Microsoft’s Depressed Stock Price Attracts Flock of Value Investors

This is the sixth in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

At the turn of the century, few observers could have possibly foreseen that Microsoft would become a favorite bargain purchase for value investors in 2010.  The dot com boom was in the process of peaking and any company even vaguely associated with software or technology traded at stratospheric multiples of earnings.

Microsoft was certainly no exception.  The company earned $0.85 per share in fiscal 2000 and traded at well over fifty times earnings when Steve Ballmer assumed the CEO position in January of that year.  While the company has increased profits at a moderate clip and reached earnings per share of $2.10 in fiscal 2010, the stock price is now at well under half of the peak levels seen in 2000 and is firmly in “value” territory trading at ten times trailing earnings when adjusted for excess cash on the balance sheet.

Bargain Valuation Not Unnoticed

Microsoft’s bargain valuation has not gone unnoticed among value investors who have flocked to the stock in recent months.  Some of the prominent investors with significant positions in Microsoft include Arnold Van Den Berg, Wally Weitz, David Einhorn, Bill Miller, and Whitney Tilson.  (For a list of fund managers currently holding Microsoft stock, click on this link to view Dataroma’s database.)

Of course, the fact that many value investors have positions in Microsoft does not mean that it is intelligent to blindly follow but it is intelligent to use the positions of successful investors to generate ideas for further independent research.  In the case of Microsoft, the value becomes quickly apparent with a brief review of the key facts.

From Cutting Edge to Stodgy in Ten Years …

We presented much of the bullish case for Microsoft in a recent article regarding Steve Ballmer and will not repeat all of the details here.  To sum up the past decade, Microsoft continued to deliver strong results but suffered a downward revision in valuation so extreme as to deliver negative returns for investors who purchased stock a decade ago.  Earnings advanced from $0.85 to $2.10 over the ten year period which amounts to a compound annual growth rate of 9.5 percent.  During the decade, the company introduced a regular quarterly dividend and paid a one-time $3.00 per share special dividend in 2004.  Profit margins have declined over the ten year period but net profit margin of 30 percent in fiscal 2010 still signals the presence of a very strong franchise. (Download Value Line’s report on Microsoft for more useful statistics.  The report is one of Value Line’s Free Dow 30 stock reports.)

The main problem facing the company is the inability of management to profitably break into a new line of business beyond the core Windows and Office franchises.  Mr. Ballmer is facing a great deal of criticism regarding the failure of Microsoft to break into an entirely new line of business that will deliver new profit streams and potentially mitigate an eventual decline in the core Windows and Office franchises.

One cannot help but compare Microsoft’s performance to Apple Computer particularly given the fact that Apple recently overtook Microsoft in terms of market capitalization.  Steve Jobs has succeeded in creating entirely new categories of products such as the iPod and iPad and he revolutionized the mobile phone industry with the iPhone.  Meanwhile, Microsoft has introduced lukewarm products like the Zune music player and disastrous products like the Kin mobile phone that was taken off the market only months after its introduction earlier this year.  Even successful products like the XBox have not resulted in large sources of profit compared to the company’s core Windows and Office business.  Microsoft has obviously failed to break into new areas successfully and, as a result, the company has taken on a stodgy image.

But Count the Cash …

Despite the well publicized difficulties facing Microsoft, the company continues to generate significant cash flow and had approximately $36.8 billion of cash and cash equivalents as of June 30, 2010 ($4.12 per diluted share).  The company generated over $22 billion of free cash flow for fiscal 2010, paid $4.6 billion in dividends, and used $11.3 billion for share repurchases.  Microsoft is clearly still a cash flow machine. At a recent price of $23.47 and a market capitalization of $203 billion, the overall valuation of the company is clearly depressed.

Microsoft is even cheaper than the “headline” price/earnings ratio suggests when one considers the excess cash on the balance sheet.  The exact amount of excess cash is open to debate, but it appears that at least half of the cash on the balance sheet could be safely distributed to shareholders.  Adjusted for excess cash, Microsoft trades at ten times trailing earnings and less than nine times estimated fiscal 2011 earnings of $2.40 per share.

If someone had told you in August 2000 that Microsoft would be available for under nine times forward earnings one day, it is unlikely that you would have believed them.

Cloud Risks Are Exaggerated

Cloud computing is a long term threat that could erode Microsoft’s Windows and Office franchises over time.  Products such as Google Docs have gained some traction, but Microsoft still controls well over 90 percent of the office market.  The slow moving conservative nature of most information technology departments all but guarantees that Microsoft will retain a very large share in both operating system and office sales for many years to come even if cloud based solutions begin to take more share.

While Microsoft was initially slow to respond to the cloud computing threat, the company has not ignored the risks entirely.  Office Web Apps and related online services are intended to directly address the threat from solutions like Google Docs.  While Microsoft may not be entirely successful in retaining share on the cloud, many risk averse companies could be convinced to stick with a known quantity.  Making a move from desktop based Office products to Microsoft’s web solutions could be seen as a more conservative approach for IT managers concerned with career risk issues.

Tablets Beyond iPads

With three million iPads sold through June 30, Apple has proven that the tablet computer has finally arrived, but it would be a mistake to assume that Apple will “own” this market.  One very surprising aspect of the iPad’s introduction, apparently even to Apple executives, has been the adoption of the device in business environments.  The Wall Street Journal recently reported that businesses are adding the iPad as a rapid clip.  Some executives are using the iPad as a substitute for laptop computers for tasks such as email, reading documents, and even giving presentations.

One of the possible reasons behind Microsoft’s recent stock price weakness is the fear that the iPad will erode sales of traditional laptop computers running Windows.  However, it is very likely that business users have adopted the iPad as a supplement to their laptops rather than as a replacement. In addition, new tablets running Windows and Android will be released in the very near future.

There are some doubts regarding whether tablets are well suited to run Microsoft’s Windows operating system.  Although Windows 7 does have touch screen capabilities, will it provide a good user experience in the tablet form factor?  One potential solution may be the upcoming Windows Phone 7 software which is scheduled for release in October.  Windows Phone 7 has received some positive reviews (click here for one example) and may be better suited for tablet devices.

While no one can predict the market shares different players will have in tablet devices once the market matures, it is very likely that Microsoft will generate significant market share given the strength of Windows Phone 7 and the relationships the company has with corporate users.


Microsoft is one of the “least loved” companies in America today.  Investors have become disillusioned by the company’s failure to break into highly profitable lines of business beyond the core Windows and Office franchises.  The emergence of highly successful products such as the iPad have generated fears that Microsoft’s moat in operating system software may be facing a more rapid decline than previously assumed.  From an intangible perspective, Microsoft is simply no longer in fashion.

Despite the negative headwinds and many real challenges facing Microsoft, the company does not deserve to trade at current depressed valuations based on its demonstrated earnings power and formidable cash flow.  Windows and Office still have dominant markets shares and enjoy high margins that validate the presence of a significant moat.  The current corporate refresh cycle will help generate record earnings for fiscal 2011 and the company is not standing still in cloud computing, mobile phones, or tablets.  A company with this profile does not deserve to trade for nine times likely fiscal 2011 earnings.

Whitney Tilson summed up the bullish case very well in a recent presentation (pdf).  Mr. Tilson assumes fiscal 2011 earnings per share of $2.40 and assigns various multiples to arrive at a valuation (adjusted for cash/share of approximately $4).  At a modest 10x multiple, Microsoft should trade at approximately $28 per share which would imply an upside of nearly 20 percent from current levels.  A more reasonable 12x multiple would imply a share price of approximately $33 for an upside of 40 percent.  In addition, the company has a 2.2 percent dividend.  Barring an unprecedented collapse in Microsoft’s earning power over the next few years, the risk of permanent impairment of capital seems remote given the company’s current valuation.

Disclosure:  The author of this article initiated a position in Microsoft Corporation today at an average cost $23.67. This article is for entertainment and informational purposes only;  do your own research before making any investment decisions.

A Closer Look at Noble Corporation’s Q2 Results

Noble Corporation recently announced second quarter 2010 earnings of $218 million, or $0.85 per share.  The results were negatively impacted by a combination of lower utilization for the overall fleet and sharply lower average dayrates.  As a result, contract drilling revenues dropped to $687.5 million for the second quarter compared to $808.6 million for the first quarter.  Second quarter 2009 contract drilling revenues were $868.2 million.

We profiled Noble in some detail in early June when the shares traded at approximately $28.  After significant volatility in trading today, Noble shares closed up 4.6 percent at $32.06 on the earnings news despite failing to meet analyst estimates.  In this article, we will take a closer look at Noble’s quarterly results with particular attention devoted to trends on dayrates and Noble’s changing mix of revenues by rig type.

Revenue Trends by Rig Type

It is helpful to examine Noble’s revenue by rig type over the past ten quarters to get a feel for the dayrate and utilization trends.  The exhibit below provides average rig utilization, operating days, average dayrates, and contract drilling revenue for each rig type (click on the image to enlarge it).

Several facts are readily apparent from reviewing the data in the exhibit:

  • Jackup revenues are clearly in a declining trend due to a combination of lower utilization and eroding dayrates.  The average dayrate in the second quarter was $96,677, far lower than the dayrates in the $140,000 to $160,000 range that prevailed during 2008 and the first three quarters of 2009.
  • During 2009, semisubmersible rigs capable of drilling in waters over 6,000 feet produced higher revenues that largely offset the decline in jackup fleet revenues.  However, dayrates for these rigs have been under pressure during the second quarter.
  • Overall fleet utilization has dropped from 94 percent to 80 percent over the ten quarter period.

The following chart shows the revenue contribution of each rig type in a more visually intuitive format and clearly highlights the diminishing contribution of the jackup fleet and the growing importance of sophisticated semisubmersible rigs:

Drilling down to the revenue for the second quarter, the chart below shows the contribution of each rig type to overall contract drilling revenues:

Clearly, the negative sentiment surrounding the Deepwater  Horizon disaster and the Federal Government’s regulatory response has taken a toll on Noble’s second quarter results, but it is also important to note that the decline in overall revenues actually began in earnest during the first quarter prior to any hint of difficulties in the Gulf of Mexico.  The notable change in the second quarter is the precipitous drop in average dayrates for both advanced semisubmersible units and jackups.

Despite the negative trends that have taken shape so far this year, Noble posted net income of $589 million, or $2.28 per share, for the first half.  During the first half, the company generated slightly over $1 billion in net cash from operating activities while investing $490.7 million in new construction and other capital expenditures.  Also, at the end of the quarter, Noble announced the acquisition of Frontier Drilling and a significant agreement with Shell.


Noble held a conference call (available for replay at this link through July 27, or read the transcript) for investors today and most of the questions in the Q&A session were related to the outlook for dayrates and utilization in the wake of the negative regulatory climate caused by the Deepwater Horizon disaster. The company also released a fleet status report (pdf) on July 8.

While the company has been able to secure additional work for several jackup units around the world, it is notable that the extensions generally have lower dayrates.  With the exception of the Noble Roy Butler in Mexico and the Noble Hans Deul in the North Sea, all of the newly announced contracts for jackup rigs are at lower dayrates than the contracts they replace.  In some cases, the new dayrates are dramatically lower:  For example, the Noble Gene Rosser in Mexico was on a dayrate of $171,000 until June 19 and was recently extended through December 2010 at a dayrate of $80,000.

The deepwater situation in the Gulf of Mexico remains uncertain due to the moratorium as well as questions regarding the higher cost structure that will inevitably come from tighter regulations if operations are allowed to resume.  The good news is that Noble has been able to negotiate standby agreements with most customers.  The bad news is that the standby dayrates are substantially lower than operational dayrates and appear to limit the ability of the company to relocate rigs to other parts of the world.  Additionally, the company is involved in litigation with Anadarko over a force majeure dispute regarding the Noble Amos Runner.  While the litigation is in progress, Noble is not collecting the $440,000 dayrate for the Amos Runner, although some recovery might be possible in the event of a favorable court ruling.


There is no doubt that Noble Corporation has suffered along with the rest of the offshore contract drilling industry due to the regulatory uncertainty in the Gulf of Mexico and what appears to be a general trend toward lower dayrates particularly in the jackup fleet.  However, despite these setbacks, the company remains highly profitable and was able to leverage a strong balance sheet in an opportunistic acquisition of Frontier that doubles contracted backlog going forward.  This acquisition should close by the end of July.

Whether Noble represents a good investment at current prices depends greatly on the investor’s time horizon and tolerance for price fluctuations in the short run.  The $8.2 billion market capitalization of the company compares favorably to free cash flow that is likely to exceed $1 billion this year.  With an eventual recovery in dayrates and the contribution of the Frontier acquisition, free cash flow should eventually exceed the peak levels of 2009.

While the most prominent risk to the bullish thesis at the moment is the regulatory climate, the larger economic risk would be associated with a period of sustained low oil prices that would make deepwater exploration uneconomical.  However, with energy use in the developing world growing rapidly (For example, China recently surpassed the United States in energy usage), it seems highly unlikely to expect oil prices to drop significantly over the next five to ten years.

Disclosure:  The author owns shares of Noble Corporation.

Diamond Offshore Represents Interesting Play on Deepwater Revival

This is the fifth in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

One of the central tenets of value investing is that one must always insist on a large margin of safety before allocating capital.  When investor sentiment is favorable toward an industry or a company, prices of securities are usually bid up to a level where everything must go according to plan in order to achieve expected investment returns.  On the other hand, negative sentiment can sometimes, but not always, offer an investor opportunities to make commitments offering high returns and low downside risk.

In this article, we profile Diamond Offshore, one of the leading companies in the deepwater drilling industry.  In previous articles, we focused on two companies in the offshore drilling industry with lower risk profiles.  Both Noble Corporation and Ensco plc have exposure to deepwater drilling in the Gulf of Mexico but also have significant international operations along with large fleets of jackup rigs that are designed for less controversial shallow water drilling.

The main reason that Diamond Offshore was not profiled in the past is because the company is far more exposed to deepwater drilling and could face more regulatory uncertainty as a result.  The goal of the articles on Noble and Ensco was to identify companies that had enough diversity in operations, both in terms of shallow water and international operations, to successfully deal with an extended (or even permanent)  U.S. moratorium on deepwater drilling.  With this caveat, let us briefly examine Diamond Offshore’s business.


Diamond Offshore is one of the leading global providers of contract drilling services and operates a fleet of 47 offshore rigs comprised of 32 semisubmersible rigs capable of deepwater operations, 14 jackup rigs designed for shallow water drilling, and one drillship.  The company is well diversified by region with 68 percent of 2009 contract drilling revenues originating from outside the United States.  Revenues are heavily tilted in favor of deepwater operations with only 12.9 percent of 2009 revenues coming from the jackup fleet.  For a brief primer on the differences between rig types, please refer to our previous article on Noble Corporation. The following exhibit presents a snapshot of Diamond Offshore’s valuation as of July 15, 2010.

In contrast to Ensco and Noble which both trade at small premiums to tangible book value, Diamond Offshore commands a larger premium which is most likely due to the long term projected earnings power generated by a more advanced fleet capable of the higher dayrates that deepwater operations command.

The company has a small regular dividend but has been paying out large special dividends in recent years.  The total dividend paid in 2009 was $8 per share.  As we can see from the exhibit below, the company has been generating in excess of $1.1 billion of free cash flow over the past two years and has distributed much of this to shareholders.  Debt levels appear manageable at approximately 29 percent of total capital, although debt was increased by approximately $1 billion during 2009 to fund expansion capex.

Operating Data Snapshot:  2007 to 2009

Although Diamond Offshore operates in a single segment, the company provides more data than many competitors regarding the composition of revenues, expenses, and operating income between rig type and region.  The exhibit below is a reorganization of the data presented within the company’s MD&A section of the 2009 10-K report.  Please click on the image to enlarge it.

The exhibit breaks down operating data for contract drilling by rig type and then by geographic region.  Both high specification floaters and intermediate semisubmersibles are generally designed for deepwater activities, although in some cases they may be repurposed for shallow water drilling.  All jackup rigs are limited to shallow water drilling.  The vast majority of the company’s revenues and operating profits can be attributed to rigs designed for deepwater operations.

Gulf of Mexico Exposure

The chart below shows the breakdown of 2009 contract drilling revenues by region and includes revenues from all rig types.  The segment that is broken out shows that 32 percent of total contract drilling revenues are from operations in the United States Gulf of Mexico.

Within the U.S. Gulf of Mexico, the vast majority of 2009 revenues were attributed to rigs capable of deepwater operations.

Only 5 percent of revenues from the Gulf of Mexico were from jackup rigs and the vast majority were from high specification floaters representing some of the most advanced rigs in Diamond Offshore’s fleet.

According to the June 30, 2010 fleet status report, Diamond Offshore currently has nine rigs in the Gulf of Mexico.  Five of the rigs are semisubmersible units.  On July 12, the company announced that Ocean Confidence, one of the semisubmersible rigs, would immediately redeploy to the Republic of Congo.  The following exhibit provides a summary of the latest information regarding the Gulf of Mexico fleet.

As we can see, several customers have invoked force majeure in an attempt to exit or modify existing contracts.  Presumably, this is due to the Obama Administration’s moratorium on deepwater drilling although it is notable that the Ocean Titan is on a standby rate of zero dollars due to regulatory difficulties even though it is a jackup rig.  The relocation of Ocean Confidence out of the Gulf of Mexico could presage similar actions for other rigs if regulatory difficulties continue.  However, relocation can be expensive and time consuming and there is a possibility that mass relocations of rigs from the U.S. Gulf of Mexico could depress dayrates elsewhere in the world.


In contrast to our previous studies of Noble Corporation and Ensco, it seems clear that Diamond Offshore carries more business risk due to the higher concentration of revenues in deepwater activities in the U.S. Gulf of Mexico.  These risks may be mitigated to some extent through the relocation of assets to other parts of the world and negotiations with customers.  However, it is clear that investors in Diamond Offshore have a great deal to lose if the deepwater moratorium is extended or made permanent.

At the current valuation, Diamond Offshore certainly appears inexpensive compared to the market prices that prevailed before the Deepwater Horizon disaster.  However, Noble Corporation seems far cheaper both in terms of multiples of earnings and free cash flow as well as the price to tangible book ratio.  A similar observation can be made regarding Ensco.

It must be acknowledged that Diamond Offshore’s fleet may legitimately command a premium valuation compared to Noble and Ensco in a world where deepwater exploration is robust and premiums are placed on advanced semisubmersible rigs. However, the flip side is that they are more exposed to adverse regulatory developments in deepwater.  An investment in Diamond Offshore may turn out well at current market prices and may even offer more upside potential than Noble or Ensco, but much depends on a reasonably quick return to deepwater exploration in the Gulf of Mexico.


Diamond Offshore 2009 10-K
Diamond Offshore 2010 Q1 10-Q
Diamond Offshore Fleet Status Report as of June 30, 2010 (Excel)
Press Release on Ocean Confidence Relocation

Disclosure:  No position in Diamond Offshore or Ensco.  Long Noble Corporation.