Are Glorious Days Ahead for Microsoft?

Jack is back with further commentary on Microsoft (MSFT). For background, read the most recent two articles under the MSFT label. Here's Jack on the free cash flow margin of safety:

From Reuters, we find that Microsoft has produced:

12.50% 5-year avg revenue growth
24.16% 5-year avg earnings growth
20.26% 5-year avg ROE

The interesting thing is that growth has accelerated in the last two years. How come? Perhaps because of the $6 billion for research and development spent in 2006 and $7 billion in 2007. These items compromise earnings in the short run but are a mechanism for this relentless growth. At this rate (24%), earnings currently double every three years, and in 13 years the company will earn as much as its current market capitalization in a single year. If the P/E were to remain the same, this means the share price will go up 17 times in 13 years. If Steve Ballmer keeps doing what he is currently doing, I have no doubts about MSFT reaching that level of earnings.

When Bruce Berkowitz invests in a stock he likes to think "of the worst things that could happen. What if a natural disaster, an attack, a dirty bomb, what if financing dries up, etc.". So what happens if Microsoft is incapable of growing forever? Thus Microsoft is essentially producing free cash flow [FCF] at the rate it earns at the present time, to eternity. Its current FCF yield is approximately 7%. But hold on, what is the point of R+D and growth CAPEX when there is no more future growth?
So adding back the R+D into FCF, we add the after tax R+D (7Bn * 0.7) = 4.9Bn back into earnings. What is the picture now? FCF yield doubles to a little more than 14%. That's a neat package to have every year.

Of course Microsoft faces intense competition in the market it is in. However the lack of erosion in its incumbent business (for 25 years!) means that its core earnings are very unlikely to change. Growth may be compromised in certain areas (such as search marketing, etc.), however, Ballmer has shown that he is still capable of increasing earnings at an increasingly rapid rate.

The only problem in my mind is MSFT generates too much cash and management does not know how to allocate it. (This is why ROE has fallen from historical averages of 50+% to 20+%.) I gave a great sigh of relief when MSFT cancelled its bid for Yahoo (YHOO).

This looks like a pro-Microsoft day here, so I'll pass along comments from Justin, prefaced with his caveat that he thinks "Microsoft is a dinosaur" and that they "may have made a fatal mistake in not doing enough with the internet." Nonetheless:

 

But there are a few business segments in which Microsoft is still innovating. They are beginning to introduce a surface computing device that is simply awesome:



And in the long Microsoft tradition of stealing ideas from Apple (AAPL), they are beginning to introduce multi-touch technology into other consumer devices. I think multi-touch -- along with voice recognition -- will be the next major revolution in user interfaces, the same way the graphics user interface replaced text-based inputs. Look at this:



And as you pointed out, the X-box is doing really well. There are actually a lot of young kids who think of Microsoft as a really cool company that makes games like Halo.

If all this planning for a better future has a good chance of delivering a better future to Microsoft shareholders, why then hasn't the share price risen to reflect the strengthening business? Jack is right that earnings have been growing. Because the P/E has been shrinking, however, the share price hasn't budged.

Is everybody just wrong about the glorious days ahead for Microsoft, or are they onto something? If the future is Apple stealing Microsoft Windows share with its computers and Microsoft Exchange share with MobileMe, and Google (GOOG) stealing Microsoft Office share with Google Docs and preventing Microsoft from ever gaining any meaningful hold in internet search, then investors are onto something. If Microsoft can innovate into new markets or keep its existing market dominance relevant and growing as Jack contends, then investors are missing a great bargain.

Which do you think is the case?

Comments

[Archman Inv...:]

It depends on what you think glory days mean?
If you are looking for a stock that might return 100% or so, over the next decade or two, sure you might be happy. You ofcourse would have to make a fairly large investment to make that 100% return worthwhile.

But lets look at reality.

The company has been minting money for years, billions upon billions in quarterly revenue, yet the stock has done very little, and is actually at the same level it was back in 1998.

The company has a 250 billion dollar market cap with over 9 billion shares outstanding. Unlike a company that is 1 billion in market cap with 150 million shares outstanding, MSFT can no longer exponentially expand its market cap to deliver the sort of returns necessary to make any sort of small investment worthwhile. It's called the laws of large numbers, and it has nothing to do with what the company earns and everything to do with the underlying dynamics of the amount of shares outstanding, the current market cap, and the amount of monies needed to move the share price up.

Americans save very little as it is, so the amount invested in MSFT to receive a substantial return in the stock over the coming decades would have to be significant.

I would rather own a profitable, increasing revenue company, that has 150 million shares outstanding, 1 billion in market cap, that has the potential to rise 1000% to 11 billion market cap.

If MSFT market cap was expanded by 250 billion dollars the return would only be 100%. Regardless of what you hear in the media, if you are under 50 years old, mega cap companies are NOT where you want to be if you expect your money to grow at a significant, inflation beating pace. And I am not talking about gambling in tiny micro cap companies. The larger small caps and mid caps are where you want to be.

I missed my chance to own MSFT back in the early 90's and on, so congrats to those that made money.

You couldn't pay me to invest in MSFT, GE, etc now.

Net, net, those stocks are stable, but they are not going to make you wealthy going forward (nor have they made anyone wealthy over the past 10 years)

I rest my case.

2008 Jun 12 07:52 AM

[jimmy smith:]

i think the point with MSFT is that it is deeply undervalued right now.

you're looking at the difference between a company and its stock. you can have a great company (AAPL) but whose stock is already pricing in perfection, and thus does not offer a very good future expected return.

MSFT is, right now, +30% undervalued. you add in the dividend and the growth (15% for 2009) and you have an excellent expected return.

2008 Jun 12 10:37 AM

[Archman Inv...:]

jimmysmith:

MSFT may be undervalued right now and yes, could offer a 30% plus return, that is ofcourse you time it exact and get that whole 30% return.
Then what? Hold? Sell?

My point was more for the long term investor.

Anyone under 50 years old who wants their money to grow substantially must be invested in mid cap stocks as a means to create wealth. Mega cap stocks, even those with somewhat above average yield, are not going to make the average american (who saves very little) wealthy over the next 30 years.

Just as the folks who have owned mega cap stocks for the past 10 years. Other than XOM, which finally caught up to and surpassed its mega cap brethren, mega cap stocks have been and will continue to be forever dead money. I certainly would not want another 10 years to go by to suddenly realize you are running out of time.

2008 Jun 12 12:27 PM

[SingHash:]

Jack writes...

"However the lack of erosion in its incumbent business (for 25 years!) means that its core earnings are very unlikely to change."

I'm thinking of a company that was dominant -- absolutely, unassailably dominant -- for about 25 years. Big, powerful, and the only place to be if you really wanted to do serious computing.

Unfortunately, their business practices landed them in a bit of hot water, and they spent over a decade under intense legal scrutiny. It came to the point where legal caution stifled agility. When new, disruptive technologies emerged, the company was pummeled, decimated, and marginalized.

Eventually, they reinvented themselves and recovered pretty well -- but the paradigm had changed, and there were lots of new, more interesting places to work.

The company was IBM; the time span was 1960 - 1985. Microsoft -- which itself was instrumental in IBM's near-death experience -- is doing a lovely job of following a similar trajectory.

The best thing Microsoft could do for its shareholders right now (and I am one) would be to shut it down, liquidate its assets, and return the money to its shareholders.

2008 Jun 12 01:21 PM

[KenC:]

You do make some interesting points about the numbers; however, when you talk about specific products, I start to shake my head. The Surface table is a solution looking for a problem. Multitouch for Windows 7, it's hard to see how that could apply to anything much larger than the niche tablet market. Voice recognition, Bill Gates has been touting that it would be the way, the majority of us would navigate our PCs in 5 years, and that was over 10 years ago. And, the Xbox? It's been the 4th best selling console in the US since January, after the PS2 and PS3 and Wii. They just announced May sales and yes, again they trail.

Even if your numbers seem to point one way, perhaps the market is being influenced by the lack of excitement about products like the Surface, Multitouch, Zune, and Xbox360; not to mention the lack of leadership from Steve Ballmer and the decidedly poorly handled Yahoo! buyout. How can a buyout be a good idea to compete with Google, and then not be a good idea?

2008 Jun 13 12:28 AM