Microsoft: Skip Vista, Buy the Stock?

In the last week I’ve reviewed Microsoft’s (MSFT) strategy with respect to the acquisition of online advertiser aQuantive and the partnership with social networking site Facebook.

Those articles serve to provide context for examining Microsoft’s investment merits, that is, whether one should buy the stock at current prices. After smashing analysts’ estimates in the last quarter, the stock has found legs and new enthusiasm, and trades in the mid-$36s. Net of cash, that represents roughly 23x earnings for a company that has averaged a 25% return on equity in the last decade. Every year in that time has seen the company generate more than $6 billion in free cash flow as well, so Microsoft offers a degree of consistency in a tech world known for quickly chewing through companies without viable long-term plans.

Google (GOOG) has been heralded as the Microsoft-slayer on a number of fronts, and with the Google Docs app the company is promoting, many are worried that Microsoft’s main cash cow – its Office software – is being targeted. The thinking goes that Google’s offering Docs at $50/user/year, it can squeeze Microsoft’s spending on R&D and related areas, ultimately allowing Google to surpass Microsoft in other areas. This is far too much of a stretch connection at the current time, however, as Google Docs still has mainly entry-level functionality that will limit its appeal. For the time being, Microsoft’s most important business appears safe.

Closely following MS Office in importance is the Windows operating system platform. While the Vista product and launch was far from perfect, the natural adoption and upgrade cycle in businesses provides immense benefits to Microsoft as the natural favorite, particularly among corporations. Yes, sales of Apple (AAPL) Mac products have been growing quickly and that will mean Windows will have marginally lower adoption rates than launches of old, but Macs still have a single-digit market share and this bodes well for Microsoft. To put it another way: a 1% market share gain is a 12-15% boost for Apple, but only a 1.1% loss for Microsoft.

These two segments (Client for Windows and Business Division for Office) account for more than half of revenues and nearly all of operating profit; so their continued success is vital to the overall health of Microsoft.

The question with a company like Microsoft is often ‘how do you move the needle?’

In this case, I believe Microsoft is pursuing a good strategy by leading with several online initiatives while still offering reasonably dynamic software solutions.

To lead with the Online Services Business [OSB], something good is happening at MSN and that could be exactly the kind of spark Microsoft needs to show it can mass-monetize the online world. I realize the time series is still limited and there is much to prove, but in terms of incremental gains a 25% month-over-month jump is huge for a site the size of MSN Video. More natural consolidation should take place – likely at the expense of AOL and MySpace – and that looks to benefit the larger and faster growing players, of which MSN is now second behind the YouTube/Google juggernaut.

How will this help OSB? Traffic growth will translate to additional advertising dollars, and I’ve said that I expect the aQuantive acquisition to help Microsoft drive somewhat higher advertising rates, which could be an underappreciated consequence of that acquisition. Further, OSB will likely be a huge beneficiary of the massive influx in online advertising dollars that will be moving online in the next five years – upwards of $20 billion. OSB has seen minimal growth in the last two years and FYE2007 saw total revenues of $2.5 billion, so I’ll be looking for explosive growth from this segment in the near future as a number of factors listed above should start to come together. The 25% year-over-year revenue growth in the last quarter was a start, and once that starts flowing to the bottom line I expect it to be a high-ROIC segment for Microsoft.

For the more general growth in Client and Business Division services, the main driver will be PC unit growth, which is estimated to be about 10% in 2008. Because those two divisions average an operating margin near 70% and there is a good deal of operating leverage, earnings should grow in the low to mid double digits as long as PC unit shipments stay around 8-10%. Obviously there is some potential upside depending on the growth in OSB, and Servers aren’t irrelevant, but between 12-15% should be a reasonable near-term forecast. Thomson consensus is 12.4%, and we’ll go with that.

The next disputable variable in this valuation is the discount rate - using the Capital Asset Pricing Model [CAPM], I arrive at a rate of 8.215% with inputs of:

Rf = 3.1425%, average rate of the 1- and 3-month T-Bills

b = 1.35, from Yahoo Finance

Rm = 6.9%, earnings yield of S&P 500, plus dividend yield

Where r = discount rate, Rf = risk free return, b = Beta of security, Rm = expected market return

Substituting for:

r = Rf + b(Rm-Rf)

…yields that 8.215% answer.

The important question here is “does this make sense?” Given that this falls in the 7-9% range that the conventional wisdom asserts will be the long-run return from U.S. stocks going forward, it seems reasonable and we’ll work with that figure going forward.

With that discount rate, we can take the inverse (1/.08215) to get the FCF exit multiple of 12.2x, which is what we’ll use to value the terminal year cash flow and avoid trying to make estimates too far out. Microsoft currently trades for 21x FCF, so that is more than conservative and one could arguably go higher.

Finally, adding in Microsoft’s net cash of $21.5 billion – roughly equal to net tangible assets – gives us a total value of $30/share, or 18% less than the current stock price. If that aforementioned exit multiple gets bumped up to 16x, or about the average S&P multiple, then the valuation comes in at $36/share, meaning the stock is fairly valued.

The net result is that MSFT doesn’t look like a bargain of a stock, but it probably shouldn’t be. The firm is a consistent cash producer with about as wide a moat as can be found in the tech sector. While there is no margin of safety and thus the stock isn’t a great investment, I believe it should match to slightly outpace the general market over the next two years.

Disclosure: none

Comments

[Palm man]

Based on history, OSB has restructured almost every quarter. Is this imminent? Do you think this will help or hinder progress?

[MartinLowenthal]

Good call. I was tipping MSFT from $26 all this year and recently after Merrill downgraded. Check all the commentary at www.lompie.blogspot.co... or at Trading, Investing and a look into the future.

[Tom B]

MSFT will probably be up if you look at a 1 year horizon; down if you are a 5 year investor. Vista is inhibiting thier earnings growth and Win 7 (if ever finished) looks like yet another case of lipstick on a pig-- still not UNIX. And the developer tools will still suck. People HAVE to get wise to this nonsense eventually.

AcQuantive will never make a penny; it's a play against GOOG . MSFT is NOT a company with the competance to go tete-a-tete with Google.

XBox will continue to bleed cash.

Online services? You joke. From a company with ZERO security credibility?

Windows Mobile will die a slow death. It's not even as good as RIMM or Symbian or Palm-- how can it keep its already meager market share versus the iPhone?

The MARGINS on Windows and Office will be stretched: in the 3rd World because of LINUX; everywhere else, because of Apple.

[SingHash]

The small points of market gain for AAPL have immense leverage, and I believe JC is mistaken in dismissing the corresponding (very small) lost points for MSFT. Just a the "network effect" helped MSFT achieve dominance, the _unwinding_ of the network effect may be difficult to reverse.

Here's roughly how the story goes: when an influential stakeholder uses a Mac, it sends two signals. First, it becomes acceptable for other people to also have one. Second, business associates will have to adopt a greater degree of interoperability. Both of these phenomena lead to an accelerated unwinding of the network effect.

Certainly, a balance point will be reached -- AAPL's identity hinges on being slightly 'outside'. However, the blanket dominance of the monopolist will be broken, and people will use either platform (or Linux, or Solaris, or...) _because they want to_, and not because the herd requires them to do so.

Of course, I could be wrong. I sure was wrong when I bought equal-valued lots of MSFT and AAPL in late 1999!

[Tom B]

"Here's roughly how the story goes: when an influential stakeholder uses a Mac,"

The biggest drag on the Mac right now are the old DOS guys in Enterprise who subscribe to the Cult of Windows. Get a few Fortune 500 CEO's demanding a corporate upgrade to Mac, and MSFT will be very 1990's. Like beanie babies.

[Brian Croner]

Microsoft did an alright job on Vista, all things considered.