Microsoft Is Slightly Undervalued

Mar.23.12 | About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) is a megacap technology company responsible for the Windows operating system, Microsoft Office, Xbox, Bing, and a slew of other products and services. It has five divisions:

  • Windows and Windows Live - Includes the Windows operating system and Windows Live services.
  • Server and Tools - Includes Windows Server, Enterprise Services, Windows Azure, Visual Studio, and Windows embedded device platforms.
  • Microsoft Business Division - Includes Microsoft Office.
  • Online Services Division - Includes Bing, MSN, and adCenter.
  • Entertainment and Devices Division - Includes Xbox, Skype, and Windows Phone.


Microsoft's stock has risen about 23% YTD, trading most recently at around $32 per share. Let's take a look at revenues and cash flows.

2007 2008 2009 2010 2011
Revenue (Mil $) $51,122 $60,420 $58,437 $62,484 $69,943
Free Cash Flow (Mil $) $15,532 $18,430 $15,918 $22,096 24,639
FCF Margin % 30.4% 30.5% 27.2% 35.4% 35.2%
Interest Expense $0 $0 $0 $151 $295
Tax Rate 30.0% 25.8% 26.5% 25.0% 17.5%
Unlevered FCF (Mil $) $15,532 $18,430 $15,918 $22,209 $24,882
UFCF Margin % 30.4% 25.8% 26.5% 35.5% 35.6%
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Microsoft is a strong cash producing company with UFCF margins over 35% in the last two years. Revenue grew by 12% between 2010 and 2011, and analysts predict 5.7% revenue growth in 2012 and 8% revenue growth in 2013. Earnings growth is predicted to be 7.96% over the next five years.

Cash (Mil $) $51,736
Debt (Mil $) $11,932
Net Cash (Mil $) $39,804
Cash/share $4.67
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As of the most recent earnings report, Microsoft has $4.67 in cash per share with about 8.5 billion shares outstanding. Debt has been increased in the last few years to take advantage of low interest rates, according to the most recent annual report. Overall, the balance sheet is very strong.

Future Growth

Microsoft dominates the PC operating system market with 76% market share, and it's market share of productivity software is currently 95%. Growth of cloud-based competitors such as Google Documents may cause market share to decline, but dominance in both of these categories, which represent a large portion of total revenue, is likely to remain intact. Microsoft currently has a small share of the mobile phone market, 4.4% in January of this year, but the recent release of Windows phone 7, which has generally good reviews, could grow that share in the future. Microsoft has partnered with Nokia to produce Windows 7 phones and certainly has the recources to push the platform. Windows 8, the newest version of the Windows operating system due sometime this year, is meant to be an OS for both the PC and the tablet. If it succeeds, it may allow Microsoft's tablet market share to increase dramatically.

Valuation

I use a discounted cash flow analysis to determine the fair value of the stock. I will project revenue to grow at 5% annually for the next 10 years and 3% thereafter. I will assume a UFCF margin of 35% and use a discount rate of 15%. This yields a fair value estimate of $33 per share. Buy targets for various margins of safety are listed below:

Margin of Safety Buy Target
10% $29.70
15% $28.05
20% $26.40
25% $24.75
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At current prices I believe Microsoft is slightly undervalued. There is much uncertainty in the future of Windows 8 and Windows phone, and if they prove to be successful, earnings could grow much faster than my projections. It will be interesting to see how Microsoft fares in the mobile market going forward.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.