Microsoft Corp.
1. Company Summary:
Microsoft Corporation develops, manufactures and licenses a broad range of software products and services, most notable of which is the Windows operating system and its Office suite. It operates in five segments: Windows, Server and Tools, Online Services, Business, and Entertainment and Devices. It also designs and sells hardware, including the Xbox 360 gaming console and the Zune MP3 player.
2. Strengths and Weaknesses:
a) Strengths
- Capable Management: Strong growth in Revenue, Operating Income and Net Income in 3, 5 and 8 year periods combined with an increasingly strong Return on Equity, despite tough economic conditions and intense competition (See table). Over the last 8 years, Equity has declined (due to buybacks) from 52,180 to 46,175 while earnings have increased 5,355 to 18,760!
- Favourable Point in Product Cycle: In the last three years, the Windows OS line and Office Suite have accounted for on average ~56% of Revenues and the Windows and Business (Office) Divisions have accounted for on average ~33% of Operating Profits. These software products have now been refreshed with Windows 7 and Office 2010, so we are looking at a new product cycle of upgrades, at a time when IT spending is increasing due to a strengthening economy and companies resuming capex that was delayed over the last several years (Source: Gartner – forecast 5.1% increase in IT Software spending for 2010).
- Shareholder friendly: MSFT has a strong history of dividends and share buybacks, having returned more than $170 billion through repurchases and dividends since 2000 and is in the middle of a $40 billion buyback allowance running through 2013 (Source: Microsoft).
|
|
3 Year |
5 Year |
8 Year |
|
Revenue (CAGR) |
6.9% |
9.4% |
10.4% |
|
Operating Income (CAGR) |
9.3% |
10.6% |
14.3% |
|
Net Income (CAGR) |
10.0% |
8.9% |
16.9% |
|
ROE (Average) |
42.1% |
40.6% |
29.1% |
b) Weaknesses
- Overly reliant on two products (See Strength #2 above) with high competition from new entrants which employ business models that differ significantly from that of Microsoft. The efficacy of the competition’s efforts to disrupt Microsoft’s dominance in these two markets is not clear, though Microsoft does appear to be positioning to defend against these attempts (e.g. Microsoft recently released Office365 to defend against inroads being made by Google Documents and has positioned itself with Microsoft Azure to take advantage of the trend toward cloud computing).
- Microsoft operates in industries that are characterized by large, well capitalized competitors. Although it has not been seen yet, the presence of high competition generally leads to declining returns on equity to more normal levels.
3. Valuation:
In estimating the value of the firm’s earnings power, I used the trailing four quarters as revenue, averaged 10 years of expense ratios to arrive at a sustainable no-growth EBIT. As a no growth perpetuity, I use CapEx = DepEx and Working Capital as fixed. My resulting value per share is $28.51, or 14% higher than it is currently priced.
4. Investment Thesis:
Given the conservatism built into these calculations, I feel confident that Mr. Market has misjudged Microsoft. It appears that Microsoft is being priced as less than no-growth perpetuity with the same free cash flow generating characteristics. Additionally, even if Microsoft’s share price improves to $28.51, this would represent a P/E multiple of just 13.5, still well below its competitors. Any growth in Microsoft’s multiples to a level nearer to its competitors represents just that much greater of a return.
This is a company with a wide moat (though, possibly at risk over the coming decade) a strong management, solid operating growth statistics and a history of allocating capital in a shareholder friendly manner.
Author Disclosure: At the time of publication, the author DOES have a position in securities of this company.
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