Has the time come to invest in Microsoft (MSFT), the ubiquitous Redmond, Washington, company we all love to hate? Microsoft is not the company it used to be and we should not expect it to be. It has long had a virtual monopoly on the operating system used by personal computers and the most widely used general office suite of applications of any vendor. I have been using Microsoft products since the days of DOS and have suffered through my share of "blue screens of death." In all fairness, the current iteration of Windows is the best yet. Microsoft is not the growth engine of yesteryear. It is, however, a cash machine.
For those folks who just woke up from a thirty year coma, Microsoft develops designs and supports software and related products. It operates in five segments: Windows and Windows Live, Server and Tools, Online Services, a Business Division and Entertainment and Devises division. It has products for operating systems for personal computers, servers, cell phones; server applications; productivity applications; it offers business solutions; management tools; software development tools; games and online applications. The company has cloud computing applications and now offers, through the acquisition of Skype, live videoconferencing.
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Microsoft's success is explained, in part, by its duopoly with Intel (INTC). In this partnership, Intel provided the microchips which powered most personal computers and Microsoft the operating system. The combination became known as Wintel. The chip market has changed particularly for cell phones. The leading cell phone chip designer is ARM Holdings (ARMH), a designer of 32-bit reduced instruction set (RISC) chip architecture. The Windows 8 operating system is designed to work on the ARM architecture as well as Wintel platforms. This capability will give MSFT greater access to the cell phone market.
The company is making a major effort to build-out their cloud offerings with products such as Bing, Windows Live, and Xbox Live. Microsoft intends to connect the dots among products such as Kinect, Windows, Windows Azure, Windows Phone, Windows Server and Xbox. They want the transition from one platform to another to be seamless.
For Microsoft's quarter ending December 31, 2011, sales increased 5.0%, year-over-year to $20.89 billion and 20.22% sequentially. Diluted earnings are $0.78 per share as compared to $0.77 for the prior year. Sequentially, diluted earnings increased 14.7%. On a trailing twelve month basis, sales increased to $72,052 million year-over-year from $66,690 million, an 8.0% increase and about 3% over FY11 sales. Diluted earnings per share increased 17.45% y-o-y to $2.76 and about 2.6% over FY11 diluted earnings per share. Free cash flow grew 9.66% to $3.18 per share as compared to $2.90 in FY11. The dividend increased to $0.72 for the trailing twelve months from $0.64 in FY11.
Sales for FY12 are estimated to range from $72,609 million to $74,824 million; the mean estimate is $73,847.1 million. This would be about a 2.5% increase. Sales are expected to grow in the $76,761 million to $82,687 million range with a mean estimate of $79,737.4 million. This would represent an increase of about 14% over FY11.
We are seeing some slippage among the several profitability ratios. Trailing ROA, ROE and ROIC ratios are below five year averages. Operating income of $27,077 million for the trailing twelve months is actually below the $27,161 million reported for FY11. Cash and short term investments skyrocketed in FY11 to $52,722 million from $36,788 million in FY10. It declined slightly in the trailing twelve months to $51,736 million. With long term debt of just $11,932 million, Microsoft is flush.
Microsoft's margins are also being squeezed. Gross margin declined to 76.4% from 77.7% in FY11 and is below the five year average of 79.4%. Similarly, operating margins contracted to 37.6% from FY11 reported operating margin of 38.8%. The operating margin is about flat with the five year average.
Microsoft has been in a fairly tight trading range for the last ten years. The argument is often made that Microsoft on a valuation basis is "cheap". With a P/E of 11X, MSFT is trading below the market's multiple. The enterprise value ratios are instructive. EV/EBITDA is significantly less than the industry median whereas EV/sales appear to be high. Analyst estimates for a target price range from $20 to $37 and have a median value of $33. A DCF estimate provided a value range of $37.50 to $45.00.
My own estimate of fair value based on EV/invested capital is about $35. The stock is now trading close to its 52-week high. The real question is whether Microsoft will again be priced as a growth company. This may be a big stretch. Microsoft is so large that each new initiative or product introduction can only have an incremental effect on sales and earnings. Microsoft has become a large-cap defensive play that pays an ever increasing dividend. MSFT is likely a good addition to a portfolio built around dividend paying stocks.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MSFT over the next 72 hours.