Refocus Your Microsoft Investment Lens From Growth To Value

| About: Microsoft Corporation (MSFT)

Seemingly every day another article is published outlining reasons Microsoft stock should be avoided. True, the stock has flat-lined for the past decade. As a momentum investor, that would concern me. As a value investor, however, it provides an opportunity. The following are issues usually highlighted in any bearish article describing Microsoft:

No presence in the tablet market will lead to the demise of Windows. Overstated, but definitely a headwind. From a value perspective, the reality is much less disconcerting, as revenues are far more stable than the headline risk. In fiscal 2012, the Windows money-minting segment, which is correlated to the PC market worldwide, will likely be flat. Emerging markets are growing. The business segment is entrenched and still growing. Consumer sales are flat to down.

These trends are expected to continue in 2012, with Windows revenue projected to grow around 2-3%. This growth decline includes unfavorable comparisons from 2011, as Windows 7 enters the late stages of the refresh bell curve. Windows 8 should be released in late 2012. Conservative expectations for 2013 include modest growth rate from the upgrade cycle. Optimists project incremental growth, with some traction in the tablet market. The Windows division drove 27% and 45% of fiscal 2011 revenues and operating income respectively. Operating income might drop a little in 2012 from launch activities surrounding Windows 8.

Cloud computing threatens the Office franchise, Microsoft Business Division ("MBD.") This threat just isn’t realistic looking out two years. Most of Microsoft’s business is in the enterprise, while the early Cloud adoption is driven by retail and small business. Whether the Cloud represents an opportunity or a decelerator beyond 2013 is yet unclear. What is clear is that this division is entrenched and in a strong cycle. MBD generated 32% of total company revenue in fiscal 2011, growing 21% over the previous year. Operating profits were robust, growing at a similar rate. The comparisons next year won’t be quite as favorable in the second year of the Office upgrade cycle.

Company guidance is for low double-digit growth in 2012. Investors should note that most of this business has already migrated to multi-year license schemes, providing much better forecast visibility. At the end of fiscal 2011, Microsoft reported $8.2 billion of MBD unearned revenues deferred, representing about 30% of the forward guidance. Microsoft also reported unbilled revenue under contracts totaling $18.5 billion. The MBD represents a significant share of these contracts, though the average length of these contracts isn’t disclosed. It’s unclear how much of forward guidance is represented in these contracts, but it appears reasonable to assume that it’s a significant percentage.

MSFT has failed in the smart phone market (Entertainment and Devices). The good news for value investors is that this issue is largely irrelevant. It’s pretty easy to see lost opportunities historically in this market, but today’s reality is that the downside is baked in. They have no base despite heavy investment spending. If the Nokia launch provides traction, the upside adds value to what currently exists. The Entertainment and Devices division earned 13% of company revenues in fiscal 2011, up 11%.

After years of investment in Xbox and phone, this division has finally become a profit contributor. In fiscal 2011, operating profit grew 90%, or 15% of revenues. Xbox has an entrenched position, with 57.6 million cumulative units shipped. Investors should know that the Xbox consoles, similar to most gaming companies, are sold at a loss. Profits follow from game titles sold into the base. Following the Skype acquisition and the early success of Kinect, this division should contribute nicely going forward, assuming no upside from phones. Company is guiding for mid-teens growth in 2012.

Steve Ballmer is inadequate as CEO. The CEO’s job is primarily to drive performance and value creation for shareholders. Therefore, I’ll focus on performance and value and revisit this sentiment in closing.

It’s also worth remembering the number of times over the past that similar concerns were voiced. Some of the more notable issues include:

  • Linux will eliminate the need to buy Windows. Sound familiar? Linux was launched in 1991, and by the launch of Windows 95 many were seeing the end for Microsoft.
  • Windows Millennium and Vista were poorly designed and buggy products, proving development is best done by smaller teams. No argument here. Ultimately customers skipped upgrade cycles, waiting for better products which slowed revenues. The releases of Windows XP and Windows 7 were much better and have led to improved performance this decade.
  • Microsoft Bob and “Clippy” were not only bad, but irritating products. True, but they were mostly retail efforts, which ultimately didn’t lead to any lasting impact.
  • Netscape has won the browser wars. As has happened many times before, Microsoft eventually fixed issues in Explorer and grew to over 80% share. Those who foretold their demise were proven incorrect. Now Explorer has lost some market share to Chrome and Firefox, in part driven by the antitrust actions. No one seems to believe this decline will have any significant operational impact.
  • Zune’s failure is a leading indicator for Microsoft’s franchise decline. The product failed, but the conclusion was overstated. Zune launched in 2006 and was killed in 2011 without ever gaining any traction. During this period, earnings per share increased from $1.20 in fiscal 2006 to $2.69 in fiscal 2011, despite a recession in 2008 and a soft economy for much of 2011.
  • US and EU antitrust lawsuits are distractions that will hurt Microsoft. Not much to add except that now Google is getting the attention and Microsoft is still performing well.
  • The Skype purchase was way overpriced, indicating that Microsoft is terrible at acquisitions. It is too early to say how much truth there is to this concern. Investors should know more after 2012, but it’s currently hard to see how this changes the outlook negatively. Some would argue any "overpayment" was justified because it was made with overseas cash. I don't find that argument compelling personally and will wait to see how they integrate the intellectual assets the purchased
  • Investing in gaming and the launch of Xbox (2001) was a huge mistake. Competitors are too entrenched and taking market share will be too expensive. Time has proven Microsoft right with this one. In the earnings press release for September 30, 2011, Microsoft announced that they shipped more Xbox consoles than anyone else for the ninth consecutive month. The entertainment and devices division is growing nicely and has become a profit contributor after absorbing investments in the smart phone market.
  • Long history of failure in search. This has been a long road, and the likelihood or timing of return on investments is unclear. Progress been made though. The U.S. search market share for Bing has increased from 9.4% to 14.7% over the past 2 years. If you include the Yahoo search powered by Bing, the total is 27%. Traffic acquisition costs are significant, resulting in operating losses in 2012. Monetizing the traffic through more effective ad revenue generation needs to be a priority. I wouldn’t count Microsoft out yet, but, again, this appears to be a potential upside rather than a risk at this point. The heavy investment spending is already in the historical results as well as the guidance.

This recurring theme is similar to IBM 30 years ago. There always seems to be a long list of reasons why dominant old technology companies are on the verge of irrelevancy. Consider comments made by Greenlight Capital Inc. President David Einhorn. He was quoted last May as saying that Ballmer's "continued presence is the biggest overhang on Microsoft’s stock.” Nice headline that led many pundits to pile on, becoming even more bearish on the stock. What goes unsaid, however, is that Einhorn continued buying stock. According to 13F filings, Greenlight Capital owned 9.1 million shares, 14.8 million shares, and 15.2 million shares as of March 2011, June 2011, and September 2011, respectively. Why was Einhorn buying despite his statement? His rationale in the article was “Microsoft trades at a remarkable discount. Microsoft is not getting credit for its achievements and prospects."

The following table provides some key trends during the past decade. Since I believe value is ultimately derived from cash generation, let’s start with free cash flow (“FCF”). In 2002 and 2006, FCF was down 7%, from $13.7 billion to $12.8 billion. Growth resumed during the second half of the decade, leading to FCF in 2011 of $24.6 billion. Next, look at stock repurchases net of new issuance (“net buyback”). Though some investors argued for better use of company cash, the impact was significant and beneficial. Microsoft reduced the number of shares outstanding from 10.8 billion to 8.4 billion. That decrease of 22% combined with increased earnings drove an increase in EPS of almost 300% to $2.69 in fiscal 2011.

Operationally, Microsoft exhibited significant improvement over this period of time. Revenue growth was solid. Operating earnings growth was better. FCF generation was better yet. And EPS growth was outstanding. Next, consider the trailing price earnings (“PE”) ratio. During this period, the PE multiple dropped from 35.4 to 10.2. The pendulum has clearly swung, and, as is commonly the case, likely too far. The multiple in 2002 seemed way too high for a company generating flat earnings. Now the trailing multiple appears way too low. It should be noted that the table below calculated the PE as of the earnings release date or approximately 30 days after fiscal year-end. Since then the stock has continued to sell off due to macro concerns and the Intel guidance, resulting in a PE of 9.4 as of December 30, 2011.


FCF ($M)

Net buyback

% of FCF

Shares (M)







33 %








29 %








5 %








31 %








133 %








134 %








49 %








55 %








40 %








37 %





Take a look at the next table. There are several interesting trends to consider. First is the increase in FCF as a percentage of the share price. Over the past decade, the underlying cash generated per share of stock has increased from 5% of the price to almost 11%. Next, consider the dividend payout trend and resulting increase in yield from 0.3% in 2003 to the current forward dividend yield of 3.1%. Finally, investors should evaluate coverage to determine the safety of the dividends and repurchases. For fiscal 2011, the dividends represented only 21% of FCF.

In the table above, you can see that the net buybacks totaled 37% of FCF. Combined, the 58% seems quite safe. It should be noted that a significant percentage of Microsoft cash is earned and sitting overseas. Should Congress decide to act on a repatriation holiday, it could significantly benefit shareholders. Absent that, it will act as a ceiling to significant increases contrary to those that call for a doubling of the current level.


Share price Y/E

FCF $(M)

FCF per Share


Dividend payout

Div % FCF





$ 1.28

5.1 %






$ 1.38

5.1 %


6 %





$ 1.24

4.4 %


13 %





$ 1.47

5.7 %







$ 1.27

5.3 %


28 %





$ 1.66

5.3 %


24 %





$ 2.01

7.7 %


22 %





$ 1.79

7.6 %


28 %





$ 2.55

9.9 %


21 %





$ 2.94

10.7 %


21 %






In closing, consider the question posed by Mr. Einhorn and many others. Has Steve Ballmer performed so poorly that he represents the biggest overhead on the stock? Mr. Ballmer was promoted to CEO in January 2000. This analysis period, therefore, seems timely. There have been many product disappointments, notably Zune, Vista, and smart phones. Most would argue, however, that his legacy should be tied to stock price. The stock has definitely underperformed this decade, but is that truly his fault?

A CEO should be held responsible for long-term shareholder value creation as opposed to realization. When Mr. Ballmer took the reins in 2000, investors were buying this stock with a PE multiple of over 50, knowing it had a flat growth outlook and no dividend. Value investors would argue that was the time to sell not to buy. Compounding that decision by selling when the values are most compelling is the only thing that would make it worse.

Disclosure: I am long MSFT.

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