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Microsoft Corp. (NASDAQ:MSFT) has been an underperformer in the stock market for more than a decade. The stock price has stayed basically flat for more than 10 years, hovering mostly between $20 and $30/share. This is despite Earnings per Share growing from 0.69 in 2003 to 2.00 in 2012 (an annual growth rate of 11%).

There are several reasons for this, most of which center around concerns that the Windows and MS Office ecosystems are heading for a slow inevitable decline. A second important reason often cited is that Microsoft has largely missed the whole mobile revolution being dominated by Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Samsung (OTC:SSNLF), and others.

Personally, I have a lot of experience with Microsoft products as an IT consultant for a large global firm, and I strongly believe the company is here to stay. In fact I believe the company is really only 1 or 2 positive catalysts away from a nice positive bounce in the stock price for patient shareholders. Below I have outlined my thesis, evaluating the company using my 10 point system.

Note: For more information on my investing philosophy please check out my profile or website. I use a 10 point evaluation system to analyze companies. The two most important criteria in my system are the "magic formula" developed by Joel Greenblatt, and whether or not the business/industry is within my "circle of competence". Each of these criteria has a maximum score of 2 points in my system where as the other criteria I will evaluate in the article are a maximum of 1 point each. A perfect score is 10 points. I advocate to consider buying any company scoring 8 or higher.

Magic Formula

The first criteria I typically check in my system is whether the company is a magic formula screen stock or not.

For those who are not aware of what the "magic formula" is, this is a stock ranking system created by value investor Joel Greenblatt. The methodology was first described in Greenblatt's The Little Book that Beats the Market. Details about his methodology including the screens can be found at his website. I won't go into detail here on the methods described in his book, but the basic premise is to find companies with a high earnings yield (measured by EBIT/EV) relative to the Return on Invested Capital (ROIC) that they produce. So you are screening for "good" companies at "bargain" prices. If you check out the website above you can sign up (for free) and view the current top 50 stocks over $50 million in market cap using this methodology. You can also change the minimum market cap to whatever number >$50 million you want to get a unique selection of companies. Following my philosophy, I check the top 50 stocks over $50 million and the top 50 over $1 billion as a starting point for stocks to analyze.

Microsoft is currently on the 50 over $50 million screen. Using my methodology I therefore give this criteria a full score of 2 points.

Interesting as well to note is that Microsoft is by far the largest company on this screen (market cap of $248 billion), whereas commonly many of the companies which appear are small caps less than $1 billion in market cap. This shows just how profitable Microsoft is, with very high margins being maintained at such a large size. This is unique and a testament to the company's strong competitive moat (more on this in the Moat section below). Returns on Assets and Equity (ROA & ROE) are also impressive at 15 and 27% respectively.

Score: 2pts

Circle of Competence

I believe it's important that before diving into the details of assessing any business, you first need to take a step back and honestly evaluate how competent you are to make these judgments. I determine whether a particular business is inside my "circle of competence" by giving this a point value between 0 and 2, using the following methodology:

  • First I go to one of the popular finance websites and I read the Profile description of the company. After reading it one or two times, if I still have no clue what the company does or industry is about, then I would score this a 0. In 99% of cases, this lack of understanding that I have of how the business/industry works would cause me to stop looking further into the company.
  • If however the profile description is simple and easy to understand from my perspective, I will score this criteria already at a 1 out of 2.
  • I'll give a 1.5 if I feel I have some relevant practical experience in the industry to have sufficiently developed my own detailed perspective on it.
  • A top score of 2 I'll only give if I really have a deep understanding of the company through personal experience with it directly.

In the case of Microsoft, I've scored this a 2. I am a full time IT consultant for a global firm, and I regularly deal with Microsoft products. Currently, I am involved in a global rollout of Microsoft Sharepoint technology, which I feel has given me some unique insights into the growing prospects of the company. I've given more detail on this below in the "Moat" section.

Score: 2pts

Business Prospects

The current breakdown of Microsoft's business is as follows. (Financials are sourced from the July 2012 10-K).

DivisionRevenue (millions)Operating Income (millions)% Change in Operating Income 2011 to 2012
Windows18.3711.46-6%
Servers and Tools18.687.4318%
Online Services Division2.86-8.12*given as not meaningful
Microsoft Business Division23.9915.717%
Entertainment and Devices Division9.590.364-71%

Here I've given some further details as described in the company's 10-K filing on the reasons for change in operating profits as compared to the previous year:

  • The Windows division income decreased in the most recent year primarily due to extra R&D expenses related to Windows 8, as well as decreases in revenue. This I believe is not very surprising as the overall market for growth in new PC shipments has remained quite stagnant recently.
  • The Servers and Tools Division is growing strongly, with a continued adoption of the Microsoft ecosystem in enterprises.
  • The Online Services Division continues to struggle, with the large operating loss mostly attributed to the recent goodwill impairment charge for the aQuantive acquisition which didn't work out as planned.
  • The Microsoft Business Division is growing steadily. As discussed in more detail below in the "Moat" section, I've provided some practical examples which explain why this is the case.
  • The Entertainment and Devices Division, which includes Xbox, Skype and Windows Phone, had a growth in revenue but decreases in profit due to changes in the product mix sold and joint venture costs with Nokia.

As we can see from this table, the results are somewhat mixed for Microsoft - the enterprise focused divisions (Server&Tools and Business) are growing strongly. The other divisions have had various difficulties, some more severe than others (Online Services a particular weakness).

I do however think there are several near-term catalysts all of which have a potential large positive impact on the company's prospects:

  • New XBox in 2013/2014
  • Windows 8 being launched in 2012
  • Windows Mobile finally gaining traction in 2013
  • Windows Surface Tablet gaining market share in 2012/2013

I won't go into details on each of these potential catalysts here. The point I want to make is simply that with all of these new big products being released in 2012 and in the near future, if any one of them or a combination has any meaningful success in the marketplace, it will be a positive catalyst to propel the stock price.

If you combine this fact with the sure and steady growth of the enterprise focused divisions, it leads me to conclude that this is a compelling time to invest in the company. The downside risk is very minimal compared to the growth prospects.

For these reasons, I have given this "business prospects" criteria a full score of 1 point.

Score: 1pt

Shareholder Friendly

With this criteria, I look at what actions the company management have taken that are directly supportive to shareholders. Microsoft continues to deliver cash to shareholders in the form of dividends. There is a forward dividend yield of 3.10%, a payout ratio of only 38%, and insider ownership still remains relatively high for such a large company at close to 10%. In addition, there is a consistent history of raising the dividend over the past 10 years. The company recently raised the quarterly payout from $0.20/share to $0.23, an increase of 15%.

Based on this evidence cited, the company is clearly friendly to shareholders and on this criterion, I can score a full 1 point.

Score: 1pt

Moat

Many articles have been written on Microsoft describing its competitive advantages. In this section, I want to focus on some particular aspects which I have personal experience with while working in the IT industry.

The first point I want to make is that many "techies" have been anti-Microsoft for years. I myself was one of them in the mid-2000s as a student. A lot of developers despised the proprietary nature of Microsoft and felt the only reason the company was so strong and profitable was due to its past successes. Many still feel this way. Not helping this notion was the failure of Windows Vista, which really gave the company a negative perception in popular opinion circles.

But here's the thing - after leaving the university and starting to work in the real world, I realized just how dominant Microsoft is. I also realized that real techies only make up a small portion of the corporate workforce, and the majority of employees want and need to use technology that they are familiar with and is usable for their everyday tasks. The usage of Microsoft products to do just these kinds of tasks is so embedded in organizations that this will not change anytime soon. Recently, I worked at a client which was spending more than 2 years to roll out Windows 7 to 60,000 end users. You would think after the flop of Windows Vista, maybe they would seek alternatives? But think for a moment - what corporation is going to spend millions of dollars converting their workforce to use the Apple Mac Operating System for all employees or some other less familiar option? This they will not do because of the sheer risks involved in the loss of worker productivity. Also, it is imperative that other necessary Microsoft products can still be used seamlessly with the operating system (e.g. Word, PowerPoint). No corporation I've worked for would consider doing it. The risks are just too high with the current alternatives. It will be years before any other viable alternative to Windows could realistically be adopted by the average workers on a mass scale.

Currently, I work at another client that is rolling out Microsoft Sharepoint 2010 (social collaboration and document storage and management software) to more than 100,000 end users. This project also is taking more than 2 years.

In the case of both these project examples, they cost in the tens of millions of dollars. When corporations spend this kind of money, they are really committing to the software vendor. The switching costs to later on choose another competitor's product are huge - not only would a software migration project take another perhaps 1 or 2 years, but potentially tens of thousands of people need to be re-trained.

These examples show how Microsoft clearly is not going away, and in fact I argue it has some compelling advantages over competition in the enterprise space. This I believe is particularly evident for enterprise collaboration & communication technologies. My current client uses Microsoft products for: email (MS Office), conference calling (Office Communicator & Lync), document management (Sharepoint), Office 365 in the cloud, databases (SQL Server), and social collaboration (Yammer). In fact with recent purchases of Yammer and Skype, Microsoft is quietly taking full control of the enterprise social collaboration space. 85% of Fortune 500 companies use Yammer. As of 2011, 70% of the Fortune 500 used Office Communicator/Lync. There is also compelling reasons for companies to continue to invest in the Microsoft suite of collaboration products, as they integrate seamlessly with MS Office. This has a big competitive advantage which increases worker productivity.

The examples above clearly show how strong an advantage Microsoft has, and this greatly minimizes the downside risk of the business.

Based on this analysis, I therefore score my competitive "Moat" criteria with a full 1 point.

Score: 1pt

Conservatively Financed

With this criteria, I look at whether there are any risks to the financial health of the company. A quick glance at the numbers will tell you right away that there is no questioning the strength of Microsoft's balance sheet. The company has $62 billion in cash and less than $13 billion in debt (the debt/equity ratio is only 0.1925). The current ratio is a healthy 2.6. Without needing to look further, I am confident there is minimal financial risk and I can score this criteria with a full 1 point.

Score: 1pt

Predictable Earnings

With this criteria I look at how predictable and dependable a company's earnings have been in the past. Generally I do not like to invest in wildly cyclical businesses where in my opinion it is notoriously difficult to time when a good entry point might be.

As stated at the beginning of the article, in the past 10 years, earnings per share have grown consistently, with an average increase of 11% per year. Interesting to note here though is that earnings per share dropped from 2.69 to 2.00 in the most recent year. This was due almost exclusively to an impairment charge in its money losing internet division. The impairment was from the loss of value in an older acquisition that didn't work out well (aQuantive).

This is an example that shows Microsoft is vulnerable to some fluctuation in earnings, as some acquisitions of internet or other software companies might turn out to be poor additions to company value in the long run. With uncertainty continuing in the weaker parts of the company, such as the internet division, I've given this criteria a half score of 0.5 out of 1. I cannot ignore that there is some risk that this will happen again in the future.

Score: 0.5pts

Margin of Safety

To calculate whether the current price constitutes a sufficient margin of safety against what I feel is the intrinsic value of the company, I have performed a simple DCF, using one my favorite DCF calculators. I compare the potential return of an investment to that of US treasuries, the ultimate "risk free" return. Since long-term treasury rates are at all time lows, (1.65% for the 10 year at time of writing) I use as a minimum a discount rate of 6% in order to be more conservative.

  • Current Earnings: $2.00/share
  • 10 year average growth of Earnings: 5%
  • Growth after 10 years: 0%
  • Discount rate: 6%
  • How confident are we in our earnings estimate? : 75% confident

With these conservative assumptions, I have calculated an intrinsic value of $37/share. I have assumed a growth rate that is less than half of the previous 10 years. With a current market price at time of writing of $29.66, this is margin of safety of about 20%, with a potential upside appreciation of 25% (37/29.66). To give this criteria a full score of 1 in my system, I look for a margin of safety where I am confident enough that the potential upside is 50% or greater. In this case it is less, so I will score this 0.5 out of 1.

Also note I have taken the assumption here that earnings for the next 10 years are starting at today's level of $2.00/share. Assuming the company does not have any similar goodwill impairments in the coming few years like which has just occurred, the growth rate will actually be more significant. So this further solidifies my confidence in my estimates and future prospects of the company in terms of earnings growth.

Score: 0.5pts

Total Score: 9pts.

Conclusion: Microsoft Corp is a buy.

To summarize my position overall:

Although there are some concerns with Microsoft in relation to the mobile revolution and inevitable decline of its core business, I believe this is completely unwarranted as the company is really only 1 catalyst away from a positive jump in share price. With the launch of Windows 8, further dominance in the enterprise space, the upcoming release of a new XBox, and the recent Surface tablet, there are plenty of chances for this to happen. In the mean time, there is a good dividend with minimal downside risk. So what is there not to like?

Disclosure: I am long MSFT, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Microsoft: Still Strong In The Enterprise And Plenty Of Catalysts For Big Gains