to businesses through Microsoft Online Services offerings, such as Microsoft Dynamics CRM Online, Exchange Online, and SharePoint Online, and through Windows Azure and SQL Azure. Microsoft enables the delivery of online advertising across their broad range of digital media properties and on Bing through their proprietary adCenter platform.
Microsoft is a highly profitable company. In the last 5 years operating margins and return on equity have been above 30%. The Operating margin and return of equity in the last quarterly filing are 39% and 44%. This for a company with $10 billion in debt and more than $40 billion in cash. If you adjust for debt and cash the Return on Equity becomes even more impressive. Microsoft generates around $66 billion in revenue.
The company is structured in 5 divisions: Windows & Windows Live, Server and Tools, Online Service, Microsoft Business & Entertainment and Devices. Graph 1 provides an overview of the different divisions and their % of total revenue and % of total operating income.
Graph 1: Revenue and Operating income % per division
Click to enlarge
Let’s take a look at the financial figures and key ratio’s in Graph 2. Revenue has more than doubled in the last 10 years from $25 billion in 2001 to more than $66 billion TTM and free cash flow has almost doubled from $12 billion to $23 billion.
Graph 2: Financial figures and ratios
Click to enlarge
The stock price (adjusted for splits) has gone nowhere in the last 10 years and has mostly traded in the $20 to $30 range. Graph 3 provides a trend of the stock price based on the closing price of the last day of the fiscal year.
Graph 3: Stock price trend
To value Microsoft we will first take a look at the asset value. Our objective is to look at the asset value versus market value over the last 10 years and see how attractive the company is currently priced. To do this we will take the market to book value ratio and the market to adjusted book value ratio. For the adjusted book value ratio we will first calculate the reproduction value of Microsoft. For that we will do the following adjustments to book value:
  • Add 3 years of annual R&D expenses (conservative estimate that it will take this long to develop the products portfolio)
  • Add 3 years of 50% of the annual SG&A expenses (conservative estimate on the resources required to get into the market)
Graph 4: market to (adjusted) book value ratio

Graph 4 indicates that the stock is currently trading at the lower end of the market to (adjusted) book value ratio. Based on this first analysis the current price might offer an attractive entry point.

To analyze the stock further we will try to estimate intrinsic value. The Earnings Power Value method will be used to come to an estimate of intrinsic value.
First, earnings need to be adjusted to represent the cash investors can extract and still leave the company functioning. Second, we need to determine a discount rate. Last, we’ll estimate the future growth of the company
Following is the adjustment to the earnings reported in its latest annual submission:
  • EBIT margin of 37% (median of the last 5 years)
  • SG&A, R&D and Depreciation adjustment
  • Tax rate of 30% (median of the last 10 years)
  • Discount rate of 12%
This gives a current Earnings Power Value of $25 (excluding future growth). Microsoft shares are currently trading against a price that assumes that the company will not grow anymore. This is an attractive entry point as it provides future growth as a margin of safety.
Let’s try to estimate the margin of safety. To estimate future growth we’ll take a conservative growth percentage of 5%, cost of capital of 12.5% and a ROIC of 28% (minimum for the last 5 years). This gives a stock price of $34. With the current stock price between $25-26 you are looking at a potential 30 to 40% upside. Graph 5 shows the stock price versus intrinsic value for the last 10 years. Since the middle of 2008 Microsoft has been trading below intrinsic value.
Graph 5: Stock price versus intrinsic value

Disclosure: I am long MSFT.