By Mark Bern, CPA, CFO
There seems always to be a general wish by most investors that changes with the times. Today it is probably, “Wouldn’t it be great to buy the next Google (GOOG)?” Fifteen years ago I distinctly remember everyone was looking for the next Microsoft (MSFT). More than once in the late '90s I heard people mention wishing they could find the next Cisco (CSCO) or Intel (INTC).
This isn’t just a new trend related to tech stocks, though. Around 1990, just before tech got really hot, it was Berkshire Hathaway (BRK.A). Around the same time General Electric (GE) was the one people wished they could clone and find anew. Going back even further, people were wishing that they could find the next General Motors (GM) or Ford [(F). Today that may be pretty hard to believe.
In the mid '80s it was Apple (AAPL); then it wasn’t; now it is again. BRK went out of style in the late '90s but has had a nice run over the previous decade that saw its shares rise nearly 50 percent while the S&P 500 actually dropped. Thus, I recently saw an advertisement of the “next Berkshire Hathaway stock!”
My point is that great companies, most of the anyway, have great runs where the stocks soar. But the same stocks go stagnant for months and sometimes years between those great runs. The next Apple turned out to be the old Apple with new management. BRK didn’t need new management to make another big run; it just needed the right economic climate to thrive.
So, my other point is that the next great opportunity just might be a great company that has been idling for a while. That leads me to the two companies I want to compare today: Microsoft and Intel. Both are still great companies with dominant positions in their respective industries, and both have been going nowhere fast post-2000.
Valuations for both companies got way out of whack during the Internet Bubble that burst in 2000. Owners and employees of both companies watched in horror as the stock prices tumbled to lows in 2002. Remarkably, the stock prices fell even lower amidst the 2008-'09 financial crisis that gripped the country and much of the globe with fear. But today earnings per share for Intel are about 54 percent higher than at the 2000 peak. And Intel’s cash flow per share has grown 62 percent over the same period.
What is even more remarkable is that Microsoft’s earnings didn’t drop during after 2000. Earnings per share at Microsoft went up in all but one year (2009) since 2000 and are now 216 percent higher than its earnings per share in 2000. Its cash flow per share has grown 212 percent. Yet both companies are valued far lower today than at their respective peaks in 2000. Microsoft’s price is trading 56 percent lower than its 2000 peak, while Intel is now 69 percent lower. In 2000, both companies were poised to fall from the perch high above and only Intel paid a paltry dividend yielding 0.1 percent. How things change.
But is it really time to write off either company for dead? I don’t think so. I’m not sure that either one is going to have a run like Apple just did, either. But for those of us who like solid, proven, companies that dominate their respective industries, throw off dividends over three percent, have the financial strength and cash flows to weather the worst economic disasters and maintain the potential for steady growth well into the future, these two companies may look enticing. So, how have the two done since the recent recession?
Microsoft peaked at around $37 in 2007, and subsequently dropped below $16, a 59 percent fall, in 2009. Microsoft stock is currently trading at $25.56 (near the close on December 15, 2011). Investors who owned the stock throughout the entire period are still down about 26 percent, including dividends. Ouch! But is that justified? To all those Softie haters out there, of course it is. But for the average value investor looking for a good yield for income and some appreciation potential to keep ahead of inflation we’ll need to dig a little deeper. We’ll do that below.
Let’s take a look at Intel over the same period. Intel peaked at around $26 in 2007 and subsequently fell to about $13, a 50 percent drop. Intel stock is currently priced at $23.31 (also near the close on December 15, 2011). Investors who owned this stock throughout the entire period, peak to present, are only down about one percent, after including dividends.
Since the S&P 500 index is still about 20 percent below its 2007 peak, Intel would appear to be performing well. Some readers may feel that it is more appropriate to compare these two companies to the Nasdaq 100 index, but I choose the broader S&P 500 because we’re not just considering tech stocks for our portfolio and I like to measure all stocks against the same index for consistency's sake.
I needn’t point out how well investors would have done had they invested in either stock near the bottom in 2009. I do find it curious, though, that Intel fell less and rose more than Microsoft since Intel’s earnings fell more than did Microsoft’s and Microsoft also recorded much stronger growth in sales, cash flow and earnings over the last five years.
Let’s look at the numbers without a predisposition for or against either company. Intel’s sales and earnings per share rose by five percent and two percent on average over the last five years, respectively. MSFT’s per share sales and earnings rose by an average of 15 percent and 12 percent, respectively, over the same period. Cash flow at Intel and MSFT, over that same period, rose by and average of two percent and 13 percent, respectively. MSFT only had one year in which sales dropped by 3.3 percent, while Intel saw sales decrease for two consecutive years, two percent in 2008 and 6.5 percent in 2009.
But sales came roaring back for Intel in 2010 with an increase of over 24 percent and are on track to be up another 23 percent or more in 2011. The increases at MSFT were more moderate at 6.9% and a likely 12 percent for 2010 and 2011, respectively. Earnings at Intel fell rather hard in 2008 (-22 percent) and 2009 (-16.3 percent), while at MSFT the only drop occurred in 2009 and was -13.4 percent. On the positive side, Intel increased earnings per share (EPS) 166.2 percent in 2010 over 2009 and it looks like we’ll see about a 14.6 percent rise in EPS in 2011. MSFT, on the other hand, increased EPS a consistent 29.6 percent and 28.1 percent in 2010 and 2011, respectively. It would seem the market no longer values consistency.
Profit margins at both companies are improving; however, the dips at MSFT have been more muted and less frequent than at Intel. That would appear to be due to the differences between the semiconductor and computer software industries. At MSFT, the profit margins are generally higher and are reported for 2011 at 33.1 percent while at Intel the profit margin looks like it will come in around 22.5 percent this year. Both are above the respective five-year averages for each company, probably due to expense reductions during the Great Recession.
Bill Gates has left the building! MSFT has taken on some debt at the historically low levels of interest to build cash, something unheard of when Gates was at the helm. Gates loathed debt. I always liked that about him. But with rates so low it may actually be a prudent move to build cash cheaply to fund future growth and acquisitions. MSFT has a debt-to-equity (D/E) ratio of 20.9 percent, while Intel’s D/E ratio sits at only four percent.
Return on Total Capital (RTC) at MSFT is 33.8 percent while RTC at Intel is 22.5 percent. Return on Equity (ROE) at MSFT is 40.6 percent and at Intel ROE is likely to be 23.5 percent in 2011. By comparing these last two ratios we can tell if the companies are utilizing debt efficiently. If ROE exceeds RTC, it indicates that the debt is adding value for shareholders. Conversely, if RTC exceeds ROE, it would indicate that management is not deploying capital well enough to achieve an adequate return on investment to justify the added debt. Since neither company has high debt levels we can see that debt poses no real concern for either, especially since both are deploying capital efficiently.
Now let’s take a look at one of my favorite areas: dividends. The yields at the two companies are currently 3.1 percent and 3.6 percent for MSFT and Intel, respectively. Both are nice (Intel being a little nicer), but what is just as important is how consistently the companies are at raising their dividends and what the prospect is for future increases. Intel has raised its dividend for the last eight consecutive years. MSFT has raised its dividend if eight of the last nine years. That’s pretty close, but by how much has each increased its dividends? Intel has increased its dividend by an average of 25.5 percent per year over the last five years while MSFT has increased its dividends by an average of 21.5 % over the same period. So far, Intel has a small advantage on dividends.
Let’s look at the payout ratios. The payout ratio at Intel is 33 percent while at MSFT it is 22 percent. It would appear that Mr. Softie has more room to grow dividends than does Intel going forward. But, since Intel is starting out with a lead in yield I should think that this race is likely to be a dead heat over the long term with larger increases from MSFT which will eventually catch up to, and possibly surpass, Intel at some time in the future.
Now we get into the more subjective aspect of this analysis. Neither company is going to roll over and play dead for its competitors. These are two dominant companies that know how to win having done so many times to establish positions of industry leadership. Both companies have significant, sustainable advantages in multiple areas; Intel has patents and capital investments that are unmatched, while MSFT also has patents and a huge penetration rate that reaches over 90 percent of computer users. Both have significant brand values that would be extremely difficult to replicate and both also have gobs of cash flow available to invest and acquire in new areas of potential growth.
I believe both will be able to grow sales in the 10 to 12 percent range, on average, for many years to come. I expect EPS to grow slightly faster at MSFT due to its higher profit margin. I also expect dividends to grow faster at MSFT, as I stated previously, in the range of 15 percent on average per year compared to about 11 percent per year on average. The P/E for MSFT is about 9 times trailing twelve months earnings, while it is about 10 for Intel. I really don’t think that either deserves a multiple premium at this point. This is turning out to be closer than I expected!
Now we need to look at one other thing to determine which one presents a better value at the current time. Both are somewhat cyclical, but MSFT is less so. The market does not seem to perceive this point. Earnings dip further in economic downturns for Intel, but the company’s stock price did not fall as far as did that of MSFT during the last recession, and Intel’s stock rebounded better as well.
There seems to be an investor preference bias toward Intel over MSFT. However, the cycle for semiconductors seems to be nearing another downturn, in my opinion, while MSFT appears ready to continue to grow unabated. Will this be the time MSFT earns the respect of investors? Unfortunately, I doubt it.
Looking strictly at the numbers and company outlooks as well as the current valuations, MSFT should provide shareholders a better long-term total return. But the preference issue is still a concern. I believe that both companies are currently undervalued due to the uncertainties posed by the European sovereign debt situation and the grudgingly slow growth in the U.S. economy. If I were to start a position today, I would probably buy MSFT. But I own Intel, like the higher yield and plan to stick with it.
How’s that for a politically correct opinion?