Two years after the market hit the March 2009 lows, finding low risk – high reward investment opportunities are becoming consistently more scarce and difficult to find. With the total market valued at 94.1% of United States GDP, making it modestly overvalued and predicting subpar returns into the future, it is important to look into sectors or stocks with great fundamentals that are undervalued and can deliver good gains.
It is also important to consider that constant monetary stimulus put in place by the FED with their “Quantitative Easing” programs are starting to fuel inflation. The massive liquidity injected by the FED by monetizing treasuries and mortgage backed securities have caused a down trending dollar and speculators flocking into commodities, soft commodities and precious metals. “Non printable assets” have to go up in price in order to maintain their real value as the dollar is being debased. This high speculative demand in commodities and soft commodities is also boosted by the strong growth and demand in emerging market economies for these assets.
The latter is starting to put considerable pressure on the margins of companies that are produce and sell products with high commodity inputs. Also consumers when faced with higher gas and food prices are obliged to cut down on discretional spending which is a negative for most companies.
In the current environment we need to find a company that has:
- High Profit Margins and Returns on Capital that can be maintained regardless of inflationary pressures and a weaker consumer.
- A market for their products that will grow regardless if global economic conditions deteriorate or improve.
- The ability to innovate and surprise with new and attractive products that contribute to earnings growth.
- The stock of the underlying company has to be significantly undervalued.
I believe I have found such a stock in Microsoft Corporation (MSFT, Financial).
Company Overview:
As summarized in Gurofocus.com, “Microsoft develops, manufactures, licenses, and supports a wide range of software products for a multitude of computing devices. Microsoft software includes scalable operating systems for servers, personal computers, and intelligent devices; server applications for client/server environments; knowledge worker productivity applications; and software development tools. The Company's online efforts include the MSN network of Internet products and services and alliances with companies involved with broadband access and various forms of digital interactivity.”
Microsoft’s business divisions are the following as stated on their latest annual share holder report:
- Windows & Windows Live Division
- Server and Tools
- Online Services Division
- Microsoft Business Division
- Entertainment and Devices Division
The Windows and Microsoft Business divisions are key to the company’s profitability. Together they bring 30% each of total revenue and almost the totality of the operating income. Microsoft states that “Windows Division revenue growth is largely correlated to the growth of the PC market, as the original equipment manufacturer (“OEM”) distribution channel accounts for approximately 80% of total Windows Division revenue “.
For Business Division, Microsoft states that “Approximately 80% of MBD revenue is generated from sales to businesses, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue. Revenue from this category generally depends upon the number of information workers in a licensed enterprise and is therefore relatively independent of the number of PCs sold in a given year. Approximately 20% of MBD revenue is derived from sales to consumers, which includes revenue from retail packaged product sales and OEM revenue.”
In these two business divisions MSFT has created economic moats that assure high profitability and earnings growth in the coming years and maintaining its dominant position of 90% market share in operating systems. These moats make MSFT a money making machine in any economic environment.
MSFT Moats – Switching Costs and Network Effect:
MSFT controls the operating systems and business software market with Windows and Excel. You can argue that these products have their deficiencies and Apple or Google offer better solutions. However MSFT´s dominance in these markets has created a huge barrier for new products that could be better or cheaper thanks to high switching costs and a network effect.
People and business around the globe have spent billions of dollars buying MSFT products. They use MSFT products on a daily basis, business personnel is trained to use MSFT products, IT employees are trained to implement and fix issues of MSFT products. You need to use and dominate MSFT products in order to work in any almost any line of business. You need to share files and data in formats that are compatible with MSFT products.
Although we have seen products such as “Open Office” and “Google Apps” enter the market, MSFT’s market share remains intact. Open Office is free and a good product and hasn’t been able to dethrone MSFT as king. If a free quality product can’t hurt the company it shows that the company has built a very strong economic moat. Open Office and Google Apps are just minor threats that help MSFT to stay in their toes and constantly improve their products for their consumers.
Another positive that maintains MSFT´s economic moat is that the company has deals with all major computer manufacturers around the world that package their software as a standard. These manufacturers have spent billions of dollars designing computers that are optimized to run MSFT´s software. A computer brand that can’t run MSFT would go broke almost instantly. Even Apple, one of MSFT’s fiercest competitors, is allowing MSFT to sell their software with Office 2011 just being launched. With 1 Billion users worldwide, Apple can’t afford not to have or run MSFT software.
An additional positive factor is that this economic moat that produces constant and growing earnings, high operating margins and Return over Capital isn’t very affected by an inflationary economic environment as the one we are heading into. Microsoft’s cost of goods sold has averaged only 18.15% of its revenue during the last decade.
Bottom line is that people and business have spent tons of money in MSFT products and have been trained to use them. Changing from Microsoft to another competitor is very expensive and risky for companies. The whole world uses Microsoft software and you need to dominate their applications in order to work in almost any job. This assures Microsoft a steady and growing earnings as PC’s market grows and business worldwide invest in technology to make their operations more efficient.
Powerful Economic Moat Results:
How many companies can you find with a better track record than MSFT?
MSFT powerful moat allows it to maintain high profit margins and returns even during a steep economic downturn. Earnings growth resumed rapidly after the worst economic downturn since the great depression.
Growth Drivers and Forecasts:
Due to the economic moats Microsoft possess I expect it to retain a dominant position in the operating systems and business software markets with Windows and Excel. Margins should maintain high with a very slight downtrend. Currently Windows has a 90% market share (75% if we subtract the pirate copies which don’t make MSFT a dime) and Windows 7 has been the fastest operating system in history with over 175 million copies sold.
Windows:
The PC market is growing rapidly thanks to notebook and netbook sales which have grown at an average rate of 24% during the last 5 years. Projecting a declining growth rate for the next 6 years in notebook and netbook sales and 0% growth in Desktop computers, Microsoft should be selling 27.3 Billion in Windows licenses by 2017 from the current 18.5 Billion.
Office:
I expect Office to maintain a slightly declining market share of productivity software during the next 6 years to a still very high 90%. Utilizing my forecasts for PC market growth, the business division should be selling 23.1 Billion by 2017, an increase of 4.5 billion from the current sales.
Entertainment and Devices:
In the “Entertainment and Devices “ division Microsoft has done great progress. In 2005, when MSFT launched the Xbox, the company captured 2% of a highly competitive industry. In 2010 MSFT has managed to increase its market share to 17% and produce a $679 million profit that consolidates its place in the market with great hardware, games and online multiplayer capabilities. Its recent launch of Kinect, a motion detector sensor controller, was a complete success. It broke the Guinness world record of the fastest selling consumer electronics device with 8 million units sold in 60 days. Not even Apple could manage that with the iPad or iPhone. The Kinect´s and Xbox success shows that Microsoft still retains the capability to enter and succeed in new markets. Forecasting until 2017 I expect Microsoft to grow its participation in the gaming console market up to 20%.
R&D and Cash:
Another factor for growth to consider is the huge amount of resources Microsoft spends in R&D which has averaged 15.53% of revenue during the last decade. Always trying to introduce new technology that changes the way people work and interact, and in the process create a new market in which it has total control, Microsoft is heavily focused on “Cloud Computing” which is the next wave in the technological revolution. CEO Steve Ballmer states: “The cloud is revolutionizing computing by linking the computing devices people have at hand to the processing and storage capacity of massive datacenters, transforming computing from a constrained resource into a nearly limitless platform for connecting people to the information they need, no matter where they are or what they are doing. This has profound implications for the way people use technology across their lives to work, learn, communicate, and have fun.”
Ballmer adds: “At Microsoft, we firmly believe the impact of cloud computing will be as big as – or bigger than – the previous waves of technology change. The opportunities cloud computing will create for our customers, our partners and our company will be immense. When it comes to the cloud, we are all in”
Currently MSFT is devoting most of its R&D budget on “Cloud Computing” research and for 2011 90% of their engineers will be working in products or projects related to this new technology.
The potential for growth in this new technology is extremely high but at the same time, hard to forecast. As you will see in the Microsoft valuation, this isn’t discounted in the price.
In the other hand, depending the method you wish to use, Microsoft has approximately $3.5 to $5.0 dollars of cash per share free of debt. That is $29 to $41 billion dollars MSFT has available to buy or have a share of companies with new technologies and higher flexibility that offer good growth prospects. Even simpler than that, Microsoft can and does invest in themselves by buying back their own shares and reward their shareholders by increasing earnings and dividends per share. Microsoft has the capability of buying $16.3 Billion of its own shares according to the current buyback policy.
I believe that at the current prices the potential uses of cash are not discounted in any premium or form in the stock price.
Other Divisions and Forecasts:
You can see a detailed model I used to value Microsoft and forecast other divisions in the following link: https://www.trefis.com/company?hm=MSFT.46409&shr=46409&from=share
Valuation – The Stock is Cheap:
Using the Trefis model I linked above and utilizing a 12% discount rate the target price I obtain for Microsoft is of $36.83 per share, 45% above the market price.
Using a simpler approach using the Gurufocus.com DCF calculator I halved Microsoft’s historic earnings growth rate to 7% and gave it a 0% terminal growth rate. The price obtained per share is of $27.68. Add the free cash of $4 dollars per share and you obtain a price of $31.68, 25% over the market price using very conservative estimates.
Valuation Ratios:
Using valuation ratios you can also see that Microsoft is not expensive and the stock price does not carry an important growth premium. Its current business operation is undervalued and the market is ignoring the potential of Microsoft’s R&D and cash that could be put to work.
Using historical valuations for Microsoft, the P/E ratio is at the bottom of its historic range:
The stock is cheap using a conservative DCF analysis and offers a considerable margin of safety in its current business operations, not taking in account future growth opportunities. Using valuation ratios or historic P/E’s suggests that Microsoft is cheap and the market is not pricing growth in this stock. The stock could gain as the market corrects the price to a fair valuation and / or Microsoft surprises with unexpected earnings growth, new technologies and products or by buying – partnering younger companies.
Microsoft Technical Analysis:
Using Technical Analysis, Microsoft looks like a good “oversold” buy candidate.
It is currently at a support level created by the rising bottoms trend line and a previous low set at $25 dollars.
Its “Stochastic Oscillator” is currently in “oversold” territory and we have consistently seen Microsoft bottom out or at least get a significant bounce from these oversold readings. The only time in which we a saw a more prolonged decline in price of the stock, despite oversold readings, was during the market crash in 2008-2009.
Buying Microsoft now using technicals would be following the buy low and sell high mantra.
Smart Money Buying:
As a sort of confirmation that Microsoft is cheap and it is offering opportunity to reap great profits, I have observed that successful investors and fund managers have been buying the stock during the last quarter or have the stock as part of their portfolio.
In the S&P 500 Guru owned stocks grid, 29 of the 48 Gurus the site tracks own Microsoft. Together with JNJ, MSFT is the most owned guru stock. During the last quarter of 2010 David Tepper, manager of the most successful hedge fund from 2008 -2010 doubled his stake on the stock.
During the same time period, value investment gurus such as Joel Greenblatt, Ronald Muhlenkamp, Donald Yacktman and Charles Brand were also buying.
Conclusion:
In my view Microsoft is a clear buy because:
- It possess a powerful moat due to high switching costs and a network effect that allows it to maintain a near monopolic market share of the operating systems and productivity software. These markets are expected to grow in the future.
- The company will remain profitable in good or bad economic conditions and won’t be as affected as other businesses by higher commodity prices or other inflationary pressures.
- Very high and consistent profit margins and returns over capital over a 10 year period.
- New growth opportunities thanks to extensive R&D in the next technological wave (cloud computing) and lots of cash to buy up or partner with new hot companies.
- Stock is significantly undervalued discounting their current operations and has no premium for future growth potential.
- Smart Money investors own Microsoft and have been buying at the current prices during the last quarter of 2010.
Disclosure:
I am long Microsoft at an average price of $26.14 per share.
It is also important to consider that constant monetary stimulus put in place by the FED with their “Quantitative Easing” programs are starting to fuel inflation. The massive liquidity injected by the FED by monetizing treasuries and mortgage backed securities have caused a down trending dollar and speculators flocking into commodities, soft commodities and precious metals. “Non printable assets” have to go up in price in order to maintain their real value as the dollar is being debased. This high speculative demand in commodities and soft commodities is also boosted by the strong growth and demand in emerging market economies for these assets.
The latter is starting to put considerable pressure on the margins of companies that are produce and sell products with high commodity inputs. Also consumers when faced with higher gas and food prices are obliged to cut down on discretional spending which is a negative for most companies.
In the current environment we need to find a company that has:
- High Profit Margins and Returns on Capital that can be maintained regardless of inflationary pressures and a weaker consumer.
- A market for their products that will grow regardless if global economic conditions deteriorate or improve.
- The ability to innovate and surprise with new and attractive products that contribute to earnings growth.
- The stock of the underlying company has to be significantly undervalued.
I believe I have found such a stock in Microsoft Corporation (MSFT, Financial).
Company Overview:
As summarized in Gurofocus.com, “Microsoft develops, manufactures, licenses, and supports a wide range of software products for a multitude of computing devices. Microsoft software includes scalable operating systems for servers, personal computers, and intelligent devices; server applications for client/server environments; knowledge worker productivity applications; and software development tools. The Company's online efforts include the MSN network of Internet products and services and alliances with companies involved with broadband access and various forms of digital interactivity.”
Microsoft’s business divisions are the following as stated on their latest annual share holder report:
- Windows & Windows Live Division
- Server and Tools
- Online Services Division
- Microsoft Business Division
- Entertainment and Devices Division
The Windows and Microsoft Business divisions are key to the company’s profitability. Together they bring 30% each of total revenue and almost the totality of the operating income. Microsoft states that “Windows Division revenue growth is largely correlated to the growth of the PC market, as the original equipment manufacturer (“OEM”) distribution channel accounts for approximately 80% of total Windows Division revenue “.
For Business Division, Microsoft states that “Approximately 80% of MBD revenue is generated from sales to businesses, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue. Revenue from this category generally depends upon the number of information workers in a licensed enterprise and is therefore relatively independent of the number of PCs sold in a given year. Approximately 20% of MBD revenue is derived from sales to consumers, which includes revenue from retail packaged product sales and OEM revenue.”
In these two business divisions MSFT has created economic moats that assure high profitability and earnings growth in the coming years and maintaining its dominant position of 90% market share in operating systems. These moats make MSFT a money making machine in any economic environment.
MSFT Moats – Switching Costs and Network Effect:
MSFT controls the operating systems and business software market with Windows and Excel. You can argue that these products have their deficiencies and Apple or Google offer better solutions. However MSFT´s dominance in these markets has created a huge barrier for new products that could be better or cheaper thanks to high switching costs and a network effect.
People and business around the globe have spent billions of dollars buying MSFT products. They use MSFT products on a daily basis, business personnel is trained to use MSFT products, IT employees are trained to implement and fix issues of MSFT products. You need to use and dominate MSFT products in order to work in any almost any line of business. You need to share files and data in formats that are compatible with MSFT products.
Although we have seen products such as “Open Office” and “Google Apps” enter the market, MSFT’s market share remains intact. Open Office is free and a good product and hasn’t been able to dethrone MSFT as king. If a free quality product can’t hurt the company it shows that the company has built a very strong economic moat. Open Office and Google Apps are just minor threats that help MSFT to stay in their toes and constantly improve their products for their consumers.
Another positive that maintains MSFT´s economic moat is that the company has deals with all major computer manufacturers around the world that package their software as a standard. These manufacturers have spent billions of dollars designing computers that are optimized to run MSFT´s software. A computer brand that can’t run MSFT would go broke almost instantly. Even Apple, one of MSFT’s fiercest competitors, is allowing MSFT to sell their software with Office 2011 just being launched. With 1 Billion users worldwide, Apple can’t afford not to have or run MSFT software.
An additional positive factor is that this economic moat that produces constant and growing earnings, high operating margins and Return over Capital isn’t very affected by an inflationary economic environment as the one we are heading into. Microsoft’s cost of goods sold has averaged only 18.15% of its revenue during the last decade.
Bottom line is that people and business have spent tons of money in MSFT products and have been trained to use them. Changing from Microsoft to another competitor is very expensive and risky for companies. The whole world uses Microsoft software and you need to dominate their applications in order to work in almost any job. This assures Microsoft a steady and growing earnings as PC’s market grows and business worldwide invest in technology to make their operations more efficient.
Powerful Economic Moat Results:
How many companies can you find with a better track record than MSFT?
MSFT powerful moat allows it to maintain high profit margins and returns even during a steep economic downturn. Earnings growth resumed rapidly after the worst economic downturn since the great depression.
Growth Drivers and Forecasts:
Due to the economic moats Microsoft possess I expect it to retain a dominant position in the operating systems and business software markets with Windows and Excel. Margins should maintain high with a very slight downtrend. Currently Windows has a 90% market share (75% if we subtract the pirate copies which don’t make MSFT a dime) and Windows 7 has been the fastest operating system in history with over 175 million copies sold.
Windows:
The PC market is growing rapidly thanks to notebook and netbook sales which have grown at an average rate of 24% during the last 5 years. Projecting a declining growth rate for the next 6 years in notebook and netbook sales and 0% growth in Desktop computers, Microsoft should be selling 27.3 Billion in Windows licenses by 2017 from the current 18.5 Billion.
Office:
I expect Office to maintain a slightly declining market share of productivity software during the next 6 years to a still very high 90%. Utilizing my forecasts for PC market growth, the business division should be selling 23.1 Billion by 2017, an increase of 4.5 billion from the current sales.
Entertainment and Devices:
In the “Entertainment and Devices “ division Microsoft has done great progress. In 2005, when MSFT launched the Xbox, the company captured 2% of a highly competitive industry. In 2010 MSFT has managed to increase its market share to 17% and produce a $679 million profit that consolidates its place in the market with great hardware, games and online multiplayer capabilities. Its recent launch of Kinect, a motion detector sensor controller, was a complete success. It broke the Guinness world record of the fastest selling consumer electronics device with 8 million units sold in 60 days. Not even Apple could manage that with the iPad or iPhone. The Kinect´s and Xbox success shows that Microsoft still retains the capability to enter and succeed in new markets. Forecasting until 2017 I expect Microsoft to grow its participation in the gaming console market up to 20%.
R&D and Cash:
Another factor for growth to consider is the huge amount of resources Microsoft spends in R&D which has averaged 15.53% of revenue during the last decade. Always trying to introduce new technology that changes the way people work and interact, and in the process create a new market in which it has total control, Microsoft is heavily focused on “Cloud Computing” which is the next wave in the technological revolution. CEO Steve Ballmer states: “The cloud is revolutionizing computing by linking the computing devices people have at hand to the processing and storage capacity of massive datacenters, transforming computing from a constrained resource into a nearly limitless platform for connecting people to the information they need, no matter where they are or what they are doing. This has profound implications for the way people use technology across their lives to work, learn, communicate, and have fun.”
Ballmer adds: “At Microsoft, we firmly believe the impact of cloud computing will be as big as – or bigger than – the previous waves of technology change. The opportunities cloud computing will create for our customers, our partners and our company will be immense. When it comes to the cloud, we are all in”
Currently MSFT is devoting most of its R&D budget on “Cloud Computing” research and for 2011 90% of their engineers will be working in products or projects related to this new technology.
The potential for growth in this new technology is extremely high but at the same time, hard to forecast. As you will see in the Microsoft valuation, this isn’t discounted in the price.
In the other hand, depending the method you wish to use, Microsoft has approximately $3.5 to $5.0 dollars of cash per share free of debt. That is $29 to $41 billion dollars MSFT has available to buy or have a share of companies with new technologies and higher flexibility that offer good growth prospects. Even simpler than that, Microsoft can and does invest in themselves by buying back their own shares and reward their shareholders by increasing earnings and dividends per share. Microsoft has the capability of buying $16.3 Billion of its own shares according to the current buyback policy.
I believe that at the current prices the potential uses of cash are not discounted in any premium or form in the stock price.
Other Divisions and Forecasts:
You can see a detailed model I used to value Microsoft and forecast other divisions in the following link: https://www.trefis.com/company?hm=MSFT.46409&shr=46409&from=share
Valuation – The Stock is Cheap:
Using the Trefis model I linked above and utilizing a 12% discount rate the target price I obtain for Microsoft is of $36.83 per share, 45% above the market price.
Using a simpler approach using the Gurufocus.com DCF calculator I halved Microsoft’s historic earnings growth rate to 7% and gave it a 0% terminal growth rate. The price obtained per share is of $27.68. Add the free cash of $4 dollars per share and you obtain a price of $31.68, 25% over the market price using very conservative estimates.
Valuation Ratios:
Using valuation ratios you can also see that Microsoft is not expensive and the stock price does not carry an important growth premium. Its current business operation is undervalued and the market is ignoring the potential of Microsoft’s R&D and cash that could be put to work.
Using historical valuations for Microsoft, the P/E ratio is at the bottom of its historic range:
The stock is cheap using a conservative DCF analysis and offers a considerable margin of safety in its current business operations, not taking in account future growth opportunities. Using valuation ratios or historic P/E’s suggests that Microsoft is cheap and the market is not pricing growth in this stock. The stock could gain as the market corrects the price to a fair valuation and / or Microsoft surprises with unexpected earnings growth, new technologies and products or by buying – partnering younger companies.
Microsoft Technical Analysis:
Using Technical Analysis, Microsoft looks like a good “oversold” buy candidate.
It is currently at a support level created by the rising bottoms trend line and a previous low set at $25 dollars.
Its “Stochastic Oscillator” is currently in “oversold” territory and we have consistently seen Microsoft bottom out or at least get a significant bounce from these oversold readings. The only time in which we a saw a more prolonged decline in price of the stock, despite oversold readings, was during the market crash in 2008-2009.
Buying Microsoft now using technicals would be following the buy low and sell high mantra.
Smart Money Buying:
As a sort of confirmation that Microsoft is cheap and it is offering opportunity to reap great profits, I have observed that successful investors and fund managers have been buying the stock during the last quarter or have the stock as part of their portfolio.
In the S&P 500 Guru owned stocks grid, 29 of the 48 Gurus the site tracks own Microsoft. Together with JNJ, MSFT is the most owned guru stock. During the last quarter of 2010 David Tepper, manager of the most successful hedge fund from 2008 -2010 doubled his stake on the stock.
During the same time period, value investment gurus such as Joel Greenblatt, Ronald Muhlenkamp, Donald Yacktman and Charles Brand were also buying.
Conclusion:
In my view Microsoft is a clear buy because:
- It possess a powerful moat due to high switching costs and a network effect that allows it to maintain a near monopolic market share of the operating systems and productivity software. These markets are expected to grow in the future.
- The company will remain profitable in good or bad economic conditions and won’t be as affected as other businesses by higher commodity prices or other inflationary pressures.
- Very high and consistent profit margins and returns over capital over a 10 year period.
- New growth opportunities thanks to extensive R&D in the next technological wave (cloud computing) and lots of cash to buy up or partner with new hot companies.
- Stock is significantly undervalued discounting their current operations and has no premium for future growth potential.
- Smart Money investors own Microsoft and have been buying at the current prices during the last quarter of 2010.
Disclosure:
I am long Microsoft at an average price of $26.14 per share.
