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Should You Buy Microsoft?

May 23, 2011 | About:
Geoff Gannon

Geoff Gannon

414 followers
Someone who reads my blog sent me this email:

Hi Geoff,

I am probably not the first one to ask about this old article...

"I don’t own shares of Microsoft (MSFT). I won’t be buying any either. I don’t normally own such large stocks. I prefer much smaller businesses, because the mispricings tend to get more out of whack. You aren’t going to see Microsoft trade at an EV/EBIT of 7.5 or something like that, but you do sometimes get those chances in small (high-quality) businesses."

With EV/EBIT at 5.7 now, are you a buyer?

Buffett recently commented that Microsoft is cheap. The last time I heard him make remarks like that about Wells Fargo and American Express, anyone who invested would have been very happy one year later...

Corner of Berkshire also has several board members that are very positive about investing in Microsoft right now.....

I get a lot of questions about Microsoft . It's definitely the stock I get asked about most.

Microsoft looks very cheap.

Microsoft has three businesses I like: Windows, Office and Xbox Live.

One business I hate: Search.

And one business I don't understand: Servers.

Two of the three businesses I like — Windows and Office — have huge competitive advantages but also face serious technological threats. The third — Xbox Live — has technological tail winds, but will never achieve a monopolistic position like Windows and Office did.

For an investor, Xbox is inconsequential compared to Windows and Office. So let's look at the two businesses that matter most at Microsoft: Windows and Office.

Those businesses are so profitable that any change in the model — even if the customer stays with Microsoft for their operating system and office applications needs — will result in a huge decline in profitability.

The operating margins in Windows and Office are close to 70%. To put this in perspective, even FICO's scoring segment — a monopolistic business with near zero marginal costs — only has operating margins around 60%.

So, you could see a decline of $3.5 billion in Microsoft's operating income and it would still have operating margins consistent with a monopoly where it costs almost nothing to produce an additional copy of your product.

If Microsoft's operating margins were cut in half in those businesses, it would still be considered a very good business.

That's the problem. Microsoft earnings reflect not only a monopoly position — but a valuable monopoly position.

Not all monopoly positions are valuable.

I've mentioned AT&T (T) before. American Telephone & Telegraph had a 14-year head start in the long distance business because it had an exclusive patent on the telephone until 1894. Because of networks effects, the idea of competing long-distance services was silly by 1894. AT&T was a monopoly. But as Buffett has pointed out, AT&T didn’t earn high returns on capital over its lifetime. It was a monopoly. But not a profitable one. And AT&T’s shares sometimes sold in the stock market for less than their book value.

There’s another famous example of an often below book value behemoth considered to have a dangerous hold on its market: U.S. Steel. Despite controlling two-thirds of the U.S. steel market the company frequently failed to earn a decent return on its shareholder's capital.

I’m trotting out these dusty relics of American business to make a point.

Microsoft doesn’t earn mind boggling profits just because it’s a monopoly.

Two separate yet equally important factors made Microsoft the free cash flow gusher it is today:

1) Microsoft is a monopoly

2) Microsoft is in an extraordinarily profitable business

People on both sides of the argument for and against investing in Microsoft tend to understate the importance of No. 2. Actually, they ignore it.

One of the major concerns with Microsoft right now is that they are afraid of losing their monopoly position because of technological change. They are afraid of the products they make going exclusively online. They see their stock trade at ridiculous levels because of this. And so they may do something very stupid, like compromise on No. 2. They may try to keep customers by making those customers less profitable. By changing the model in some way.

This explains why I started out saying how Microsoft’s operating margins like Windows and Office are higher than those seen even in insanely profitable businesses like FICO’s scoring segment. Any change to Microsoft’s business model will almost certainly reduce the company’s profits per customer.

It’s important you understand that it’s not enough for Microsoft to keep its customers. It has to keep them on the same terms. In more competitive businesses, it’s not unusual for there to be pretty similar profit margins on the same product even when slight changes are made to how it’s sold. That won’t happen at Microsoft. Right now, the company has the best possible way of selling its products. It’s very unlikely that sales of the same Windows and Office products that are made in a different manner — I’m looking at you, Cloud — will result in the same level of profitability per customer. Profits per customer will almost certainly fall if Microsoft makes any changes to how it sells Windows and Office.

What about Skype?

Does that crazy deal prove Microsoft’s management is insane?

Some people are upset about the Skype acquisition.

It doesn't bother me at all.

Even if Skype is never profitable as a stand-alone business and never would be whether or not Microsoft bought it, the purchase could make sense for Microsoft.

Microsoft Windows and Office together are worth over $250 billion.

I know Microsoft trades for less than that. But I'm telling you what I'd appraise the franchises for if Microsoft was a public company. Xbox Live is also worth something. Very little right now — relative to those two franchises — but we're still talking about more than a quarter trillion of franchise value that needs protecting.

Now, what did Microsoft pay for Skype?

$8.5 billion.

That's less than 4% of the value of Windows and Office.

In other words, if all Microsoft did was buy Skype as insurance — a way to add additional defenses into the two important bundled experiences the company sells — it only paid 4% for that insurance. We can work through probabilities of that defense actually helping to reduce a decline in Windows and Office, and I'd say we're likely to come out the other end at best unsure whether paying $8.5 billion for Skype made sense. But, I certainly don't see any clear and convincing evidence that the Skype purchase was a mistake. It's uncertain. It depends on integration. Which I know nothing about. And it also depends on the uniqueness of what Skype offers remaining that way. And obviously I have no clue what barriers there are in that business. We just have to hope those are things Microsoft’s managers did know when they made the deal.

The Skype acquisition certainly didn't reduce my confidence in Microsoft's management. I can't say it raised it either. But at least they're considering some of the same competitive moves I would consider if I was in their position. Whether $8.5 billion was the right price is another question. But Skype makes sense.

This also brings up the issue of whether Microsoft needs to be more innovative. My own feeling on this has always been that pure technological progress — being the first to do anything — has less to do with the success of Microsoft, Google (GOOG), Apple (AAPL), etc. than most people think.

What we call tech companies are usually less innovative than drug companies and chemical companies. They're further from science and closer to consumers. They’re more in the elegant systems business than the incremental progress business.

There are exceptions. Like Intel (INTC). But Intel is in a bad business. It just happens to dominate that business through a constant race to the bottom. Intel is a good example of what happens when you have a very strong competitive position but operate in a business that isn't especially profitable. Intel is a mixed bag. Nowhere near as good a business as Microsoft.

Intel only has half the value equation going for it. And it's certainly no better than half as good a business as Microsoft.

So, my concern with Microsoft continues to be that it's just something I'm very unsure of in terms of its potential to generate this kind of free cash flow year after year for many years to come.

There are competitors who are willing to spend lots of money to try to take business away from Microsoft despite the fact that they may not reap huge rewards as a result. You can see the same approach with Bing. It doesn't make any sense for Microsoft to own Bing. There's no good reason to keep Bing going. But Microsoft keeps trying to make it work. That’s not unusual for a tech company.

I'm most concerned about Google, because Google's activities make the least sense from a profit seeking point of view. They experiment with a lot of stuff that ultimately comes to nothing.

Google earns almost all of their profits as an advertiser supported media company, yet they think of themselves as a tech company.

For an investor in Google, the only tech that matters is related to search and advertising.

So, it’s alarming to see a company like that pursue disruptive and destructive innovations whenever they can — regardless of whether there’s money in it for them. As long as there’s hope, they’ll keep hoping. And Google has a lot of cash to spend on hopes and dreams.

A well-financed, irrational competitor is never a good thing.

Having said all that, the most likely scenario is that Microsoft's stock returns 15% a year from here if you buy and hold it right now.

If you covered up the name Microsoft — the way I did in the Blind Stock Valuation — I would certainly buy the stock.

The problem I have is that I don't so much agree or disagree with the alleged severity of the technological threats Microsoft faces as much as I don't understand them. I'm very unsure of how Microsoft's customers would respond to industry changes.

We don’t have much of a history of behavior to go on, because something as inextricably intertwined with everyday business as Microsoft's products are today hasn't been threatened in this way before. The products we are talking about are not simple. And some people clearly aren’t going to switch away from them no matter what.

For example, I use Windows and Office. And always have. But I’d be open to switching away from Windows or some of Microsoft’s applications — but never Microsoft Excel.

In reality, I know I personally won’t be switching from Windows or Office for a very, very long time because of how much time I spend using these products and how much I do with them.

Even if equally good — but different — operating systems and applications were offered to me for free, I wouldn’t be the least bit interested. The time I’d spend learning something new is way more costly than what I pay Microsoft for their product. Price just isn’t an issue.

So, nobody can compete on price with Microsoft for me as a customer.

But is that true of other people?

I have no idea. I’m constantly amazed by how differently people use computers to do their work. There’s a very wide range of different ways people use Microsoft’s products — and I don’t feel I know enough about a lot of people whose work routines are completely different from mine.

Still …

I think — but can't say for sure — that investors, analysts and tech executives are understating some important human elements here and overstating the idea that if a better product is available for less money in a more convenient way that people will adopt it. I have serious doubts that's true. In fact, I'm guessing it would take a lot more than that for someone to breach Microsoft's moat.

However, there's the constant issue of how Microsoft will react. Whether they will overreact. And smother the golden goose in an attempt to save her from an as yet unseen attacker.

Then there's the leadership issue. Bill Gates is focused on charitable work instead of Microsoft. And I have a lot more faith in Bill Gates than anyone else at Microsoft.

If Bill Gates was 100% devoted to Microsoft, I'd buy the stock. This is a situation where management matters.

Microsoft is a tricky stock for me.

My dad owns the stock. And I told him in the last week or so that he shouldn't give a moment's thought to buying any of the other stocks he owns — or looking for new ones — he should just load up on Microsoft. Which shows you how cheap I think the stock is.

Still I’m not buying it myself. Which probably says something too.

Look, if you like the business — you should buy the stock.

Microsoft's stock price is clearly too low.

It's just a question of whether Microsoft is the sort of business you don't want to get involved with.

The probabilities are clearly in Microsoft's favor. You mentioned Buffett. If I was running Berkshire's portfolio, I'd buy Microsoft. Your choices among companies that size are so limited. If I was at Berkshire, I'd load up on Microsoft.

But I can choose from more than 10,000 stocks out there for my own portfolio. I can buy Japanese net-nets if I want. Even if their business implodes, those stocks will still be worth more than I paid for them.

Or I can buy businesses that I think truly are bulletproof buy and hold forever businesses. I'm talking about businesses where I can predict how their customers will behave in 5 or 10 years. And I can imagine how their customers would behave under almost any situation imaginable.

I don't think Microsoft is like Coca-Cola in terms of being able to predict long-term buying habits. The user’s behavior is more complicated at Microsoft than at Coke.

That's the risk. A change in customer behavior.

So, no, even at today’s low, low price it's still very unlikely Microsoft will end up in my own portfolio.

But I also feel more certain about Microsoft than I do about any other large-cap stock. It's extremely probable that Microsoft will outperform the market over the next five years or more. The odds of that not happening are pretty low.

So if you own mega-cap stocks and you diversify more than I do, I definitely think it makes sense to buy Microsoft even though I won’t be joining you.

I sent my thoughts to the person who asked the question about Microsoft. This is what he had to say in response:

Initiatives like OpenOffice and LibreOffice don't seem to have a big impact on Microsoft Office.

I have personally tried these applications and have come to the conclusion that they are good basic copies of Microsoft Office applications but lack certain key features which made me return to Microsoft quickly.

It is highly likely that there will be a need for OS software and office applications 10-20 years from now.

It is highly likely that Microsoft will be the preferred provider for these applications.

At the same time, it is strange that something so "basic" can generate so much profit for one company

Regarding Gates, I am sure that he still is very connected to Microsoft at a strategic level, having the majority of his personal wealth tied up in Microsoft. If anything, being detached from day-to-day operations might even be an advantage for him to see the bigger picture in tech; you can bet that the Skype acquisition wouldn't have happened if he had been against it.

I am seriously considering taking a 2-4% leap (2013) position that would give me approximately 15% portfolio exposure to Microsoft.

Based on how he feels about Microsoft’s business and its long-term prospects, that kind of investment probably makes sense for him.

Even if you love Microsoft at this price, you should consider whether you’d want to buy LEAPS — like he’s planning to — or the stock itself.

My own usual approach is to buy a much larger position in the stock itself. If I was truly convinced of the durability of Microsoft’s long-term earning power, I’d probably put 20% to 25% of my portfolio into Microsoft stock instead of buying the LEAPS.

Using LEAPS makes sense for some investors. And the odds on the January 2013 LEAPS paying off look good.

Last I checked, you only had to pay about $3 to get the option to buy Microsoft stock at $25 a share in January 2013.

So, if you’re determined to invest in Microsoft, you can decide between paying $24.50 a share to buy the stock today or paying $3 to have the option of buying the stock at $25 in January 2013.

Obviously, there are other expiration dates and strike prices available. But this isn’t an article about options.

So, I’ll just say that Microsoft LEAPS are something you might want to look into.

Follow Geoff at Gannon On Investing

About the author:

Geoff Gannon
Geoff Gannon


Rating: 4.0/5 (40 votes)

Comments

WIBruin
WIBruin - 3 years ago
There are a bunch of odd references to US Steel here.
Sivaram
Sivaram - 3 years ago


LOL, yeah the US Steel thing seems messed up... Anyway, as usual, excellent article by Geoff.

The big risk with Microsoft, as Geoff alludes to, is that even if they maintain market share, their profit margins may decline. For instance, say tablets end up replacing 50% or 60% of the laptops and Microsoft's Windows still remains the dominant tablet operating system (yes, there isn't a tablet OS right now but let's say Microsoft somehow captures that). Well, in that case, what happens if the price of Windows falls from $75/license or whatever it is for large OEMs, to, say, $25.

I also find it fascinating how Geoff looks at the Skype purchase. I haven't seen anyone look at such a move as strategic insurance but it's an insightful way to look at it. I'm still not sure what the value propostion of Skype is but then again I'm not the type that communicates much.
viksingh01
Viksingh01 - 3 years ago
The behaviour change that MSFT needs to worry most about is not consumer but IT departments. That I believe won't change anytime soon. A case in point Black Berry vs I phones, and windows/office is 100 times more important and integrated.

80% of the windows and office sales comes from Corporate. They are rational buyers and are not going to switch just because Ipads are cool. There is a huge cost to switching - training, loss of productivity, equipment cost etc. The average age of the top management in most cos. is 50 years +, a group not knows for its tech savvy. Switching to a different system has to be a no brainer investment decision, which it will never be as MSFT will catch up to most innovations to keep its customers happy.

I believe, given the price $24.5 approx, they just need to buy the stock and we will get good returns. they make $2.5 + FCF per year. $4 in cash. Lets say for next 10 years they will have the windows and office division with similar economics, xbox, phone and bing more profitable to mainitain a 5% earnings increase. all the earning either go in stock purchase, dividends or cash build up. Over next 10 years they will have roughly $30 /share FCF. Assume, half of that will go on the books, and half for dividend and stock buyback. In 10 years you will have 30% more ownership, of a stock making $4 per today's share (5.5 eps after buy backs) and holding $19 in cash. How much will it be worth even if the multiple doesn't expand. 19+5.5*8=63. that is 10% return all you have to is build cash and buy stock.

Do we seriously believe that 8 multiple is justified, it should atleast be 10.

Skype is just too complicated, but obviously there are two sources of value realization. 1. How it develops as a stand alone business within microsoft 2. how it adds to competitiveness of MSFT products.

#2 is hard to tweak out, therefore performance as a standalone will be something to watch out for and may be assign some value for strategic purposes.

Skype will be a standalone business within MSFT, lets see how it goes.

MSFT is a classical unloved blue chip, you may get better returns elsewhere, but MSFT will give you resonable returns at lower risk.

Vikram

sciomako
Sciomako - 3 years ago
Vikram,

Where do you get the 80% figure for corporate sales?

--

J

mikewen
Mikewen - 3 years ago
You missed another important business: Windows Phone

After Nokia partnership and Skype, Windows Phone very likely be able to gain decent market share.

I do not agree your thought on Intel, Intel is in the best position to benefit from Global PC growth,

third countries consumers can copy Windows(Big problem for MS), can have their own search site (Baidu), or their own eBay, Amazon ,etc, but they can't make their own CPU.

That's why so many analysts can't understand Intel's earnings and got it all so wrong!

We will see Intel's earnings growth in next few years.

mikewen
Mikewen - 3 years ago
You did not even mention Servers/Tools business ?

Microsoft Exchange server already the leader of email servers.

And their Visual Studio is the best development tools.

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