By Brooks Woolson
Few products elicit as much emotion as computer software, particularly operating systems. There are Mac people and there are Windows and between them lies an abyss no one can cross. Despite the intense rivalry, Microsoft (NASDAQ:MSFT) fans have been forced to admit Apple's (NASDAQ:AAPL) superiority in the mobile market. With almost zero presence in the market, there's been very little for Microsoft fans to brag about. That's all about to change. Microsoft announced its release preview will be available in the first week of June. Release previews occur three months before the product is released to manufacturing. If manufacturing begins on-schedule in October, Windows will be released just-in-time for the lucrative holiday shopping season.
Windows 8 will be a revolutionary release for the company. Microsoft will release three versions of the new operating system, two compatible with Intel's (NASDAQ:INTC) x86 processor architecture, nearly universal in PCs, and one compatible with ARM Holdings (NASDAQ:ARMH) and its ARM processor design. The release of Windows onto the ARM microarchitecture is meant to capture sales in the smartphone market. ARM Holdings has control over 95% of the smartphone and tablet processor market. On the other hand, Intel has zero presence in that market. Its first move into ultra-mobile computing will come in the upcoming release of Atom-powered phones in the Chinese market. Windows 8 is Microsoft's attempt to jump into the ultra-mobile market as well and, though it will run on desktop computers, it is designed with the smartphone user in mind.
Microsoft stock trades for $32 per share with a trailing price-to-earnings ratio of 11.78 and a forward P/E of 10.59. The company has earnings per share of $2.73 and recently raised its dividend to $0.80, bringing its yield to 2.50%. In the trailing twelve months, Microsoft had revenue of $73.03 billion and its first-quarter 2012 revenue was 6.00% higher than 2011. Its net income in 2011 was $23.15 billion, up 23% from $18.76 billion in 2010. It has $58.16 billion in cash and short-term bonds on debt totaling just $13.15 billion.
Windows 7 has impressive sales figures. 525 million licenses sold in just over two years, which is the fastest adoption rate for a Microsoft operating system. Sales of Windows 7 are still relatively brisk. Another 75 million copies have shipped since Microsoft announced its 450 millionth sale at the September 2011 BUILD conference. Large corporations are committed to upgrading from Windows XP and staying with Microsoft. This is the impetus behind continued Windows 7 sales. For the large firms that have already begun the process of upgrading from Windows XP to 7, it does not make sense to suddenly abandon 7 for 8. In contrast to 7, Windows 8 is totally new direction for Microsoft and it has already warned corporate users that there are likely compatibility gaps present. While this may be fine for consumers, businesses can't afford to have sale or database software suddenly become incompatible. Windows 7 won't take a bite out of the new operating systems sales anyway, as Windows 7 does not run on smartphones and new PCs will ship with Windows 8 as soon as it is released.
Windows smartphones will hold 16.6% of the ultra-mobile market by 2015. Tablet PC sales will close in on 250 million cumulative units shipped by that year. Smartphones will top 1 billion accumulated sales that same year. Considering that only 67 million tablets and 469 million smartphones have been sold to date, Microsoft has a huge opportunity before it. Based on the sales numbers, we can see that there are about 183 million remaining tablet sales and 531 smartphones to be sold before 2015. Punch those numbers into your calculator and you will find Windows 8 running on 30.4 million tablet PCs and 88.1 million smartphones by that year. Taken together, Microsoft will sell 118.5 million copies of windows into this market segment alone, desktop and laptop sales are excluded here.
Windows 7 Home Premium currently sells for about $100 per license and, though this is just speculation, Windows 8 will probably cost about the same. This means the new operating system will bring $11.85 billion in additional revenue for Microsoft. Microsoft's profit margin is 33%, so $3.91 billion will be added to Microsoft's bottom line by its ultra-mobile platform. The company will continue to see sales in the desktop segment of the Windows market, so this represents additional income, not a replacement of what Microsoft already has.
Under this scenario, Microsoft will have net income of $27.25 billion, or earnings of $3.60 per share. For simplicity's sake, let us round the price-to-earnings up from 11.78 to 12. At that earnings multiple, the share price will cross $43 in 2015, 34% higher than where it is right now. If you buy the stock today, you will realize 11.33% annualized returns over the next three years. That's a clear win for investors and this stock is a must-own.
I believe that Microsoft has taken to heart the lessons from the failure of its Vista platform in 2006. The company no longer releases operating systems that are essentially rough drafts to the public. Executives at the company have, in my opinion, finally grasped how the older strategy diluted the value of the software giant's brand. In addition, I believe that Windows 8 will be a much more stable platform than previous versions. Without getting too technical, it continues the process that Microsoft started with Vista, shaking out support for older technology to ensure rock-solid support for new hardware and software. Through its innovative .NET framework, the company has created an easy-to-use and common platform for software engineers to develop products for Windows. When Windows 8 takes the mobile market by storm, its apps ecosystem will thrive because of the relative ease of developing a product with .NET. Microsoft won't have to incur the cost of developing an app ecosystem for its operating system, and a rich portfolio of products for Windows 8 will drive sales. Better still, for PC users who don't like its Metro UI, it will be easy to switch back to the classic version of the desktop.
Microsoft stock is a great buy because it is underpriced based on the clear growth potential it has. On a price-to-earnings basis, Microsoft is 32% cheaper than Apple, which trades at a multiple of 17.28. Windows 8 will be well-vetted before it hits the market, so I believe the risk of a flop is low and the chance of a pop in the stock is high. Microsoft is cheap at these levels and would be a great addition to your portfolio.