Making The Value Case For Microsoft

| About: Microsoft Corporation (MSFT)

Pretend for a second that you didn’t read the headline to this article. I’d like to tell you about a company that on October 20, 2011, reported record Q1 revenue of $17.37 B, which was up 7% over the previous year’s Q1 revenue. Along that same line, net income of $5.74 B was up 6% versus the prior year, and earnings per share of $0.68 were up 10%.

What if I were to tell you that you could buy this company for 9X ttm earnings? Would that be an investment that might interest you? This company, of course, is Microsoft (MSFT). Now you say you’re less interested? You shouldn’t be.

With the thorough domination of the mobile space by Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG), many investors have grown fearful that MSFT won’t have a place in the future of computing. Other investors may be turned off because they see a stock that traded in the low $30s as far back as 2001, and sits just under $25 today. Unfortunately, MSFT only earned $0.66 per share in 2001, which meant investors were paying roughly 47X earnings to buy it in the low $30s.

Stocks with P/E ratios that high generally come back to earth sooner or later, and MSFT has done just that over the past decade. While the stock price has languished, the company has performed quite well. In fact, the stagnant stock price, and solid growth of the business have now converged at a point such that MSFT is a compelling opportunity as both a value and dividend stock.

As mentioned above, MSFT is still producing strong growth. Looking at the source of this growth in greater detail should help to allay some of the fears investors have about the imminent demise of the company at the hands of AAPL and GOOG. Microsoft’s business division sells the familiar Office Suite, as well as productivity server offerings such as Lync, SharePoint, and Exchange.

Revenue of $5.62 B for Q1 was up 8% over the previous year. The Server & Tools segment, as the name suggests, sells server applications and management tools. Q1 revenue of $4.25 B was up 10% over the prior year period. This was the sixth consecutive quarter of double digit revenue growth for this segment.

The Windows & Windows Live division recorded Q1 revenue of $4.87 B, which was up 2% over the prior year period. The 2% increase was in line with growth in PC sales, which makes sense, as virtually all PCs use Windows for their operating system.

A commonly used metaphor for value investing is that of someone walking along a sidewalk, picking up cigarette butts, hoping to find one that still has a few puffs left. The expected demise of the Windows segment is what is causing the investment community to think of MSFT in this way.

As Macs become more popular computer choices, and people increasingly use smartphones and tablets for many computing tasks, sales of PCs have slowed. However, with Windows sales only making up 28% of Q1 revenue, while still achieving some small growth, it certainly doesn’t seem like a “sky is falling” scenario. With the strong growth in the business segments mentioned above, and Microsoft’s recent focus on rewarding shareholders with dividends and buybacks, investors could find that this stock has many more puffs left than the market expects.

MSFT pays a quarterly dividend of $0.20, good for a yield of 3.3%. Based on ttm earnings of $2.75, this is a payout ratio of 29%. MSFT has been aggressively raising its dividend over the past 4 years, and its low payout ratio, combined with expected future growth in earnings, leaves plenty of room for future increases. MSFT also repurchased 38 M shares, at a total cost of $1B, during the past quarter.

The company has $11.2B of a $40B repurchase plan remaining, which runs through 2013. It is good to see that total share count outstanding has decreased year over year, from 8.614B to 8.392B. This means that the repurchases are actually benefitting shareholders, and not simply balancing options awarded to employees.

The previously mentioned lines of business alone make the stock a good value, so you can view an investment in MSFT as also coming with a free option on MSFT’s innovation. MFST spent 13% of revenue in Q1 on research and development, which has given them an extensive patent portfolio. MSFT receives $5 for every HTC Android phone sold, and is currently pursuing licensing agreements with other Android manufacturers in the range of $7.50 to $12.50 per phone. Pretty nice profit on products they spend nothing to manufacture.

Also, the Kinect, a device developed to allow gamers to control an Xbox through body motion, is going to end up being so much more. If the Kinect becomes truly game-changing, or MSFT invents something else in a few years that does, an investment in MSFT could turn into a home run. This is a stock with limited downside, a solid dividend yield, and a good opportunity for upside.

Disclosure: I am long AAPL.