I recently wrote an article examining repatriation tax impacts (or rather, lack thereof) of the recent NDS acquisition by Cisco (CSCO). My fellow SeekingAlpha contributor Tradevestor commented, bringing up an issue that's often raised by investors:
But something (someone) about CSCO and MSFT bothers most of the investors - Chambers and Ballmer.. The company and stock have gone nowhere under them in the recent years
After further discussion, Tradevestor and I decided to collaborate and write about Microsoft (MSFT) together. Here, I'll be analyzing the bull case for Microsoft, and in Tradevestor's article, he'll be analyzing the bear case. Hopefully, after reading both of our articles, you'll have a thorough understanding of the arguments both in favor of and against Microsoft.
I'll start off with Tradevestor's thesis: that the company and stock have gone nowhere. Let's start with the stock price. At first glance, I'm seemingly caught with my pants down. A quick look at the chart reveals that Microsoft's stock has pretty much been as flat as a pancake for the past decade.
But here's the thing: the stock wasn't flat because of mismanagement. Au contraire. Over the past decade, MSFT has grown annual EPS from roughly $0.50 a share to well over $2.50/share. (Note that the recent dip is due to a non-cash write-down, and thus should be ignored. Ignoring the write-down, MSFT earned 67 cents per share for the quarter, shattering analyst consensus of 58 cents per share.)
You'd think that a company that grew earnings by a factor of 5 would be rewarded by a skyrocketing share price, right? Not necessarily. Rather, ten years ago, Microsoft was viewed completely differently. It wasn't viewed as a "boring old tech company" as it is today. (More on that viewpoint later.) Back then, Microsoft was an exciting growth company, somewhat akin to the recent wave of "social" internet companies like LinkedIn (LNKD), Facebook (FB), Groupon (GRPN), and Zynga (ZNGA). What do 2002 Microsoft and the current-day tech companies have in common? Premium valuation. Back in 2002, Microsoft traded at a P/E of over 40, which slowly compressed down over the course of the decade. Therefore, the stellar EPS growth didn't translate into stock price gains. Shareholders in Facebook, Zynga, Groupon, and LinkedIn - take heed! This is exactly what your future looks like. Strong P/E growth but nowhere to go for the stock.
Today, however, the overvaluation problem is far behind Microsoft - in fact, the opposite is true. Given a share price that's hovering around $30 and adjusted TTM earnings of say $2.73 (eliminating the write-down), Microsoft trades at a dirt cheap TTM P/E of under 11 - a significant discount to the market as a whole. Factor in Microsoft's net cash of $51B, which works out to roughly $6 per share, and Microsoft's P/E ex-cash is a mind-bogglingly cheap 8.8. (Please note that due to daily price fluctuations, this figure may be off by a decimal point, but it's reasonable enough to get the idea.)
Over the last decade, then, Microsoft has shifted from an expensive growth stock to a bargain bin value stock. Oh, yeah - it now also offers a solid .20 cent quarterly dividend that's good for a >2.5% yield.
Given all the above factors, it's no wonder value investor Don Yacktman holds a significant stake in Microsoft. And as for Microsoft's management? Yeah, they've made mistakes (cough, aQuantive, cough). But that doesn't necessarily mean you shouldn't like the company:
"We didn't buy Microsoft because of its management. We bought it in spite of it." - Don Yacktman in an interview with Kiplinger
So on the off chance that Microsoft finds a competent manager, it'll be poised for even more success.
Breaking Down Microsoft
Microsoft has gotten a bad rep because of the whole "PC is dead" myth. According to shortsighted commentators, the Apple (AAPL) iPad means PCs are dead, and with them, companies like Microsoft, Cisco, Dell (DELL) and Intel (INTC) are as good as bankrupt.
But on closer inspection, that isn't true. Despite an appallingly soft macro backdrop, Microsoft's still trucking along, registering single-digit top-line growth in developed economies and double-digit growth in emerging economies. Check, MSFT bears.
Let's add in one more factor. The revenue growth mentioned above occurred as revenue from the flagship Windows OS dropped 13% from $4.7B in FY '11 to $4.1B in FY '12. Why? Um, Windows 8, which was unveiled about a year ago, immediately leading to a nasty case of the Osborne effect - seriously, who in their right minds upgrades their OS when a new one is just around the corner? That's like going out and buying an iPhone 4S today when you know the iPhone 5 is coming out in a few months.
Trefis believes that the release of Windows 8 and Office 15 will serve as a catalyst for both revenue and stock price. Trefis has a price target of $41 on Microsoft, which I think might actually be a little conservative - $3 EPS would represent a mere 10% increase in adjusted earnings, and with a more market-like P/E of 15, Microsoft could hit $45. In any case, Microsoft has significant upside. Check out the full Trefis model of Microsoft's price. In any case, Microsoft has significant upside from current prices. And I believe that right there is checkmate.
Keeping in mind that Microsoft is a $250B company with lots of moving parts, it would be futile to try and analyze each individual cog in the Microsoft clockwork in a single article. Nonetheless, I'd like to hit two of the highlights.
- Tablets and Apple
Ever since the I'm-a-Mac-I'm-a-PC commercials, it's almost impossible to discuss Microsoft without someone bringing up Apple. Over the past few years, Apple has certainly been a major cultural phenomenon as well as a fantastic investment. Nonetheless, it's important to not get tied up in a logical fallacy. Just because Apple's doing well doesn't mean Microsoft can't. In fact, as I'll examine below, some of Microsoft's strategies may end the iPad's reign as tablet du jour.
One of the main complaints about tablets like the iPad is that for power users, they're less useful than a salad spinner. They're not significantly more powerful than a smartphone, but they're a lot bigger and can't fit in your pocket. Thus, they're the worst parts of a phone and a laptop in one shiny $699 package.
On a seemingly unrelated note, the main problem facing non-Apple and non-Google entrants into the tablet/smartphone market is that they don't have Apple's "ecosystem," which is techie code for all the pretty shiny apps. With Apple's iOS and Google (GOOG) Android taking the lion's share of the market, and legacy providers like Research in Motion (RIMM) also taking a nibble, it's hard to convince app developers to create applications when there aren't a lot of potential users.
In one fell swoop, Microsoft tackles both of these problems. Windows 8 is a unified OS that works on tablets and desktops alike. This means two things: 1, Windows tablets can run REAL programs like Office rather than just Angry Birds, and 2, developers making programs for Windows are now making programs that work equally well on tablets as well as desktops. Since Windows has over 65% of market share on all devices (see below) compared to roughly 10% for the iPhone/iPad duo, the advantage of writing for Apple users just got flambeed. Unfortunately, I've run out of chess sayings at this point, so I guess this is checkmate again.
All in all, the Windows 8 tablet-PC unity is a solid strategic move by Microsoft, and one that shareholders in Apple and Google should pay attention to - it removes part of the existing "ecosystem" advantage. Windows 8 also benefits providers of Intel Ultrabooks, like Dell, as many of these Ultrabooks will provide touchscreen functionality and bridge the gap between "tablet" and "laptop," combining the best features of both.
That brings me to the next major factor I'd like to discuss:
- The changing face of software
Long gone are the days of going down to Best Buy (BBY) and buying a boxed copy of Adobe (ADBE) Photoshop. The new hot thing is the "cloud," with everyone from Cisco to e-tailer Amazon (AMZN) trying to cash in. Consumers are increasingly demanding cloud solutions, meaning Microsoft and other software companies have to rethink how they offer software.
As I examined in my article Microsoft's Outlook Is Ahead Of The Game, Microsoft seems to be making a lot of progress in this front. To borrow a quick quote from a great ZDNet article about Microsoft's strategy:
Putting two and two together, it's clear that Microsoft is making a huge bet on a fundamental change in the software industry, one that changes the way people buy software. Instead of boxed copies that connect to cloud services, it's working towards a future where users and IT departments buy subscriptions to cloud services, and get desktop software as part of the package.
It's a future that's less software plus services and more services plus software. It really is a bet-the-company strategy, one that changes revenue models and customer and partner relationships.
Microsoft to world: Apple isn't the only innovative company out there.
There are many other facets of Microsoft as well, including the Bing search engine and Xbox gaming platform, but I'll save those for another article - this one's gotten quite long already. Hopefully, my analysis of two key themes (valuation and innovation) has shed some light on why I view Microsoft in a positive light.
Tradevestor has some great counterpoints in his article, so if you haven't read it already, I'd recommend you go do so now. As always, reader comments are appreciated - after reading my article and Tradevestor's, what do you think of Microsoft? Are you a bull or a bear?