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Mr. Buffett, At What Price You Would Buy Microsoft ?



This summer I spent some time considering an investment in Microsoft. It is clearly a dominant company with an incredible balance sheet. And it had arguably become quite cheap. By my calculations Microsoft was pretty much offering a 10% free cash flow yield. I laid it out like this:

Here is a simple look at the numbers:

Cash flow from operations over the past 3 years

2007 - $17.7bil

2008 - $21.6bil

2009 - $19.0bil

To make is easy I’ll estimate the business is producing $20bil per year.

Current shares outstanding – About 9 billion fully diluted

Share price today - $26

Market cap is therefore - $26 x 9,000,000,000 = $234bil

Microsoft has about $32bil of net cash on the balance sheet, so the enterprise value is in roughly $200bil.

So if you are buying a share of Microsoft today you are basically buying a business that is producing $20bil of free cash flow per year and for that you are paying $200bil which is a 10% free cash flow yield.

And I certainly wasn’t the only person interested as quite a few well known value investors were picking up shares of Microsoft at those prices. Whitney Tilson who was buying shares provided a very nice analysis of the company here:

Other well known investors buying included Einhorn and John Griffin. Of course one person who wasn’t buying was Warren Buffett.

When I consider that Buffett is sitting on $30 billion of cash yielding basically nothing today I find it very interesting that he wasn’t tempted to deploy at least some of that into Microsoft with its dominant business and 10% (and growing) free cash flow yield. When you further consider that he is best buddies with Bill Gates and therefore must have a huge advantage in analyzing the business his lack of interest is even more intriguing.

In the late 90s an e-mail exchange between Buffett and a Microsoft employee was posted on the internet where Buffett explained why he was not a shareholder at that time. Of course the price then was much steeper relative to cash flow than it was this summer, but it does sum up the reason for Buffett’s avoidance. The details of the exchange are as follows:

Microsoft employee Raikes on why Microsoft was an excellent investment:

RAIKES: “In some respects, I see the business characteristics of Coca Cola or See’s Candy as being very similar to Microsoft. I think you would love the simplicity of the operating system business. For example, in 1996, there were 50 million PCs sold in the world, and about 80% of them were licensed for a Microsoft operating system. Although I would never write down the analogy of a “toll bridge,” people outside the company might describe the business in that way. Those 40 million licenses average about $45 per, for a total of about $1.8 billion in revenue…

In 2000, there will be about 100 million PCs sold. We think we can reduce piracy to 10% and license 90% or 90 million of the PCs. But we also have “pricing discretion” – I think I heard this term used in conjunction with your pricing decision on See’s Candy. We will be transitioning the world to a new version of our operating system, Windows NT… We can achieve average license revenue of $80. So 90 million licenses at $80 per license totals about $7.2 billion, up from just under $2 billion in 3 to 4 years. And since there are effectively no cost of goods sold and a worldwide sales force of only 100-150 people, this is a 90% plus margin business. There is an R&D charge to the business, but I’m sure the profits are probably as good as the syrup business…

So I really don’t see our business as being significantly more difficult to understand than the other great businesses you’ve invested in. But there is one potential difference that worries me, and it is key part of the reason I spent the time to share these thoughts with you. The difference I worry about is the “width of the moat.” With Coca-Cola, you can feel pretty confident that there won’t be a fast shift in user preferences away from drinking sodas, and in particular, Coke. In technology, we may more frequently see “paradigm shifts” where old leaders are displaced by new. Graphical user interface replaces character user interface, the Internet explodes, etc…

In technology, the moats may be narrower… I am very confident about our business for the next 5 to 10 years. But I will admit it is easier to be confident about Coke’s business for the next 10 years… My theory is that you don’t invest in technology or Microsoft because you see the moats are narrower; too much risk and the potential for a fast paradigm shift that would too quickly undermine your equity position…”

And Buffett in reply:

BUFFETT: “Your analysis of Microsoft, why I should invest in it, and why I don’t, could not be more on the money. In effect the company has a royalty on a communication stream that can do nothing but grow. It’s as if you were getting paid for every gallon of water starting in a small stream but with added amounts received as tributaries turned the stream into an Amazon. The toughest question is how hard to push prices…

Bill has an even better royalty [than Coke]—one which I would never bet against, but I don’t feel I am capable of assessing probabilities about, except to the extent that with a gun to my head and forced to make a guess, I would go with it rather than against… If I had to make such decisions, I would do my best but I prefer to structure investing as a no-called-strikes game and just wait for the fat one.”

I certainly find it amazing that 15 years later having spent huge quantities of time with Gates that Buffett still isn’t interested even at a price that would be reasonable for an average business never mind a dominant business. I guess that is what makes Buffett so great. He will only buy when he feels certain that the investment is within his circle of competence and that the price is a bargain. Buffett didn’t miss much by not investing in MSFT in the late 90s when the price relative to cash flow was much higher as the stock price has gone virtually nowhere. Surely 15 years from now MSFT investors will have had a little better run.

About the author:


Rating: 3.3/5 (25 votes)


Kerpang - 3 years ago
Microsoft earning visibility is certainly not as clear as Coke's.

Have you not heard of new Google desktop OS, MacOS, Linux, OpenOffices, Oracle Virtualisation, VMWare, Cloud computing etc..

But for PE 10x (ex cash), it is probably worth a punt.
Davethebooker - 3 years ago
Circle of Competence is a great Phrase. That is your whole article . Why waste so much space ?
Energywonk - 3 years ago
microsoft is already dead. windows phone 7 is really quite good, but its too late. we are beginning to experience technological lock in, with iphone infrastructure reinforcing its dominance everywhere. its a shame. game over. short microsoft.
Sivaram - 3 years ago
Buffett didn't grow up with computers so it'll be difficult for him to get a handle on them. Think about it this way: Buffett probably spent 80% of his life analyzing companies that are unlike the modern technology companies. Companies like Microsoft, Google, and the like, are very new and different from what existed pre-1990's. That is not to say that the business itself is something different; it's all the same. But it does mean that the economics of the business may be a bit difficult for someone who spent most of his life in the 50's to 80's period. For instance, I have a hard time understanding social networking Internet service companies simply becaues I never really grew up with them.

If you look at some of the younger so-called value investors, like David Einhorn, they do buy technology companies.
Kfh227 premium member - 3 years ago

Microsoft is also embedded in the server markets. They might become smaller but they will not go away.
Adib Motiwala
Adib Motiwala - 3 years ago
A minor point but Cash from operations is not FCF.
DocMoney - 3 years ago
Where to begin...

I agree with valuation of MSFT, with EV/FCF being around 10, at least when I bought the stock at about 25 not too long ago. CROIC is in the order of 30%, which is ridiculously good and rivals that of cigarette companies. Also something like 30 bil excess cash on the balance sheet... This is not just a castle with a moat, this is a coastal fortress on an island in the middle of the ocean with 16 inch guns and plentiful ammo.

Now let's talk about what they do. Windows is hugely dominant and that is unlikely to change any time soon. Now I am a linux user, and I am typing this under Ubuntu Linux 10.10. But my friend recently showed me windows 7, and I was impressed - they finally got it right. Windows 7 is fairly straightforward, stable and relatively easy to use, which is really all you need from an OS. Internet explorer is dominant as well, and I use firefox and google chrome and I do not think they have what it takes to displace IE. Now they are good browsers, but they do not have a significant advantage and the incumbent, IE, will therefore likely remain where it is. Plus through partnerships with PC manufacturers, Windows has a huge competitive advantage (should we call it distribution network?).

Next is Office. This is the big dog. In fact, this dog is as big as godzilla and nothing is going to touch it any time soon. I actively use Google docs and OpenOffice; one huge advantage MS office has over open office is macros, which just do not work nearly as well on OpenOffice. Some more sophisticated users told me interconnectivity with other software in MS office is unparalleled and is required now in many companies.

For both Windows and Office, support infrastructure is available everywhere and support matters for enterprises in a big way, because they do not have the time to tinker with Linux or Chrome OS. They just need the thing to work again so that they can get their work done. Advantage: MSFT again.

Next: WIndows mobile. I actually think MSFT showed a surprising amount of innovation here. Why use desktop with icons when you can make it all icons that are active? I like the idea. I feel this will compete effectively and steal market share from apple and maybe even android. MSFT just needs to release enough apps. Time will tell if they can do this. I use an android phone and do not have extensive experience with windows phone, however.

Next: Xbox. Videogames are a huge business and MSFT executed very well here. Kineckt is also a huge hit, and XBOX leads nintendo wii in the number of games and I feel effectively competes with SONY PS3 on all levels. I use PS3 and Wii but I tried Xbox and it is very pleasing to use.

MSFT is pushing its way into cloud computing and just got a big US government contract... It is buying back its shares by bucketloads and shamelessly hiking its dividend. I think that MSFT is finally hitting on most, if not all, cylinders and deserves a position in a prudent investor's portfolio.

Oh, one more thing... Wouldn't Mr. Buffett be accused of insider trading if he bought MSFT, given his friendship with MR. Gates?

Brucechin premium member - 3 years ago
to Further Motiwala's comment, one needs to deduct Capex to get FCF.. For a tech company like MSFT capex can be in equipment but more often it is in R&D expenditures.
Sivaram - 3 years ago

Oh, one more thing... Wouldn't Mr. Buffett be accused of insider trading if he bought MSFT, given his friendship with MR. Gates?

Nope... IANAL but just because you know the insiders of another company doesn't mean you can't buy that company. You just can't act on non-public material or anything else secretive.
Energywonk - 3 years ago
Doc money: good overview. in short microsoft is a classic encumbent, that was once innovative and is now being eroded by cloning/imitation etc. gates in fact acknowledged decades ago that all monopolies eventually fail and it was rumoured the only pic he had on his wall was of henry ford to remind him not to go the way of ford!! strange that when iphone was released gates stepped down from MSFT. heres my response:

Xbox. i agree, not a bad job, they should survive here, but the console is at end of life. hopefully next generation will continue to build on the brand loyalty/strengths. red ring of death eradication is highly recommended!

as an HTC touch HD, windows 6.1 user i can tell you that the phone is good, the software is awful. windows phone 7 is great and i have used a bit, its a good step up and truly some innovations here but its a little too late in my opinon.

Office: this is already being eroded by googledocs as you mention, the resistance to upgrade to vista and office 2007 in enterprise and the fact that everything is being made compatible with it. the entire computer is shifting to the pocket. the traditional desktop and therefore msft core markets are dissapearing............who cares about office? i work in enterprise and i can tell you, office has 5 years left before its irrelevant/perfectly imitated.

yep cloud is very important, but google is showing that the eventual cost of storage is zero. yes zero. if microsoft is chasing this market they need innovative leasing models etc to generate the kind of cashflow they are used to

if you are after some good dividends then MSFT is probably not a bad bet for next 5 years, but how much downside capital loss will you experience chasing yield?

buffetts rule still applies. if you understand tech, and can pick the winners, get on a trend you will do well. for instance HTC is a great manufacture, and will do well via android........if not, you should adhere buffetts rules. technology is hard to invest in!!!

DocMoney - 3 years ago
Energywonk, thank you for reminding me that overconfidence can hurt the investor:) I also value your opinion as that of someone who works in enterprise. I am a physician - a radiologist - and my work depends very heavily on computer hardware and software. So please allow me, for the sake of debate, to offer the following thoughts.

Windows mobile 7 being too late - MS Internet Explorer (IE) was also late to the market and at the time, vastly inferior to Netscape. I remember this very well. However, MS simply outgunned Netscape eventually. This is exactly what MS is good at - let the others innovate, then pick out the promising areas and simply steal them. With so much cash and such wide market share, they can take on any opponent and give them a run for their money. Apple is NOT invincible, and neither is Android. Blackberry is quite entrenched in the corporate market but it too can lose market share. This part of MSFT's biz has nowhere to go but up, since as you correctly described, prior versions of Windows Mobile were subpar.

On to Google Docs. While fairly easy to use and available from any decent connected computer, almost regardless of platform (OS/Browser), there are a few drawbacks. The biggest drawback is, AFAIK, that Google does not support its docs nearly as well as MSFT supports Office. If google begins to offer that support, it will cost Google money and the product will eventually become not free. As someone whose work depends on software working smoothly and someone who has no time or desire to tinker with things instead of being productive, I believe that support is essential to being accepted in the business realm. Lost productivity can easily wipe out any gains associated with paying less for a product. Additionally, Google docs is now nowhere near as capable as Office. Building up google docs to match MS Office will be quite costly and limitations of running within a browser may serve as a barrier. Another thought is that, with cybersecurity being paramount, creation of documents offline and their offline storage may again become more widely practiced. Google docs has an inherent security risk associated with unencrypted data transmission and probably not very secure storage of documents.

On to cloud. Cost of storage approaching zero will help MSFT rather than hurt it, since it will pay less for storage. It will charge for value added services, and as a result of decreasing costs its margins may actually get fatter.

Xbox - I see no problem with MSFT updating xbox when needed.

Mobile computing replacing desktops - sure, but not in all applications. Cheapness and ridiculous power of desktops, as well as ability to use them with large and multiple monitors, are again making them attractive to enterprises... Why use a tablet or phone for those who do not have to be mobile and can sit in a cubicle (probably a very large percentage of workers)? Windows 7 runs on laptops and tablet PCs as well, and now there is windows for the phone. So MSFT has its hand in all mobile devices, and I see no reason why its office suite cannot be adapted for these devices if need be.
Energywonk - 3 years ago
i cant fault your analysis doc. you have almost convinced me. ahahhaha, and perhaps it highlights the difficulty in tech investments especially for an encumbent that appears to be slipping, but going down fighting. i prefer more certainty when i allocate capital. perhaps a collar strategy is appropriate that way you can play both ways?
DocMoney - 3 years ago
Energywonk - I simply sold some puts on MSFT... Heads - I keep the premium, tails - I get some more shares on the cheap.
DocMoney - 3 years ago
Oh - regarding collars and strangles - that tends to work better when stock can make large movements, does it not? I do not expect MSFT to move too quickly.
Energywonk - 3 years ago
collars are generally to lock in profits on the long position. i assumed you had owned MSFT for a while?
DocMoney - 3 years ago
Nope, got it not too long ago... up almost 8% on it but was thinking holding for the long haul...
James Nyka
James Nyka - 3 years ago what price you would buy????????? what price would you buy...
Andy10 - 3 years ago
Hi, i haven't analysed MSFT in detail, but my guess is that the truth is somewhere in between Energywonk's and DocMoney's opinions, that is in a decade or two MSFT might become something like GE, using it's scale and financial power to stay competitive, having corporations as core clientele, but also making products for the end users. so i agree with docmoney - msft is becoming a classic cash cow which can be a good bargain at the right price. But i also agree with energywonk that the margins could erode to a certain extent as a result of much higher competition nowadays than 5-10 years ago.

i do use Windows 7 and MS Office 2010 (and quite happy with it), but i don't own any shares of MSFT ;)
Dthanasse - 3 years ago
The only reason to buy MSFT is for its spin-off value. Consider the company as a huge conglomerate...spin-off:

1) Windows/Office

2) Server software business

3) Hardware (Kinect/X-box)

4) Search/Internet (Bing/IE)

5) Mobile phone software

This will than let the market decide on the winners and losers. The cash can deployed to the fastest growing businesses. Windows/office could than become an income play (most likely no long-term growth so pay a healthy dividend).

It doesn't take much forward thinking that 5 spin-offs would produce more value that the present $25-$26 stock price. More importantly...the spin-offs would add some 'excitement' to the stock; something it hasn't seen in a decade.

Position: Long MSFT
Batbeer2 premium member - 3 years ago
This will than let the market decide on the winners and losers

I don't think it's the (stock) market that will decide that. The stock market only expresses the current consensus opinion on the likely winners and the likely losers. That opinion may or may not be reasonable.
Cm1750 premium member - 3 years ago
Mr. Market has been shown to be pretty inefficient at times, although value will eventually be realized.

Like WMT, MSFT has been dead money for the past decade. People hate buying dead money stocks and portfolio managers are underweight it for that reason.

I look at it from an owner's perspective. I bought some at $23.85 last year and and looking to add more under $25.

Excluding interest income and including option expense, calendar 2011 FCF is at least $2.64. To get a 10% FCF yield, you pay $26.40 then add excess adjusted cash of $3.50 (pay repatriation tax) gives a price of $29.90.

MSFT may continue holding the $5+ cash/share, but will return roughly $2.50 to shareholders via buybacks and dividends this year. Buying shares at $25 gives a "realized" 10% FCF yield even if the existing cash balance sits there earning 0%. I give zero credit to cash balances to account for the repatriation taxes MSFT will have to pay in order to distribute FCF to shareholders over the next 10+ years.
Yswolinsky - 2 years ago
Pretty good call Canadian Value look at this quote from Buffett:

Microsoft Corp is a value play at current levels but Berkshire Hathaway considers itself restricted from buying the stock due to close ties with founder Bill Gates, Berkshire Chief Executive Warren Buffett said on Saturday.

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