What Will Wake The Sleeping Microsoft?

9/6/2010


  Recent Price
$23
  Dividend
$0.52
  Yield

2.2%

  P/E Ratio
11
  Shares (millions)
8,821
  Long-Term Debt as % of Capital
10%
  52-Week Price Range
$31.58 - $22.73

In 1994, The New Yorker described Microsoft ($23; MSFT) chairman and cofounder Bill Gates as a grizzly, ferocious in his confrontations and prone, when sensing weakness in a victim, to punctuate his tirades with biting sarcasm. Microsoft tends to behave in a similar manner, defending its businesses against rivals like a mother protecting her cubs. These practices helped Microsoft become the world’s most powerful technology company but also ensnared it in lengthy antitrust battles in the U.S. and Europe.

In the stock market, it’s the investors who have become bearish, with Microsoft shares retreating 23% so far this year. This decline is not the result of a sudden trend, but rather the extension of a lost decade in which Microsoft’s stock has generated a negative total return of 9%.

Microsoft faces no shortage of concerns. But amid the pessimism we see an attractive buying opportunity, and we rate Microsoft a Buy and a Long-Term Buy for at least five reasons:

Leverage in existing markets. The Windows operating system runs more than 90% of personal computers (PCs). Not surprisingly, PC sales have a huge effect on Microsoft’s results. And though shipment data could be shaky in the months ahead, long-term trends remain favorable. In addition, the new version of Microsoft’s ubiquitous Office suite of business software, released in June, should boost results in fiscal 2011 ending June.

Presence in new markets. Many of Microsoft’s forays into new spaces have fizzled — such as the pen-computing craze of the early 1990s, interactive TV, and the Kin smart phone abandoned in July less than two months after its launch. The Xbox gaming system, launched in 2001, is one of Microsoft’s biggest success stories. In July, Xbox once again became the top-selling console. Looking ahead, Microsoft will continue its push into cloud computing, or software provided over the Internet on demand, while introducing a new operating system for mobile devices.

Cash position. Microsoft’s coffers brim with $36.79 billion in cash versus just $4.94 billion in long-term debt, putting net cash per share at $3.50. Free cash flow surged 53% to $17.52 billion over the last year. The dividend, last increased in 2008, seems due for another hike, and share buybacks should also continue. Perhaps no one in the past 10 years has liked Microsoft’s stock more than Microsoft, which has devoured enough to shave 20% off the share count.

Valuation. The shares look cheap from just about every angle. At 11 times trailing earnings, shares trade 36% below their five-year average and 47% below the average systems-software stock in the S&P 1500 Index. Exclude the $3.50 per share in net cash, and Microsoft’s P/E sinks to 9.5. The stock also trades at a discount to historical averages for price/sales and price/operating cash flow.

Outlook. Wall Street projects per-share profits of $2.36 in fiscal 2011 ending June, up 12% on 9% higher revenue. Microsoft has posted profit surprises of at least 7% in each of the last four quarters.

An annual report for Microsoft Corp. is available at 1 Microsoft Way, Redmond, WA 98052; (425) 882-8080; www.microsoft.com.

MICROSOFT
Quarter

    Per-Share
     Earnings*

Sales
Change

      Quarterly
      Price Range

P/E Ratio
Range

Jun '10 $0.51 vs. $0.34 + 22% $31.58 -

$22.95

16 - 12
Mar '10 0.45 vs. 0.33 + 6% 31.24 - 27.57 17 - 15
Dec '09 0.74 vs. 0.47 + 14% 31.50 - 24.43 20 - 16
Sep '09 0.40 vs.

0.48

- 14% 26.25 - 22.00 16 - 14
           
Year
(Jun.)

Sales
 (Bil.)

Per-Share
Earnings*
Per-Share
Dividend

52-Week Price Range

P/E Ratio
Range

2010 $62.48 $2.10 $0.52 $31.58
-
$22.00 15 - 10
2009 $58.44 $1.62 $0.46 28.50
-
14.87 18 - 9
2008 $60.42 $1.87 $0.41 37.50
-
26.87 20 - 14
2007 $51.12 $1.42 $0.37 31.48
-
22.23 22 - 16
             
————————————————— Quadrix Scores † —————————————————
Overall Momen-
tum
Value Quality Financial
Strength
Earnings
Estimates
Performance
94 84 84 89 89 36 34

   * Earnings exclude special items.
   † Quadrix® scores are percentile ranks, with 100 the best.


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