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.

Summary

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.

Microsoft’s Depressed Stock Price Attracts Flock of Value Investors
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9 thoughts on “Microsoft’s Depressed Stock Price Attracts Flock of Value Investors

  • September 1, 2010 at 8:01 am
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    MIcrosoft wastes most of its free cash flow on buybacks, small M&A, and organic growth that goes nowhere. Have whatever earnings you like, if you waste the free cash flow, it will not avail. They are bad capital allocators, and need to start paying out a higher dividend.

  • September 1, 2010 at 8:06 am
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    I disagree with the idea that buybacks (particularly at recent valuations) are a “waste” of free cash flow. I do agree that many of Microsoft’s initiatives to develop new lines of business have failed to bear fruit, as noted in the article.

    If the goal is to outperform, it is almost always necessary to buy when there are “obvious” problems everyone is talking about but have been overdone. Whether it is Microsoft, Noble, Ensco, or others in the “Graham Unpopular Large Company” series, the common thread is that the companies in question have the ability to survive adversity and the market has become more pessimistic than warranted by the data.

  • September 1, 2010 at 10:08 am
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    Very nice post. I’m more concerned about attacks on Microsoft’s current businesses (Windows and Office), than its ability to break into new lines of business. Clearly Google is the known threat. But with cloud computing a company currently in a college dorm room could foreseeable create a product that makes Windows or Office obsolete very quickly. For that reason, I don’t think it’s possible to tell what Microsoft will look like in 10 years.

    • September 1, 2010 at 10:14 am
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      It is indeed very difficult to forecast whether Windows or Office will maintain market share in ten years. However, in the corporate environment, Microsoft has tremendous power due to the very large installed base. One factor I did not mention in the article is the nature of corporate information systems and how slow they are to change over time. I worked in software for over a decade and witnessed this firsthand in many environments. Custom software is very “sticky” and new implementations are often difficult to accomplish and very expensive. As a result, IT departments are very risk averse in general and tend to shy away from dramatic changes.

      While obsolete technology will eventually die regardless of IT dept. inertia, Microsoft is not as far behind the curve as the market seems to believe. The company has made progress in cloud computing and technologies such as Silverlight help developers leverage existing architectures to deploy rich applications over the internet.

      CIOs are very aware of “career risk” – the risk of being fired due to a faulty implementation of new technology. Sticking with Microsoft software on the cloud is a fundamentally less risky way to proceed than making some dramatic shift to Google Apps or something similar.

      Even if Microsoft’s core Windows and Office franchises decline over time and are not replaced by new business lines, the decline is very unlikely to be precipitous in nature in my opinion. At least at the current valuation, there seems to be an asymmetric nature regarding the reward/risk tradeoff biased to the upside.

    • September 7, 2010 at 11:57 am
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      Sadly, I think the best think happening for Microsoft is the ATT / Verizon / cable stranglehold on broadband that ensures the USA continues to lag Asia and Europe in Internet speeds. Until broadband becomes much faster and cheaper for the typical end user, cloud computing for Office remains pie in the sky for many heavy users.

      Google apps and Open Office or similar could slow Microsoft growth but probably not stop it entirely for several more years.

  • September 1, 2010 at 2:46 pm
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    Ravi, I am probably preaching to the choir here, but wanted to put out some thoughts nevertheless.

    Regarding Buybacks being good, this is usually not the case with technology companies that issue a large number of stock awards and options:

    “The Dirty Little Secret About Buybacks
    All those share repurchases are doing investors little good. Here’s why”
    http://www.businessweek.com/magazine/content/06_04/b3968099.htm

    The true cash flow that the company has, backing out the stock awards, should be closer to 11 B rather than to 22 B.

    Regarding the dominant franchises that Microsoft has, I agree that it will take some time for customers to shift. But with new computing environments comes disruption risk as we have seen with Apple. People now want the capability to compute on multiple devices, so the device itself faces commodity risk.

    As another example, even a couple of years back, it was very hard to forsee that Nokia would be under threat of losing the predominant position that it held.

    Paying 10 times earnings for Microsoft is therefore different from paying 10 times earnings for WMT or JNJ.

    • September 2, 2010 at 3:14 pm
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      I do agree that the effect of share issuance related to options must be considered so perhaps we should look at “net repurchases” – meaning repurchases less new issuance.

      (in millions)

      FY 2008:
      Repurchases: $12,533
      Issued: $3,493
      Net: $9,040

      FY 2009:
      Repurchases: $9,353
      Issued: $579
      Net: $8,774

      FY 2010:
      Repurchases: $11,269
      Issued: $4,578
      Net: $6,691

      So yes, in aggregate, Microsoft does issue quite a bit of new shares related to the options program. And this offsets part, but obviously not all, of the repurchases that are being made. Over the past three fiscal years, we have $33,155 million in repurchases, $8,650 million issued >> $24,505 Net.

      The bottom line, in my opinion, is that even considering the options program (which I would love to not see – who wouldn’t?) Microsoft is returning significant cash to shareholders both through repurchases and dividends.

      I think the market is implicitly factoring in a very quick decline in Windows, Office, and Server solutions and that this is highly unlikely to occur given the near term corporate refresh cycle and the much improved product lines with Windows 7 and Office 2010. Many companies never upgraded from XP and systems are getting long in the tooth – the fundamentals for FY 11 are very strong.

      • September 12, 2010 at 5:09 am
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        Generally, Microsoft has become a boring stock to own. Part of it is the lack of a charismatic leader (esp since so much of Microsoft total business is dependent on consumers) who can create a buzz about the company and its products, Microsoft the corporate name (and logo) also drawing snores, but technologically, they should be surging forward leveraging (as you suggest) their MS Office franchise on SOA to develop and successfully market an ‘end game’ platform for ERP, SCM, CRM.

        With Windows 7 and MS Office 2010, they have ‘debugged’ everything that prevented this software from being taken very seriously at the enterprise, in terms of stability, security and even look and feel, so imho, they should race to out ‘fuse’ MS Dynamics, Navision and other related software onto Windows and MS Office 2010 against Oracle Fusion promise, as yet undelivered, but long overdue platform for their long suffering Peoplesoft, JDE and even Oracle Apps customers. In this regard, they should have either swallowed SAP by now, and moved rapidly to deliver on, again, the end game of SAP platforms using the Windows and MS Office platforms. Why, I ask, did they stop at Duet (Mendocino) and not go to the end game.

        Also, they are not seeing a great future ahead for verticals, much like what Oracle has done. They should be using their core franchise to develop vertical applications for retail banking, FMCG, telco, oil&gas, government, etc and aggressively going after M&A opportunities in these areas instead of pouring billions to develop me too products like Zune, Bing, etc.

        There is an overarching ‘Sun Tzu’ aspect to all this I think, and it is on 2 counts:
        – we need a refreshed, dynamic, irreverent leader at the helm, and unfortunately, the current leadership does not provide it, across the world;
        – Microsoft should increasingly portray itself as an aggressive, mean, being on the defensive underdog in the industry, against the likes of IBM, Oracle, Google. It should be producing statistics that show that these companies are attacking Microsoft’s very future, and that it has to worry less about anti-trust issues and fight like a rotweiler.

        I have waited and waited since Mar 2000, when I thought Microsoft’s fate was sealed with the anti-trust settlement, to see the underlying transformation of the company, but have been thoroughly disappointed as an investor. All the charity in the world, pounding the table, etc will not get the job done, as a ‘has been’ like Mr. Ellison has so deftfully re-engineered Oracle to be the lean and mean machine it is today. Have no doubt, Oracle is rotweiler because of Mr. Ellison’s unbelievable manoeuerings of people, organisation, his clients and of course, the acquisitions.

  • September 12, 2010 at 6:56 am
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    I forgot to add that becoming more of a rotweiler should also extend to be a far disciplined enforcer of its IP rights, working alongside whoever it needs to work with to ensure that it receives every cent of its licence revenues, whether it is consumer or corporate.
    The argument to extend its corporate reach surreptiously by accepting consumer piracy can only hold water so long, as it relies more and more on corporate revenue streams. No doubt, this is probably the most difficult issue facing Microsoft’s revenue model, but as Oracle, Google, even Autodesk before it, a permanent solution to this problem must be found. Solving this issue permanently will have a surprising, imho, corollary effect on the level of respect Microsoft earns in the world!!

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