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:
http://www.scribd.com/doc/34316183/T2-Partners-Presentation-7-13-10
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.
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:
http://www.scribd.com/doc/34316183/T2-Partners-Presentation-7-13-10
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.
