Microsoft: Missing the Bigger Picture

Jan.20.12 | About: Microsoft Corporation (MSFT)

INTRODUCTION

Microsoft (MSFT) continues to churn out impressive results in spite of fear the Windows division cash cow era will come to an end. The intense focus on Windows misses the traction taking hold in other business segments helping to fuel strong overall results. Revenue increased primarily due to strong sales of Server and Tools products, the Xbox 360 entertainment platform, and the 2010 Microsoft Office system.

Microsoft announced record fourth-quarter revenue of $20.89 billion for the quarter ended December 31, 2011, a 5% increase from the same period of the prior year. Operating income, net income and diluted earnings per share for the quarter were $7.99 billion, $6.62 billion and a record $0.78 per share.

We’ll take a look at the numbers then share our valuation analysis.

THE NUMBERS BY BUSINESS SEGMENT

The TTM revenue and operating income for each segment through 12/31 is shown below.

MSFT_REV_SEG

MSFT_TTM_OpINC_SEG

The steep increase in the Windows revenue and operating income from September 2009 was a result of the Windows 7 launch. The following decline is a normal pattern after a launch starts to mature but the important story is how other segments picked up the slack producing overall strong results. It is not unreasonable to expect another spike up in the Windows division’s performance when Windows 8 is launched. Windows 8 beta may be available in a month and widely available sometime in the second half of 2012. We expect Windows operating income in the range of $10-13 billion going forward. Windows is no longer an earnings growth driver but the facts are this segment will continue producing large amounts of cash for the foreseeable future.

The strength of MSFT’s consolidated financial performance is shown below:

MSFT_Consolidated

Free cash flow generation is approaching $27 billion annually. They have $52 billion on the balance sheet despite $2.7 billion in share buybacks and dividends.

MARKET PERCEPTION

MSFT has never received the benefit of the doubt where the PE is concerned. The diluted earnings per share are plotted against the PE ratio is as follows:

MSFT_PE_EPS

The market may finally be paying attention, coming to the realization that the obsessive focus on Windows amounts to tunnel vision that misses the whole picture. What do we mean by this? The operating income from the Windows division was approximately 62% of the total in 2007. This number has dropped to about 44% over the last twelve months yet the overall financial performance continues to perform extremely well.

Detailed quarterly data used above can be found here.

VALUATION

The PE remains below 11 as of this writing despite the impressive growth reflected in the Business, Server & Tools, and the Entertainment & Devices division.

Here is one fair value analysis based on the management’s long term financial performance. Fair values are based, in part, on the following: discounted cash flow, a modified Graham's intrinsic value formula and a P/E analysis. The valuation model consists of two parts.

  1. The discounted cash flow and the modified Graham’s intrinsic value are blended to arrive at a fair value.
  2. A P/E analysis based on historical adjusted values.

Fair value used is the minimum value of the two parts.

Part 1: Discounted cash flow and the modified Graham’s intrinsic value.

Longer term earnings growth estimate:

MSFT_EPS_growth

Projections (for EPS and cash) are arrived at by calculating the statistics for a trend line using the "least squares" method. This determines the line that best fits the historical data. Projected earnings growth through 2016 averages about 7.7% based on a combination of the 10 and 5 year trends. The 10 year projection is practically on top of the 5 year projection indicating incredibly consistent growth over the long term.

Analysts are even more optimistic, with five-year growth rates of 9.8% although this number has been reduced from 11.3% in July 2011. (Source: nasdaq.com)

Longer term cash flow growth:

MSFT_CASH_proj

Projected cash flow growth calculations are 8.02%; FY2012 through FY2015. As would normally be expected the trend for the three periods are not as consistent as earnings but still an impressive result.

Estimated long-term EPS and cash flow rates going forward are 7.7% and 8.03%, respectively. Running these projections through our pricing model, excluding the PE analysis, produces a fair value of $39. Needless to say, the result is sensitive to changes in these growth rates as illustrated below.

MSFT

EPS & Cash Growth rates

FV

EPS-7.7%; Cash-8.02%

$39.00

EPS-5.7%; Cash-6.02%

$37.00

EPS-4.7%; Cash-5.02%

$35.00

Click to enlarge

Part 2: P/E Analysis

The pricing model produces a PE of 12.5 yielding a fair value of $34. We consider Microsoft more of a value vs. growth stock so the PE seems reasonable given our single digit growth rates.

Final fair value is the minimum of the two methods or $34. This would also support a lower EPS and cash growth rates as shown in the above table. The stock is trading at a 13% discount at the time of this writing.

CONCLUSION

Ten years ago, MSFT was transitioning from a growth stock to a value stock. In 2001 the P/E was about 40, much too high for a company whose growth rate was trending down, although the top line has more than doubled since than (and EPS has more than tripled). Now we have a P/E of around 11, a 2.7% yield, and trailing twelve month earnings of $2.75 per share.

This company continues to be a cash cow, with $52 billion on the balance sheet. In the second quarter, MSFT repurchased $1.04 billion of stock and declared $1.68 billion of dividends.

The dividend has a history of increases and there is no reason to expect this not to continue. The only criticism here is the dividend should be higher, since this is more of a value story vs. growth ... plus MSFT can easily afford it.

PRO’s

  • P/E close to historic lows.
  • Earnings growth expected in the single-digit area (with buybacks).

  • History of increasing dividends.

  • Annual FCF in the $25-$27 billion range; more than enough to fund the dividend and stock repurchases while still adding cash on the balance sheet and/or investing in acquisitions.

  • Pristine balance sheet. (Triple A S&P rating.)

  • Future benefits from the Skype acquisition, the Nokia partnership and Office 365 adding to the growth potential.

RISKS

  • Unfavorable changes in economic conditions, including inflation, recession, or other changes in economic conditions, may result in lower information technology spending
  • significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect revenue

  • a significant amount of operating income comes from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions may result in higher effective tax rates.

  • My biggest fear: Acquisitions, joint ventures and strategic alliances having an adverse effect on the business although I’m sure they learned some valuable lessons from the Yahoo fiasco a few years back.

  • Delays in product development schedules resulting in playing catch-up as occurred in years past

Detailed annual data used in this article can be found here.

Disclosure: I am long MSFT.