Microsoft (MSFT) has gotten its share of not-entirely-undeserved bad press in recent months. During our Q1 2011 letter we disclosed that, “The greatest negative impact in the quarter came from Microsoft (down 19bps), a holding we have increased to take advantage of price weakness, given the current low expectations of a P/E of just 10x.” Despite the modest recovery this quarter, we still think the shares are attractively valued, as reflected by an equity multiple that remains at roughly 10x earnings, and an enterprise value of about 7x operating profit.
Irrespective of the stock's lowly valuation, we actually have some enthusiasm for Microsoft's earning prospects. As measured by operating profit, Microsoft's fiscal 2011 earnings may actually be more than 50% higher than five years ago. Though the company clearly faces challenges, we can point to a number of opportunities that suggest earnings five years hence should exceed today's – though by what amount is open to debate. We like that the market appears to have priced its business as one in permanent decline. We believe the market has therefore handed us a free option on the possibility for future growth.
Rather than provide an exhaustive list of the levers available to Microsoft to improve earnings or discuss the tremendous market share in its various business segments, we instead use an example to reflect how little credit Microsoft gets by comparing it to a current tech darling. Salesforce.com (SFE), a leading cloud player with $2 billion in revenues and valued at greater than 100x forward earnings, is – forgive us – a cloud company trading in the stratosphere. Microsoft is already a leading cloud player, as measured by number of users and revenue, and yet the market seems blind to this fact, awarding it just one-tenth the P/E. To secure Microsoft's place in the cloud, Jean-Philippe Courtois, president of Microsoft International, said earlier this year that the company would spend 90% of the company's annual $9.6 billion R&D budget on cloud strategy (more than 4x Salesforce.com revenues).11 With Microsoft‟s R&D staff of 40,000 and a portfolio of product offerings that touches almost every organization in one way or another, we give “Mr. Softee” at least a fighting chance at remaining relevant in the world of corporate cloud computing.
As for the legacy Windows franchise, the recently introduced Version 7 had the fastest take-up in the company's history. We recognize, though, that many of you may read this commentary on a computer running a predecessor, Windows XP – which continues to have the largest global installed base of any operating system. Come April 2014, we regret to inform you, Microsoft will no longer provide XP support (e.g., no more maintenance updates). We suspect this will drive another strong cycle of upgrades, contrary to what Microsoft's valuation would suggest is a business in steep decline.
Microsoft isn't the only large-cap technology company to be viewed so negatively, as can be seen in the following chart. Large-cap tech stocks are as cheap as we've ever seen them, both on an absolute basis and relative to the broader market and historical sector multiples. We have therefore invested in a basket of other such companies that we find inexpensive.