Microsoft has been put under a lot of fire recently. After the NSA scandal and a somewhat disappointing fourth fiscal quarter and total financial results for fiscal year 2013, investors were let down by the evolution of Microsoft, thus bringing down its stock by more than 11%, which actually translates in a market value loss of $34 billion. However, despite of all these events, it seems that right now is the time for you to buy Microsoft shares, if you were interested in doing this in the past.
Tim McAleenan brings an interesting, yet simple theory into discussion with his posting on the SeekingAlpha website. Tim advises to accord a special attention to those companies that have been quickly overvalued or undervalued. If we’re talking about overvaluation, the first company that comes into my mind is Apple, and I do recall there were some analysts suggesting that the Cupertino giant will become the first one-trillion company in the world sooner that we’ll realize it.
As a consequence of strong competition from the Android side, especially Samsung, Apple’s stock is now more “conservative”, at around $420 billion+. And now we have Microsoft, which is an example of sudden devaluation. But are only emotions to be blamed for Microsoft’s stock or there are solid facts to worry about?
Microsoft’s shares: an appealing investment?
Microsoft’s main income is obviously its software division with an emphasis on business, and now, the Redmond giant is expanding further the role of the cloud, proof to that being the staggering amount of servers they now possess – one million. But the main thing investors are concerned with is the future, of course. And now, the future is all about mobile. They are afraid that Microsoft won’t be able to sustain a viable business model when it comes to emerging mobile technologies.
For most of the non-tech persons, that plainly translates into smartphones and tablets. And Microsoft is doing horribly bad there, with Windows Phone barely managing to resist behind iOS and Android and with an almost $1 billion loss on its Surface tablets. As a side fact, Microsoft keeps on pushing Surface vs iPad ads, just like nothing happened. Tim draws a parallel with McDonalds back in 2002-2003, when its shares fell from $30 to a low of $12.70 as investors were afraid McDonalds will not be able to adapt to the trend of eating healthier food.
Of course, McDonalds managed to survive and actually to flourish its business. And it was the perfect moment to invest in its stock, because of the following reasons:
- The share price was unfairly beaten down, just a result of emotions and fear over the future
- The company was entering harvest mode, thus becoming a cash cow that was accelerating its dividend payout ratio while simultaneously growing earnings at a healthy clip (dividend gre by 27%, earnings by 14% over the past decade, payout ratio increased from 27% in 2003 to 57% in 2013), thus probably making rich those who seized the opportunity
Microsoft now finds itself in somehow the same position with regards to the growth of the mobile world. Tim explains further:
Microsoft has grown earnings per share by 11% since 2003. It has grown earnings per share by 14.5% since 2008. But why have investors experienced total returns that lag earnings growth? Simply because the valuation has steadily marched downward. In 2003, investors were willing to pay $26 in share price for every dollar of profit that Microsoft generated. In 2008, they were willing to pay $16 in share price for every dollar of profit Microsoft pumped out for shareholders.
The terms of investing in Microsoft are much different today. As of Friday’s close, Microsoft traded at $31.40 per share while generating $2.60 in annual profits, $0.92 of which get returned to the owner each year for every share you hold. That’s only 12x earnings. If you buy Microsoft today, you are buying a company with a 8.28% starting earnings yield plus whatever the future earnings per share growth rate of the firm happens to be.
And if the company decides to go into “harvest mode” and increase its payout ratio from the current 35% to 60-65% over the long term, shareholders can experience the wealth-building joy that occurs when you get to reinvest dividends into a company growing its dividend rate higher than its earnings rate while giving you the chance to increase your ownership stake at the lower valuation of 12x earning.
How the future looks for Microsoft
Also, let’s not forget that Microsoft has a huge amount of $77 billion in cash. They could make a lot of things with that money. We can see that they’re trying, as they have spent in the fiscal year of 2013 more than $10 billion on Research and Development. Microsoft could do so many things with that huge pile of money. As the future is not only mobile, but also web, Matt Krants with USA Today reminds us that Yahoo now nears Microsoft’s 2008 buyout bid price – $31 a share, meaning an offer of $44.6 billion.
It’s hard to believe that Microsoft could even try to launch a new offer for Yahoo!’s acquisition, now that their new CEO is kinda cool, which makes investors feel positive and confident about the future of the company. But, just as a side fact, Microsoft could buy Yahoo! at its current $32.1 billion market value and still have almost $45 billion left. This is something that speaks about the financial power of this company.
And, yes, let’s not forget about Windows 8, shall we? Traditional PC sales are declining, we all know that, but soon support for Windows XP will also end, meaning that especially government agencies and enterprises will have to make the jump to a new version. And it’s hard to believe they will choose Windows 7. People are buying more and more tablets, and even if the iPad still remains the king, what will happen when those that have used Windows for as long as they can remember will need a tablet?
And what if your boss will give you a tablet? Maybe computer sales or declining or maybe we are redefining the term “computer”. What’s sure is that Windows 8 is a product that’s not meant to deliver profits immediately, but on the long run. And the Windows Store, even if it is not perfect at the moment, it will definitely get better in time, thus delivering some sweet cash to Microsoft.
No, Microsoft is not doomed, they will just adapt. And for all of you investors out there, the last piece of advice:
One of the easier ways to achieve satisfactory returns is to buy a company that has low expectations baked into the share price that allow you to make money in the event that the company can jump over one-foot hurdles. That $77 billion in cash gives the company great flexibility. That 35% payout ratio may give room for nice dividend growth over the medium term.
There is a notable mismatch between the headline risk posed to the company compared to the profits it continues to pump out. As the price of Microsoft stock has been beaten down to $31.40, it has reached the point where it does not take a whole lot to go right over the next five to ten years in order for shareholders to do well, as they potentially stand to benefit from some combination of: (1) future growth above pessimistic expectations, (2) an acceleration in the dividend payout ratio, (3) an expansion in the P/E ratio above 12, and (4) the utilization of the $77 billion in cash for something like a substantial buyback program.