The Bulls' Case For Microsoft

Apr.24.12 | About: Microsoft Corporation (MSFT)

By Denis Hurley

Compared to the likes of Apple (AAPL) and Google (GOOG), Microsoft (MSFT) has considerably less consumer product star power and a reputation for being a blundering giant among more lithe and innovative competitors. However, the world's largest software developer maintains long-established positions of dominance in many of its core businesses. Moreover, recent and upcoming product launches have been well received in preview releases and have considerable potential to drive revenue and income growth through 2012 and well into future years. At its current valuation and ahead of the introduction of Windows 8, Microsoft appears to be an undervalued and attractive long-term investment.

Company and Industry Overview

Microsoft is divided into five divisions: Windows and Windows Live (PC operating systems and related software, hardware, and services); Server and Tools (IT consulting, IT certification programs, and productivity enhancing services for IT professionals); Online Services (Bing, advertising tools, and MSN); Microsoft Business (business-related and personal productivity-enhancing software, primarily MS Office); and Entertainment and Devices (Xbox, Skype, Windows Phone). Microsoft's Windows operating system (in its various incarnations) has consistently dominated the OS market for desktops, laptops, and netbooks. Web analytics companies (such as StatOwl, StatCounter, and Net Market Share) estimate that the Windows operating system boasts a current market share of around 90% of all personal computers and 80% of all computing devices including the mobile and tablet markets in which Microsoft is a serial laggard behind Apple's iOS and Android. The dominance of Windows, the company's flagship product, is buttressed by a dizzying array of additional productivity-enhancing applications as well as accompanying services. Microsoft does an excellent job tying various products and services together (sometimes in conflict with trade regulations in various countries around world) by building its applications to be most effective when combined with (some would say dependent on) other products and services.

In recent years the company has steadily diversified beyond its traditional core of PC-bound software products and services toward a more varied approach to software and service sales involving seamless flexibility over multiple computing devices, provision of multiple levels of services at varying prices, and a new focus on cloud-computing services. The company launched Office 365 - a cloud-based business computing service including the MS Office Suite among other productivity enhancing applications - in June of 2011 in attempt to capitalize on the accelerating trend toward business adoption of cloud-computing services. The product was generally well received and represents a significant step away from traditional software sales and toward greater reliance on cloud-computing services. Microsoft's cloud-based services are highly customizable to individual customers' needs, allowing any given business to adopt them for any combination of purposes and at any pace. In its 2011 annual report, the company noted particularly strong sales of cloud-based services and consumer products.

Recent acquisitions and partnerships have also expanded Microsoft's product offering and demonstrated its commitment to growing and diversifying its revenue base. Among these are a partnership with Yahoo in online search; a mobile phone partnership with Nokia (which recently unveiled the well-received Lumia smartphone); and the acquisition of Skype.


Valuation Snapshot:

LTM CY 2011 (CY) 3 Yr. Avg. 5 Avg.
Price/Earnings 11.15 10.27 12.58 15.04
Price/Book 4.05 4.10 4.90 6.06
Price/Tangible Book 6.06 5.50 7.22 8.72
TEV/Unlevered Free Cash Flow (LTM) 11.53 9.52 12.17 14.50
TEV/EBITDA 7.28 6.13 7.24 8.78
Click to enlarge

Source: Capital IQ
- LTM - last twelve months
- CY - calendar year (as opposed to fiscal year, which for MSFT ends in June)
- Forward P/E based on analyst estimates of earnings over the next twelve months
- April 13, 2012, is the baseline date for LTM numbers

MSFT is currently trading near the upper end of its 52 week range (23.65-32.95) but its average P/E ratio of 11.11 over the last twelve months from April 13, 2012, is very low compared to previous years (see above) and considerably below the sector average of just over 21. Average P/E in fiscal 2011 was a decade low 10.27, despite record net income as well net income growth topping 23% and revenue growth of just under 12% over the previous fiscal year. Microsoft's average price/book ratio for the twelve months through April 13, 2012 is 4.05 - a decade low and well under its 10 year and 5 year averages.

Historical values of price/tangible book, TEV/Unlevered FCF, and TEV/EBITDA all indicate falling valuation multiples (see previous table) in the midst of strong and steady revenue and income growth (with the exception of fiscal 2009, largely due to the global economic crisis and the deep recession in the United States). MSFT's TEV/EBITDA ratio is also below its peer group average of 9.4. Moreover, based on current market cap, TEV/EBIDTA is projected to fall to 7.2 for MSFT's fiscal 2012 and fall further to 6.5 and 6.0 in fiscal 2013 and 2014, respectively. Forward P/E is projected to be steady at 11.4 in fiscal 2012, falling to 10.2 and 9.2 in fiscal 2013 and 2014, respectively.

In sum, the company appears undervalued: 1) given near decade low current valuation metrics; 2) based on a comparison of these same valuation metrics to those of MSFT's peer group and; 3) given current projected future earnings and revenue growth.

Snapshot of Recent Growth

12 Months To Dec 31, 2011 Fiscal 2011 Fiscal 2010 % Change 12 Months to Dec 31, 2011, over FY 2011 % Change 2011 over 2010 % Change 2010 over 2009
Revenue 72,052 69,943 62,484 8.0% 11.9% 6.9%
Gross Profit (Margin) 55,032 (76.4%) 54,366 (77.7%) 50,089 (80.2%) 1.2% 8.5% 8.2%
Op. Income 27,409 27,493 24,690 -0.3% 11.4% 17.7%
Net Income (Margin) 23,468 (32.6%) 23,150 (33.1%) 18,760 (30%) 1.37% 23.4% 28.8%
Basic EPS 2.79 2.73 2.13 2.2% 28.2% 30.7%
Diluted EPS 2.69 2.10 1.62 29.6% 28.1% 17.7%
Click to enlarge

Source: and Capital IQ
- All numbers in millions of dollars ($) USD except for all percent (%) figures and for EPS figures in the bottom row; percent figures rounded to nearest tenth.
- Microsoft's fiscal year ends on June 30, halfway through the calendar year.

Revenue growth has been increasing since 2009 and accelerating in the second half of the 2011 calendar year (the first half of MSFT's fiscal 2012). Gross margins have slid recently on weak PC demand and lower margins on hardware products, such as Xbox, relative to margins on software products. Gross profits, operating income, and net income have grown rather sluggishly in CY 2012 but should be bolstered by higher margins after the introduction of Windows 8 (which will affect the company's fiscal 2013). EPS figures have increased markedly and have exceeded net income growth due to reductions in the average number of shares outstanding in every fiscal year since 2005.

Below is a breakdown of the company's recent financial performance by segment:

Financial Performance by Segment

1. Windows and Windows Live

2011 2010 2009 % Change 2011 over 2010 % Change 2010 over 2009
Revenue 19,204 19,494 15,847 (2%) 23%
Op. Income 12,281 13,034 9,790 (6%) 33%
Click to enlarge

2. Server and Tools

2011 2010 2009 % Change 2011 over 2010 % Change 2010 over 2009
Revenue 17,096 15,378 14,601 11% 5%
Op. Income 6,608 5,539 4,816 19% 15%
Click to enlarge

3. Online Services Division

2011 2010 2009 % Change 2011 over 2010 % Change 2010 over 2009
Revenue 2,528 2,201 2,121 15% 4%
Op. Income (2,557) (2,337) (1,641) (9%) (42%)
Click to enlarge

4. Microsoft Business Division

2011 2010 2009 % Change 2011 over 2010 % Change 2010 over 2009
Revenue 22,186 19,076 19,257 16% (1%)
Op. Income 14,124 11,504 11,363 23% 1%
Click to enlarge

5. Entertainment and Devices

2011 2010 2009 % Change 2011 over 2010 % Change 2010 over 2009
Revenue 8,913 6,168 6,416 45% (4%)
Op. Income 1,324 618 351 114% 76%
Click to enlarge

Source: for all of the above,
- All years refer to Microsoft fiscal years ending at the end of the 2nd quarter of the calendar year
- All numerical figures except for percent change are in millions of dollars ($) USD; percent figures rounded to nearest whole number.

The tables above indicate the relative strength of each of Microsoft's business segments. Sales in the Windows segment were more or less stagnant from fiscal 2010 to 2011 as a result of weak PC sales to consumers, which declined by 1% overall (PC sales to businesses actually grew 11% over the same period). Sluggish PC market growth combined with increased operating expenses resulted in a decrease in operating income. Overall PC sales are expected to grow in 2012 - although sluggishly due mainly to continued tablet competition - which together with the introduction of Windows 8 and increasing margins, should boost revenue generation by the Windows segment.

However, the Server and Tools division (MSFT's third largest segment) logged respectable growth in fiscal 2011 on strong enterprise sales enterprise sales. The company's Business Division (its second largest segment) logged exceptional revenue and income growth on the strength of sales of MS Office and related applications. The Entertainment and Devices Division logged the strongest growth by far with triple digit operating income growth in fiscal 2011 as a result of stellar Xbox and Xbox-related product sales growth. One black mark on the company's record is its consistently unprofitable Online Services Division, which recorded another decline in operating income, despite segment-wide revenue growth. In the final months of 2012 and future periods, the three principal drivers of revenue growth will be: 1) the release of Windows 8 and the positive effect of initial sales on sales of related products and services; 2) strength in the Business and Server and Tools Divisions due to the trend to cloud computation and; 3) continued growth in Entertainment Division sales (mainly due to Xbox products, but also potentially bolstered by mobile device-related sales).

In terms of the liquidity, the company's most recent current ratio and quick ratio are both greater than 2, indicating that the company will have no issues meeting its current obligations. Its debt-to-equity is a healthy 20%. Moreover, from the conclusion of the company's 2010 fiscal year in June 2011, through April 13, 2012, MSFT's cash and cash equivalents doubled to over $10 billion, affording Microsoft considerable maneuverability for future expansion. The company also boasts an enviable triple-AAA credit ratings across all ratings institutions, which, together with the company's low debt level and large cash cushion, afford MSFT substantial financing and investment flexibility. Finally, Microsoft offers a solid quarterly cash dividend of $0.20 (2.6% annual yield).

Update for Most Recent Earnings Release

On April 19, 2012, Microsoft released earnings results for the quarter ended March 31, 2012. In advance of the Windows 8 release later in 2012, Microsoft logged fairly strong results, although EPS for the quarter fell $0.01 to $0.60/share on the same period in 2011. Here's a quick summary of the results:

Quarter Ended March 31, 2012 % Change on 2011 Period LTM from March 31, 2012 % Change on Fiscal 2011
Revenue 17,407.00 6% 73,031.00 4.4%
Op. Income 6,374.00 12% 28,074.00 2.1%
Net Income 5,108.00 (2.4%) 23,344.00 8.4%
Diluted EPS 0.60 (1.6%) 2.73 1.5%
Click to enlarge

Source: Capital IQ;

Notes: All numbers in millions of USD ($) excluding Diluter EPS

The company's Server and Tools, Business, and Windows Divisions posted revenue gains over the same period of 2011 of 14%, 11% and 4%, respectively. Entertainment and Devices performed poorly due to a softer gaming console market than previously expected with revenue falling 16% on the same period in 2011, despite Xbox being the top-selling console in the U.S. for the 15th straight month. Online Services continued to lose money, although the division cut its operating loss over the same period in 2011.

Microsoft's results are largely in line with expectations and consistent with the company's strategy of transitioning to cloud services, as evidenced by the particularly strong performance of the Server and Tools and Business Divisions. The Windows Division also posted better-than expected revenue growth and the company noted in its earnings announcement that Windows 7 is now the operating system for 40% of enterprise desktops worldwide. The company also noted expected future strength in the coming year "[w]ith the upcoming release of new Windows 8 PCs and tablets [and] the next version of Office."


The primary risk to Microsoft's competitive position is the success of the company's transition from providing PC-bound software products to provision of more flexible and integrated cloud-computing services. In its 2011 10-K, Microsoft noted the significant risks and costs involved in implementing this transition while maintaining an innovative advantage and attracting more customers. Another significant risk is competition from both for-profit competitors and open-source providers of similar software applications. Alternative operating systems and software programs with comparable capabilities and no licensing fees could potentially be a threat to the company's business model. The threat is somewhat latent however, because open-source alternatives to Microsoft products have not been widely adopted by businesses or consumers. The company attempts to counter this risk by maintaining an innovative edge on competitors - through organic development, partnerships, and acquisitions - and providing better and more integrated software tools, complete with support services, to customers.

Some additional risks include: Failure to adequately protect corporate intellectual property rights; improper disclosure of personal data; and computing infrastructure failures that may lead to service disruptions and hemorrhaging of customers. A final and often well-publicized risk is the threat posed by government litigation and regulatory activity. Microsoft dominates the OS and productivity-enhancing software markets and ties its products together in a manner that makes Microsoft a fairly regular target for engaging in monopolistic practices. Many of these risks are simply inherent in Microsoft's business model or, in the case of regulation, fairly predictable responses to the company's dominance. Most importantly however, Microsoft's attempted business model transformation is the most significant long-term risk to the company. Successful implementation will produce substantial returns for the company and shareholders but significant missteps could have a substantial negative impact on earnings.


Microsoft is well positioned to capitalize on the trend toward provision of cloud computing services. The new Windows Phone mobile device OS - aided by a partnership with Nokia - has potential to enhance Microsoft's lackluster performance in the smartphone sector. Xbox and related product sales growth is projected to continue to show strength in future periods. Sales of MSFT's server infrastructure, as well as its plethora of business related software applications, have grown impressively in recent periods and are projected to continue to grow over the next few years.

The introduction of the latest incarnation of Windows - the faster and more flexible Windows 8 - in October 2012 has great potential to be a boon for Microsoft. Windows 8 is designed to complement the company's shifting focus toward cloud computing and allow users to synchronize settings across multiple devices. The company will also prod consumers to upgrade to Windows 8 by ending support for Windows XP - which accounts for 45% of the worldwide OS market - in 2014, more or less forcing consumers to upgrade in the near future or abandon the system altogether, which can be a costly undertaking. The adoption of the new system should also lift revenues generated from the sale of related products. Microsoft's Windows division accounts for 24% of corporate revenue - a huge fraction of which is from sales of Windows operating systems - so the potential impact of the introduction of a fresh windows system is substantial.

Conclusion: An Undervalued and Growing Giant

Based on current financial metrics Microsoft is undervalued compared to its historical valuation, undervalued relative to its peers, and appears especially undervalued given projected revenue and income growth over the next few years. The company confronts both a significant risk and opportunity in its transition to a new business model with a greater influence on cloud-computing services. One of the first major tests of the initial stages of this transformation will be the release of Windows 8 in October 2012. A warm reception of Windows 8 will bolster sales and income in coming periods - another reason to buy shares in Microsoft. But investors also have the opportunity to buy now, at historically low valuation multiples, and reap even greater returns.

Disclosure: I am long MSFT.