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Malcolm Brown
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Young Australian investor living in New York looking to make a career change to equity research. Currently undertaking CFA Level 1 exam.
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  • Microsoft - An Under Appreciated,Overlooked And Misunderstood Portfolio Staple

    Overview

    As often happens in the market, a stock can have an identity crisis in the sense of what type of stock it is and to what type of investor it is best suited to. Sometimes this identity crisis can be temporary in nature, other times it can last for years and years without a clear determination one way or another. To me, Microsoft falls squarely in the latter category. For years now, really since Bill Gates stepped down in 2000, Microsoft has had an identity crisis - is it a growth stock? An income stock? Value? Is it old, behind the times and in decline? It seems that there are plenty of investors who fall in each of these camps.

    One of the many reasons I enjoy researching and following companies is to attempt to uncover those that are first of all, overlooked by the wider market for various reasons and secondly, and most importantly, offer me the greatest opportunity to generate income over time In the case of Microsoft, I firmly believe that a large segment of the market has it wrong when it comes to what type of investment it provides the owner. While it appears that the patient, long term, buy and hold-type investor, is a dying breed these days (just read the newspaper or watch the many talking heads infected with 'short-termitis' on CNBC); for those that still subscribe to these tenets, continue reading; this analysis is for you.

    Looking for income? Look to Microsoft

    As I mentioned above, the beauty of Microsoft is that the mainstream views it as an old, behind the times business in a declining market (PCs). For the intuitive investor however, one knows that this thinking couldn't be further from the truth. Put simply, Microsoft offers the income investor a number of qualities that most every company would kill to have:

    Huge free cash flows

    Generous stock buybacks

    Reliable and growing dividends

    Capital efficiency

    Deep moats

    While none of these characteristics are ground breaking to certain companies, they are often overlooked by the market or ignored completely. Of course, this presents an excellent opportunity for the enterprising investor. Let's take a closer look at each of these.

    Huge free cash flows

    Microsoft's free cash flows are incredible. Like other stalwarts of industry, Microsoft produces huge free cash flows consistently. Using the simple method of operating income minus capital expenditure, Microsoft's free cash flows for the past 5 years are as follows.

    Year ending June 30

    2013: $24.5B

    2012: $29.3B

    2011: $24.6B

    2010: $22.0B

    2009: $15.9B

    To put these numbers in perspective, Microsoft earns more free cash flow than any other S&P non-financial company except Apple. These numbers are truly impressive. Microsoft's free cash flows are enough to fully extinguish its total long term debt almost 3 times over! Or how about this number: Microsoft earned 0.33 cents of free cash flow for every $1 of sales in 2013. Truly impressive.

    Generous stock buybacks

    Of course, as an income investor, naturally one wants to see these huge free cash flows being used for shareholder friendly activities. One such activity is buybacks, of which Microsoft is a big proponent of. Last October, Microsoft announced a new buyback program to the tune of $40B. While this number disappointed some investors as it did not increase from the previous buyback of $40B from 2008, this is still an impressive figure. For 2013, Microsoft purchased $5.3B in stock - roughly 20% of its free cash flow! The other side of the argument to this, is of course, that Microsoft has had a tendency to spend some of its free cash flow on dubious acquisitions, thereby reducing the potential for more shareholder friendly moves (see below for areas of concern). Nevertheless, one can't argue with the facts - Microsoft has taken $110B worth of shares off the market in the last 9 years, reducing shares outstanding by 22%. While not the purpose of this article, it is important to note that share buybacks are not always the best use of free cash flow due to many company's tendency to overpay for their shares. However, given Microsoft's average PE ratio of 14.45 over the last 10 years as opposed to the S&P500's PE ratio of 16.1, it would seem hard to argue that Microsoft has been overpaying for its shares.

    Reliable and growing dividends

    It is this area that is most prominent in the eyes of income investors and therefore I won't spend much time extolling the attractiveness of Microsoft's dividend policy. Over the last 10 years, Microsoft has increased its dividend from 0.08 cents a share to 0.28 cents a share as of the last quarter in 2013. That is an increase of 250%. While impressive, the beauty here is that the company can do much better. As mentioned above, Microsoft spent roughly 20% of its free cash flow last year on buybacks. Coupled with the $7.4B spent on dividends, Microsoft dished out about 50% of its free cash flow to shareholders in 2013. Fantastic right? Well, yes. But for a company with Microsoft's characteristics, it can likely do better. And it is here that the common meme of a behind the times, declining business runs into trouble. With the company's dominance in providing enterprise software and services together with its still modest dividend of 2.8%, one can conservatively deduce that Microsoft's dividend will very likely continue to increase at its 10 year historical average of 25% annualized.

    Capital efficient business

    As primarily a software business, Microsoft is an incredibly capital efficient business. While it has spent roughly $10B per year over the last three years on R&D, a very respectable number even for a technology company, it's capital expenditures have equated to approximately 9% of operating income over the past 5 years. These numbers are one of the primary reasons why Microsoft is able to generate its huge free cash flows. For a company with $77B in revenue for 2013, this is an impressive number. Microsoft has been able to increase revenues year after year while keeping capital expenditures low. This should be music to the ears of all investors, let alone income investors. A truly capital efficient business will generate a return on assets of more than 10% while paying out more than 30% of gross profits to shareholders. A company that can exceed these thresholds warrants a much deeper investigation by income investors. Suffice to say, Microsoft passes the test with flying colors. It earned a return of 21% on assets (net income divided by total assets) over the past 10 years and returned 36% of gross profits to shareholders (calculated as dividends and share buybacks divided by gross margin) over the last 10 years. Not bad for a company supposedly in a declining PC business that is behind the times!

    Deep moats

    A favorite characteristic of Warren Buffet, a deep moat is what essentially ties everything outlined in this article together. I finish with this characteristic because, without it, Microsoft would not be the income investment staple it is without it. Plain and simple. As mentioned at the beginning of the article, the common misconception of Microsoft in the market is that it is squarely in the center of a declining PC business. While I am not going to delve too deeply into this issue, it is missing the point at the end of the day. Microsoft's true core business and thus its moat, is around providing software, servers and services to enterprise customers. Apple last year received around $10B in sales to enterprise customers. Microsoft received this amount in Q4 2013 alone. Don't get me wrong, Microsoft should not ignore Apple, but it is clear that Microsoft will remain the dominant player in the enterprise market place for years and years to come.

    Looking at the numbers, Microsoft derived roughly 50% of its 2013 revenue from its commercial division with $12.6B. This hardly illustrates a company that is dependent on the whims of the PC market. Looking further, Microsoft only derived $5B in revenue, or roughly 20% of overall revenue from its devices and consumer licensing division, which includes Windows. While the decline in the PC market undoubtedly affects Microsoft's overall revenue numbers, it is a far cry from the overall market consensus of it being a big chunk of Microsoft's business.

    Areas of concern

    Despite these many under-the-radar positives, it is prudent to take a sanity check on some of the areas of concern for Microsoft. The elephant in the room of course, is the company's haphazard track record of acquisitions. The latest and certainly the most high-profile in years, is the acquisition of Nokia's handset business. By now, everyone knows the background story - Microsoft spent $7.2B (!) to acquire Nokia's handset business in an attempt to take on Apple/Samsung. It appears Microsoft is not content to license its mobile software and wanted to 'follow the leader' in having control of both the hardware and software. While analyzing the merits of this acquisition warrant an entirely separate article, in short, it appears that this acquisition is a poor use of the company's cash, and not in the best interests of shareholders.

    Another big acquisition bomb was the 2007 buyout of data advertising network aQuantive for $6B - an 80% premium (!). And that was all she wrote. Microsoft wrote off nearly the entire value of aQuantive in 2012, effectively giving up its challenge to Google. As discussed further in the section below, (what to watch for) Microsoft has had a disturbing tendency over the last several years of attempting to "wear too many hats". Such a tactic should make shareholders wary - overpaying for acquisitions, or acquiring companies that don't fit Microsoft's core business depletes free cash flow that could be put to better use in buybacks or increased dividends for shareholders.

    Outside of its acquisitions, another areas of concern surrounds Microsoft's mobile strategy. It is clear now that Microsoft missed the boat in the explosion of mobile software and smart phones, and it lags well behind Apple and Samsung in handsets as well as Android in software. Now that Microsoft has settled on Satya Nadella as its new CEO, investors should keep a keen eye on the company's mobile strategy and how it will integrate the Nokia business into the parent company. Drawing on the "wearing too many hats" theme, a sound argument can be made that Microsoft is throwing money down a rat hole at this point trying to enter the mobile hardware business.

    One final point on this topic - while these are areas of concern to shareholders, it is here that the importance of the company's fortress balance sheet shines. Its huge free cash flows affords Microsoft the opportunity to have misses. The risk is that Microsoft takes its cash for granted and spends like a drunken sailor on poor acquisitions and thereby squanders opportunities to deploy the cash in more shareholder friendly ways. With a new CEO now in place, investors should keep a close eye on the company in the coming months and years for indications of a change in culture in this regard.

    What to watch for

    With a new CEO in place, the main areas to watch for in the coming months and years will be any changes that may be instituted. The list below is not exhaustive, but are likely to be the biggest things to watch for in the intermediate future:

    A change in culture concerning focusing on its core business. Will it move away from "wearing too many hats?" Look to see if Microsoft introduces a wearable device similar to Samsung's watch/Apple iWatch for instance

    A change in culture concerning acquisitions

    The integration of Nokia's handset business

    The growth of cloud services

    Will the new CEO spin off non-core assets i.e. Xbox, Bing?

    Conclusion

    To the layman, Microsoft has had an identity crisis for years. The enterprising investor knows that Microsoft is a company that has a number of enviable attributes that only the bluest of blue chip companies can attest to having. This has created an opportunity for prudent income investors who are looking for a staple company to add to their portfolios at a fair price. It is rare, especially in today's market, to find a company that is so widely misunderstood with so many shareholder friendly attributes that is largely overlooked by the market. If one tunes out the noise and peels back the onion, they will find that Microsoft is an ideal candidate in an income investor portfolio.

    Disclosure: I am long MSFT.

    Feb 10 12:46 PM | Link | Comment!
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