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Last week I came across an article from Joshua Brown bashing value investors who feel Microsoft (MSFT) and Intel (INTC) are currently attractive purchases. Mr. Brown thinks the PC business may be in terminal decline and made several statements, which I feel are factually inaccurate. Below I will rebut those statements and discuss why Microsoft offers an attractive long-term buying opportunity.

Link to Mr. Brown's blog here
.

Below is some of Mr. Brown’s commentary:

Microsoft's 'cheapness' is the White Whale that compels all value investors to follow it out to sea, like crazed Captain Ahabs wielding DCF calculations. And they are always wrong.

The trouble with these arguments is that you could have made them in 2006, 2007, 2008, 2009, 2010 and you can probably just recycle that article and run it again in 2014, 2017, etc.

Microsoft was not cheap in 2006 and 2007 on an absolute basis, and in 2008 and 2009 was not cheap relative to the S&P 500 as shown below (Data provided by Morningstar):

2006
2007
2008
2009
2010
Currently
Microsoft P/E
25.5
20.2
10.4
16.8
11.9
9.6
S & P 500 P/E
16.8
16.5
10.9
18.6
15.5
13.5
If you consider the average S&P 500 multiple has historically been 15 times earnings, Microsoft could have been construed as expensive in 2006 and 2007, not cheap as Mr. Brown claims. Although Microsoft became cheap in absolute terms in late 2008/early 2009, it was not in relative terms, as the S&P 500 carried a similar multiple. And 2010 is the first year Microsoft was cheap in absolute terms and relative to the S&P 500.

Mr. Brown also links the following statement:

The predictions that the PC era is coming to an end are supported almost every time an important piece of research on the industry is released. Research firm Gartner has issued its new forecasts for the industry, and the data once again raise the challenge of what will eventually replace the desktop and laptop.

PC sales are not only under pressure from new devices, the economy has cut into growth as well. Gartner lowered its growth forecast for the global PC market in 2011 to 3.8% from its earlier forecast of 9.3%. The company said slow sales in Europe and the U.S. were partly to blame.

I highlight the above statement in bold because here is the actual statement from Gartner’s website:

Gartner says PC shipments to slow to 3.8% growth in 2011; units to increase 10.9% in 2012 ...

Should Mr. Brown not have mentioned the 2012 forecast? Perhaps he just relied on 24/7 Wall Street not Gartner? Let’s examine PC shipments since 2006 and include Gartner’s forecasts for the end of 2011 and 2012 according to its website:

Estimate Estimate
In Millions 2006 2007 2008 2009 2010 2011 2012
PC Shipments 239.4 271.2 302.2 305.9 350.9 364 404
Growth Rate 13.3% 11.4% 1.2% 14.7% 3.7% 11.0%
If Gartner’s projections are correct, at the end of 2012, the six year CAGR for PC shipments will be approximately 9%. And this includes arguably the worst recession since the Great Depression. Miraculously, shipments still grew slightly in 2009. This does not seem like an industry in terminal decline, more like a mature industry no longer growing at double digit rates, but still capable of growing 4-6% per year for the remainder of the decade. Although we are moving toward the cloud, you still need an operating system to access the cloud. PC’s will continue to be relevant because tablets do not provide enough functionality, storage and power for businesses.

Below I will examine Microsoft’s three main segments: Windows and Windows Live, Microsoft Business Division, and Server and Tools. Keep in mind, Microsoft’s fiscal year ends June 30.

From the most recent 10K:

“Windows and Windows Live Division (Windows Division) develops and markets PC operating systems, related software and online services, and PC hardware products.”

Revenue growth within this segment is sensitive to PC shipments. Since we have already established the global PC market is likely to grow at moderate single digit rates in the future and does not appear to be in terminal decline, let us also examine Microsoft’s operating system market share from information provided by NetMarketShare:
Desktop Operating System Market Share
Dec-10 Mar-11 Jun-11 Aug-11
Windows 93.78% 93.51% 93.32% 92.90%
MAC 5.21% 5.49% 5.67% 6.03%
While Apple (AAPL), Google (GOOG) and others have the ability to take a small amount of market share per year, in terms of both operating systems and web browsers, Microsoft is unlikely to relinquish its dominant No. 1 position. If the industry grows 4-6% per year and Microsoft cedes 1-2% market share, they are still likely to grow revenues within the Windows Division. We must also consider those customers who are still using XP and have not yet upgraded to Windows 7, as well as the release of Windows 8. These factors make it likely Microsoft will not only continue to grow Windows revenue, but also maintain terrific operating margins in the years to come. Below illustrates the tremendous amount of users who have yet to upgrade from XP, and may be forced to do so shortly, as well as Microsoft’s dominant web browser position (Data also from NetMarketShare):
Desktop Internet Browser Market Share as of August 2011
Windows IE
55.31%
FireFox
22.57%
Google Chrome
15.51%
Safari
4.64%
Opera
1.68%
Other
0.29%
Desktop Operating System Market Share as of August 2011
Windows XP
52.46%
Windows 7
30.60%
Windows Vista
9.40%
Below are Microsoft’s operating margins in the Windows Division since 2006:
Windows Division (Previously known as "Client Division")
2006 2007 2008 2009 2010 2011
Revenue 13107 14976 16865 15847 19494 19024
Growth Rate 14.3% 12.6% -6.0% 23.0% -2.4%
EBIT 10208 11467 13052 9790 13034 12281
Operating Margin 77.9% 76.6% 77.4% 61.8% 66.9% 64.6%

While it is unlikely Microsoft will generate pre-recession Windows operating margins north of 75%, they have shown the ability to maintain a margin north of 60% during a major recession, while profitability in dollar terms and revenue remain near all-time highs.

The Microsoft Business Division’s products include Microsoft Office, Exchange and SharePoint as well as cloud-based Dynamics programs and Office 365.

From the most recent 10K:

“Microsoft Business Division offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team and organization productivity through a range of programs, services and software solutions, which may be delivered either on premise or as a cloud-based service.”

This segment is also sensitive to PC shipments, but is essential to many businesses and consumers around the world. In the future, cloud-based options such as Office 365 will continue to drive revenue growth and should help maintain significant operating margins. Office consistently has over 90% market share and is even used on MACS. Dynamics CRM is taking advantage of the growing enterprise market, and while Salesforce.com (CRM) systems are growing in popularity, so is Dynamics CRM, which Leon Tribe estimates has an average customer nearly twice the size of Salesforce.com. Link to Leon Tribe’s summary
here.
Microsoft is well positioned to compete with Salesforce.com in the future, as cloud-based R&D at Microsoft is quadruple Salesforce.com’s revenues. According to Bloomberg, Microsoft International President Jean-Philippe Courtois said the company will spend 90% of its $9.6 billion research and development budget on cloud strategy this year.”
Below are Microsoft Business Division’s revenue and operating margins since 2006:

Microsoft Business Division
2006 2007 2008 2009 2010 2011
Revenue 14465 16402 18932 19257 19076 22186
Growth Rate 13.39% 15.42% 1.72% -0.94% 16.30%
EBIT 9534 10777 12358 11365 11504 14124
Operating Margin 65.9% 65.7% 65.3% 59.0% 60.3% 63.7%

As shown above, the business division just generated record revenues and a record operating profit in dollar terms, and margins are back on the rise near peak levels.
The last major segment is Server and Tools.

From the most recent 10K:

“Sever and Tools develops and markets technology and related services that enable information technology professionals and their systems to be more productive and efficient. Products and services include Windows Server, Microsoft SQL Server, Windows Azure and others, as well as Enterprise Services.”

Cloud-based solutions will not eliminate servers, they will generate demand for smaller more efficient servers. According to Gartner, server demand is still growing significantly. Shipments are on pace to grow 8-9% this year and revenue is on pace to grow over 18%. Below are server shipments since 2006:
Estimate
In Thousands 2006 2007 2008 2009 2010 2011
Server Shipments 8234 8841 9070 7564 8836 9587
Growth Rate 7.4% 2.6% -16.6% 16.8% 8.5%
The Great Recession severely affected server shipments, but demand is now at an all-time high and only took slightly over one year to fully recover.

According to IDC as of Q2 2001:

“Microsoft Windows server demand also continued to show strong growth as Windows-based hardware revenue increased 12.4% year-over-year. Quarterly revenue of $5.9 billion for Windows servers represented 45.5% of overall quarterly factory revenue and 71% of all quarterly server shipments.”
I will also note the percent of overall factory revenue is up from 42% at the end of 2010.

Revenue will not only continue to be driven by Windows servers, but also by cloud-based products such as Azure, which have grown revenues significantly year-over-year. Below illustrates Server and Tools’ strong revenue growth and operating margins since 2006:

Server and Tools 2006 2007 2008 2009 2010 2011
Revenue 9665 11171 13170 14601 15378 17096
Growth Rate 15.6% 17.9% 10.9% 5.3% 11.2%
EBIT 2868 3643 4593 4816 5539 6608
Operating Margin 29.7% 32.6% 34.9% 33.0% 36.0% 38.7%
As shown above, revenues and operating margins are at peak levels and continue to grow significantly.

Microsoft’s entertainment division has recently become profitable due to significant growth from Xbox Live and Kinect revenues. In 2011 the entertainment segment produced record revenues of $8.913 billion and an operating margin of nearly 15%. While this segment will not come close to producing as much profit as Microsoft’s main three segments, it will help mitigate the losses from Microsoft’s online business. Not only should revenue growth be generated from live video gaming systems, but also Kinect, which may be applicable elsewhere. For example, Kinect may be used in the future within an electronic bathroom mirror as a light sensor where individuals can customize their preferences. Perhaps it may substitute for a light switch? While this is not a huge deal in the overall scheme of things, it does illustrate Microsoft’s ability to innovate.

Microsoft’s one negative is its online segment. Although the search engine Bing has been gaining market share, this division has been unable to generate a profit and has not shown it can forge a relationship capable of improving margins, whether it is Yahoo (YHOO) currently or Facebook in the future. It will be very difficult to compete with Google, a firm with over 60% search market share and an even more dominant position in online advertising. In addition to focusing on its core and entertainment segments, Microsoft may be better off devoting its attention to mobile products and services, as the mobile phone market is growing rapidly but does not yet possess a dominant company with a competitive advantage. Even Apple only has 5% market share. According to Gartner, nearly 1.6 billion mobile phones were sold worldwide in 2010, and sales are expected to exceed 1.7 billion in 2011.
There is room for several companies to succeed in the mobile phone arena, i.e. Apple, Google, Microsoft, and others. Although Microsoft is late to the party, it may be easier to compete within the mobile phone market than in search because of Google's developing competitive advantage.

Even with continued losses from Microsoft’s online business and uncertainty about mobile success and its partnership with Nokia (NOK), Microsoft still remains an attractive buy because of its dominance within its three core segments and its overall profitability.

Below I will examine Microsoft’s overall profitability and why I feel it is undervalued.
Microsoft’s overall revenues and operating margins since 2006:

In Millions
2006
2007
2008
2009
2010
2011
Revenue
44282
51,122
60,420
58,437
62,484
69,943
Growth Rate
15.45% 18.19% -3.28% 6.93% 11.94%
EBIT
16472
18524
22492
20363
24098
27161
Operating Margin
37.20%
36.20%
37.20%
34.80%
38.60%
38.80%
Although the mix is different, Microsoft’s revenue, operating income and operating margin are at all-time highs. Revenue CAGR since 2006 is nearly 10%.

Return on Capital has also been impressive. While it ranged from 12% to 20% between 2002 and 2005, the range has increased substantially since, ranging from 29% to 52% the last six years, including over 38% in 2011.

Below Microsoft’s impressive EPS growth is highlighted, which is still impressive without share repurchases:

2006
2007
2008
2009
2010
2011
EPS Diluted
1.20
1.42
1.87
1.62
2.10
2.69
Diluted Share Count
10531
9886
9470
8996
8927
8593
CAGR
17.5%
CAGR w/o repurchases
12.9%
Free Cash Flow is also monstrous and growing as shown below:
In Millions
2006
2007
2008
2009
2010
2011
Net income
12599
14065
17681
14569
18760
23150
Depreciation & amortization
903
1440
2056
2562
2673
2766
Capital expenditure
-1578
-2264
-3182
-3119
-1977
-2355
Free cash flow
11924
13241
16555
14012
19456
23561
CAGR
14.6%
What an incredible growth rate in sustainable free cash flow. I define sustainable free cash flow as Net Income + Depreciation and Amortization - Cap Ex +/- one time items (NOPAT be could used instead of Net Income). There were no major adjustments to make from one-time items or major manipulation of working capital. The amount of free cash flow is so great that Microsoft could essentially pay for Skype in full with slightly more than one quarter’s worth of free cash flow. This tremendous free cash flow also gives the firm the ability to handle litigation and other uncertainties, and spend significantly on R&D. Cash flow may also help provide a catalyst, such as continued significant earnings per share growth from buybacks and/or an increase of the dividend.

Microsoft is also in incredible financial health with tangible book value near $44 billion. Cash and Investments totaled $63.637 billion as of 6/30/11, while interest bearing liabilities totaled only $11.921 billion. This leaves net cash of $51.716 billion, which is enough to pay all liabilities. This equates to $6.02 per share in net cash.

Microsoft runs a fairly conservative portfolio with less than 20% in equities and the majority of its liquid assets in short-term high quality fixed income. There are no major off-balance sheet issues, only normal contractual obligations related to debt payments, operating leases, construction and operating purchase commitments.

Mr. Brown is correct that certain investors focus too much on DCF valuation, which can be extremely sensitive to small input adjustments. Instead of DCF, I will value Microsoft based on EPS and EV/EBITDA to determine an ideal purchase price.

To account for repatriation, I will value Microsoft using $5.20 in net cash per share not $6. This assumes 90% of assets are held abroad and would be subject to a 15% repatriation tax (35% domestic rate – 20% rate already paid in foreign jurisdictions). At its current price of $26.03 per share, this essentially means you can buy the business of Microsoft for approximately $20.80 per share, a multiple of 7.7x trailing earnings of $2.69 per share.
This is substantially better than past multiples, including one as high as 60x earnings in the beginning of the decade and over 20x earnings in 2007 (Note that these multiples would be slightly lower if adjusted for net tax adjusted cash). This equates to an earnings yield near 13%. Substantially better than many stocks currently, and less risky assets such as the 10-year Treasury. A normal market multiple of 15x earnings would suggest a value of $40.35 per share for the operating business of Microsoft. After accounting for the $5.20 per share in net cash, I arrive at a fair value of $45.55 per share for Microsoft stock.
According to information from Pacific Crest Securities, the median EV/EBITDA multiple for the software company universe is just above 11. Microsoft’s current EV/EBITDA is only 5.56 as shown below:
Microsoft EV/EBITDA
Market Value of Equity
218000
Cash
9610
Short-Term Inv
43162
Equity Investments
10865
Debt
11921
Enterprise Value
166284
EBIT
27161
Dep/Amort
2766
EBITDA
29927
EV/EBITDA
5.56
If an EV/EBITDA multiple of 11 is used, the fair value of Microsoft’s equity should be $380.913 billion. Based on 8.593 billion shares outstanding, Microsoft’s equity should command a market price of $44.33 per share.

Based on my research, I believe Microsoft is worth $45 per share, far above its current market price. Purchasing near $26 per share may yield not only significant upside, but also provides over a 40% margin of safety. If given a 3-5 year time horizon, Microsoft stock has potential for significant appreciation.

Disclosure: I am long MSFT.
Source: Why Microsoft Is A Good Buy