Microsoft Screams Undervalued

Nov. 2.11 | About: Microsoft Corporation (MSFT)

When I mention Microsoft (NASDAQ:MSFT) as an undervalued opportunity to other investors and clients, what invariably comes up in the discussion is how Microsoft is selling below its share price in 1998 (adjusted for splits). The fact that Microsoft is selling below its 1998 price is not a reflection of Microsoft’s performance as a company; it is a reflection of how overvalued the stock was in 1998.

In 1998 Microsoft earned $4.5 billion. This past year Microsoft earned $23.15 billion. Moreover, after adjusting for splits, Microsoft had on average 9.75 billion shares outstanding in 1998. Today Microsoft has 8.4 billion shares outstanding. In other words, adjusting for splits, EPS was about $0.46 in 1998 and $2.73 last year, yet it is selling at the same price today as it was in 1998.

There is no doubt that Microsoft was extremely overvalued in the late 1990s. That, however, should not bear any weight on determining whether or not Microsoft is a good investment today.

Microsoft has many attractive qualities: a 3% dividend yield, nearly $57 billion in cash and short-term investments, earnings are growing in the upper single digits, and management has bought back 13% of shares outstanding since mid-2007.

Microsoft has strong competitive advantages in each of its operating divisions. Below is a table with a breakdown of how Microsoft generates its revenue and operating income. Microsoft has strong competitive advantages in all of its divisions, with the exception of its unprofitable online services division (MSN.com and Bing). Going forward tablets can be a profitable venture for Microsoft, especially if Hewlett-Packard (NYSE:HPQ) decides to use its operating system for its tablets; however, given the competitiveness of the tablet market and the dominant market share of the iPad, it could be a long time before that happens.

Division

% of Total Revenue

% of Operating Income (Loss)

Windows & Windows Live Division

26.85%

44.06%

Server and Tools

24.46%

23.76%

Online Services Division

3.61%

-9.71%

Microsoft Business Division

31.43%

50.91%

Entertainment and Devices Division

12.46%

4.18%

Unallocated and other

1.18%

-13.20%

Click to enlarge

Today Microsoft has a market value of $218 billion. It also has $57 billion in cash. After subtracting the cost of Skype ($8.5 billion) and considering Microsoft probably needs $20 billion in cash to be comfortable operating and making future acquisitions without fear of a material drop in its credit rating, we can say Microsoft has about $28.5 billion in excess cash that can immediately be taken out of the business. Subtracting the excess cash from the market value, Microsoft is really selling at $190 billion.

With earnings of $23.15 billion and a market cap of $190 billion, Microsoft is selling at 8.2 times earnings. The stock appears very cheap given Microsoft’s strong competitive position in each of its profitable divisions, the consistency of earnings, the commitment management has made to return cash to shareholders through share buybacks and dividends, and the opportunity for earnings growth in the upper single digits.

Warren Buffett said at the Berkshire Hathaway annual meeting in 1996 that you can’t get a very precise value for a company. He advised that you shouldn’t buy a company unless it was screaming it was undervalued. Today, Microsoft is yelling pretty loud.

Disclosure: Many of my clients are invested in Microsoft.