Microsoft (MSFT) is scheduled to release Windows 8 in October 2012. I have not tested the demo version, but have read many mixed reviews. Windows 8 is a big change from Windows 7 and is geared toward tablet users. Being somewhat of a tech fanatic, I do keep up with all the tech blogs and there is a growing consensus that laptops will eventually be phased out for newer, more powerful tablets.
While I do not totally share this belief, I do think that computers have already exceeded the computing needs of the average user and that today's tablets can fill most of those computing needs. For example, most desktops sold today have an AMD quad core or a comparable Pentium dual core or more powerful Pentium quad core processor. Yet, software developers have barely started developing software that utilizes more than two cores.
While we can reasonably expect consumers to continue to buy tablets, the question is whether users are willing to switch from Apple (AAPL) or Android (GOOG) operating systems to a Windows system. Additionally, we don't know if desktop or laptop users will like using an operating system that is designed for touch screen.
Yet, with all the hype and news about the upcoming Windows 8 debut, our attention should be on a Microsoft application called SmartGlass.
What is Microsoft SmartGlass?
Simply put, SmartGlass could be a game changer. While Windows 8 is headed for the red oceans of the mobile and tablet markets, SmartGlass is a blue ocean strategy headed directly for your living room. SmartGlass is an upgrade package for the Xbox that will integrate video streaming and live TV through the gaming system. Microsoft has raised the bar. All the sudden, streaming video companies such as Netflix (NFLX) have a new and leaner competitor.
However, SmartGlass isn't just another video streaming application. It is much more. Microsoft disclosed at E3 that it is currently working out agreements with cable providors Comcast (CMCSA) and Verizon (VZ), which will allow you to use Xbox as your cable set top box. SmartGlass will offer a subscription service through Xbox Live, with options such as an all inclusive sports package. With cable advertising revenues down due to DVRs, Microsoft could potentially use SmartGlass to re-monetize TV viewership with ads similar to how Google places ads on Youtube.
You can watch Microsoft's SmartGlass E3 presentation here.
Why is SmartGlass timed perfectly?
- If Smart Glass takes off, it will only compliment Windows 8 tablets and Windows phones. Microsoft can use SmartGlass to its advantage to persuade consumers to buy another Windows product. SmartGlass allows users to control their television with their phone or tablet.
- While Apple is expected to release Apple TV in the coming months, it won't be able to compete with SmartGlass. Whereas Apple TV requires consumers to buy a new television, SmartGlass works with any existing TV the consumer already owns. I can envision the diehard Apple fans lining up to buy a new $1,500 TV, but your typical consumer will probably prefer to buy a $200 Xbox (assuming they don't already own one) and getting more features than the Apple TV will offer.
- Windows 8 will be equipped with the SmartGlass application and will also require subscription fees.
I am a regular Linux user and am not totally sold on Windows 8 yet. I have always preferred PS3 to the Xbox, but after watching the E3 presentation, I have decided to buy an Xbox for my living room. I don't know if Sony (SNE) will be able to answer this gaming console challenge
Before you log into your brokerage account and buy any Microsoft stock, we need to first do a discounted cash flow analysis and determine if ownership is being sold at an attractive price. To feel comfortable with the cash flow projections, I want a company to have consistent growth in owner's earnings for the trailing ten years.
Here are the owner's earnings for Microsoft Corp.
As the graph shows, equity disappeared from 2002 to 2007. From then on, equity has been trailing up along with owner's earnings. I prefer ten straight years of positive equity, but five years is acceptable.
Using cash return on invested capital, we can predict the growth rate of cash flows. The problem (if you want to call it that) is that Microsoft is just killing it when it comes to cash return. The cash return for the past ten years has been between 50% and 106% - which is abnormally high for a young up and coming company, let alone an established company like MSFT.
We can't realistically expect MSFT to grow its cash by 50%+ every year for the next twenty years, so I am going to lower the projection to about 15% in year one and work my way down to 5% for years 11 through 20 of the 20 years. From there, I discount the future owner's earnings using a 15% discount rate.
My projection is that Microsoft should be selling for $333.2B or $38.78 per share compared to the current market cap of $249B or $29.65 per share. This means that the margin of safety is of about 24% - which is just lower than the 25% that I look for.
In summary, I believe Microsoft can be bought at a fair price with a reasonable margin of safety. I don't think you will see 1,000% return on an investment in MSFT, but you will most likely see a satisfactory return, plus dividends. Microsoft is taking its company in new directions and I think that will benefit shareholders in the end.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.