Continued from Part 1...
Forward looking earnings guidance provided by management for FY12
i) Its largest revenue and operating profit segment, Microsoft Business Division transactional revenue likely lag overall PC market. However, multi-year licensing revenue should grow low double digits.
ii) Its second largest revenue and operating profit segment, Windows and Windows Live transactional revenue in emerging market growth significantly outpacing developed market growth. Business PC growth to outpace consumer PC growth, as business refresh continues. We opined that many of the business and personal usage of Windows XP will likely to fully convert to Windows 7 due to the old cycle attrition.
iii) Its third largest revenue and operating profit segment, Server and Tools transactional revenue to track with the hardware market. Multiyear licensing revenue and enterprise services revenue to grow low double digits.
a) Key Statistics
Key statistics revealed that Microsoft is indeed in a healthy position, with Z score of 5.2 (>2.99=safe) denoted its financial strength; F score of 6 (max 9) indicated healthy business trend and only blemished by slightly higher leverage y-o-y (total liabilities/total equity increased from 0.3x (FY02) to its peak of 1.03x (FY07) then dipped again to 0.9x (FY11)). However, upon further inspection, the nature of true leverage was lower. Unearned or deferred revenue is the payment received before providing goods and services. Thus increasing customer advances in the form of unearned revenue will not require an outflow of cash in the future and thus less onerous than other liabilities. Therefore, if we were to adjust out the unearned revenue from total liabilities and recompute the true leverage (total liabilities/total equity), the leverage ratio is actually quite stable from 0.58x (FY08) to 0.6x (FY11).
Of course one may play the devil’s advocate and ask what about the increasing debt to equity ratio from 0.15x (FY09) to 0.21x (FY11)? Well, if you net off the cash, your net gearing becomes negligible ratio of <0.04x over the financial years concerned.
b) EPS and EPS growth
Microsoft’s EPS impressive exponential growth from $0.72 (FY02) to current TTM $2.73 (10 year CAGR 15.29%), is mainly attributed to increased earnings with 10 year CAGR of 11.71% to current net income of $23bil and share repurchases from 10.8bil shares outstanding (FY02) to 8.4bil (TTM). From my radar stock screen and intrinsic valuation, it appears that Microsoft may have room to run, provided its EPS growth is not compromised by other exogenous factors.
See chart: EPS and EPS growth
c) Net income and net profit margin
Not to mention its strong economic moat, evidenced by its overall up trending net margin, albeit on a volatile trend.
d) Management
Hedge fund manager, David Einhorn asserted that Microsoft has a chance at smartphone market with its partnership with another tech behemoth, Nokia (NOK) and that CEO Steve Ballmer "continued presence is the biggest overhang on Microsoft's stock." In our opinion, any dynamic business especially technology have too many moving parts for us to make a judgment call on management to provide another catalyst. Consumers are known to be fickle and the resurgence of Microsoft -Nokia innovative smartphone may swing their votes to them.
Part IV: Valuation
a) Company’s valuation
From our proprietary valuation, Microsoft currently trades at 9.39x earnings power, the lowest range compared to 10-year average low/high of 16.1x and 22.6x. Further, its P/Sales per share, P/Operating cash flow per share and P/book value per share is the lowest at 3.2x, 8.04x and 3.8x respectively, illustrating an attractive entry point.
b) Comparable Companies(Assuming the same growth rates and discount rate)
Microsoft is the cheapest amongst its peers, at PE of 9.39x, trading at 3.8x its book value and taking margin of safety into consideration.
c) Fair value calculator - DCF
GuruFocus DCF gave it a fair value of $82.16, with 69% margin of safety (closing price of $25.25 as at June 26th, with high business predictability of 4.5 star. The price target of $82.16 is based on DCF which assumes a 15.3% 10 year EPS long term growth rate, 4% terminal growth rate, 5% risk free rate, beta of 1 and 7% risk premium.
See, fair value
Part V: Headwinds
i) The significant headwinds are more extended PC refresh cycle (business and consumer spending pressure resurfaces) and notebook cannibalization from tablets where MSFT lacks. See Microsoft Windows Sales Stall in Tablet Headwinds
However, Ticonderoga Securities analyst Neil Herman, in an interview on CNBC opined "We believe Microsoft will be a major player, with its partners, in the tablet space, particularly when they come out with Windows 8" mitigates this sales cannibalization impact on notebooks from tablets competition.
ii) To change the market sentiment on Microsoft from a matured profile to a growth company
Conclusion
With so many moving parts of a dynamic sector and business, it is indeed tough to pinpoint the significant headwinds facing Microsoft.
We reiterate our conviction buy on Microsoft 1) as an attractive way to leverage on a pure play emerging market themes ie cloud computing, smart phone and transition from Windows XP to Windows 7 due to the old cycle attrition 2) new rollout strategy of Nokia’s Windows Phone 7 3) Windows 8 tablet to rival that of Apple and Android 4) cloud computing growth 5) leverage on Xbox to increase economies of scale 6) shareholder friendly actions such as dividend yield and shareholder buybacks.
Microsoft currently trades at 9.39x, the lowest range compared to 10-year average low/high of 16.1x and 22.6x-from our proprietary valuation as S&P 500 industry average trade at 12x earnings. Ergo, when Microsoft closes its valuation gap, it should be trading near $32 (EPS $2.69 TTM), with upside of 28% (Microsoft currently trades at $25.25 at the time of this writing).
But, the crucial element in order for Microsoft to realize its intrinsic value may be as simple as increasing its dividend payout ratio, given the company's strong free cash flow profile delineated below. Value investors must exercise patience and given its current 2.42% TTM dividend yield to compensate for holding the stock, it may be worth the wait.
Forward looking earnings guidance provided by management for FY12
i) Its largest revenue and operating profit segment, Microsoft Business Division transactional revenue likely lag overall PC market. However, multi-year licensing revenue should grow low double digits.
ii) Its second largest revenue and operating profit segment, Windows and Windows Live transactional revenue in emerging market growth significantly outpacing developed market growth. Business PC growth to outpace consumer PC growth, as business refresh continues. We opined that many of the business and personal usage of Windows XP will likely to fully convert to Windows 7 due to the old cycle attrition.
iii) Its third largest revenue and operating profit segment, Server and Tools transactional revenue to track with the hardware market. Multiyear licensing revenue and enterprise services revenue to grow low double digits.
a) Key Statistics
Key statistics revealed that Microsoft is indeed in a healthy position, with Z score of 5.2 (>2.99=safe) denoted its financial strength; F score of 6 (max 9) indicated healthy business trend and only blemished by slightly higher leverage y-o-y (total liabilities/total equity increased from 0.3x (FY02) to its peak of 1.03x (FY07) then dipped again to 0.9x (FY11)). However, upon further inspection, the nature of true leverage was lower. Unearned or deferred revenue is the payment received before providing goods and services. Thus increasing customer advances in the form of unearned revenue will not require an outflow of cash in the future and thus less onerous than other liabilities. Therefore, if we were to adjust out the unearned revenue from total liabilities and recompute the true leverage (total liabilities/total equity), the leverage ratio is actually quite stable from 0.58x (FY08) to 0.6x (FY11).
Of course one may play the devil’s advocate and ask what about the increasing debt to equity ratio from 0.15x (FY09) to 0.21x (FY11)? Well, if you net off the cash, your net gearing becomes negligible ratio of <0.04x over the financial years concerned.
b) EPS and EPS growth
Microsoft’s EPS impressive exponential growth from $0.72 (FY02) to current TTM $2.73 (10 year CAGR 15.29%), is mainly attributed to increased earnings with 10 year CAGR of 11.71% to current net income of $23bil and share repurchases from 10.8bil shares outstanding (FY02) to 8.4bil (TTM). From my radar stock screen and intrinsic valuation, it appears that Microsoft may have room to run, provided its EPS growth is not compromised by other exogenous factors.
See chart: EPS and EPS growth
c) Net income and net profit margin
Not to mention its strong economic moat, evidenced by its overall up trending net margin, albeit on a volatile trend.
d) Management
Hedge fund manager, David Einhorn asserted that Microsoft has a chance at smartphone market with its partnership with another tech behemoth, Nokia (NOK) and that CEO Steve Ballmer "continued presence is the biggest overhang on Microsoft's stock." In our opinion, any dynamic business especially technology have too many moving parts for us to make a judgment call on management to provide another catalyst. Consumers are known to be fickle and the resurgence of Microsoft -Nokia innovative smartphone may swing their votes to them.
Part IV: Valuation
a) Company’s valuation
From our proprietary valuation, Microsoft currently trades at 9.39x earnings power, the lowest range compared to 10-year average low/high of 16.1x and 22.6x. Further, its P/Sales per share, P/Operating cash flow per share and P/book value per share is the lowest at 3.2x, 8.04x and 3.8x respectively, illustrating an attractive entry point.
b) Comparable Companies(Assuming the same growth rates and discount rate)
Microsoft is the cheapest amongst its peers, at PE of 9.39x, trading at 3.8x its book value and taking margin of safety into consideration.
c) Fair value calculator - DCF
GuruFocus DCF gave it a fair value of $82.16, with 69% margin of safety (closing price of $25.25 as at June 26th, with high business predictability of 4.5 star. The price target of $82.16 is based on DCF which assumes a 15.3% 10 year EPS long term growth rate, 4% terminal growth rate, 5% risk free rate, beta of 1 and 7% risk premium.
See, fair value
Part V: Headwinds
i) The significant headwinds are more extended PC refresh cycle (business and consumer spending pressure resurfaces) and notebook cannibalization from tablets where MSFT lacks. See Microsoft Windows Sales Stall in Tablet Headwinds
However, Ticonderoga Securities analyst Neil Herman, in an interview on CNBC opined "We believe Microsoft will be a major player, with its partners, in the tablet space, particularly when they come out with Windows 8" mitigates this sales cannibalization impact on notebooks from tablets competition.
ii) To change the market sentiment on Microsoft from a matured profile to a growth company
Conclusion
With so many moving parts of a dynamic sector and business, it is indeed tough to pinpoint the significant headwinds facing Microsoft.
We reiterate our conviction buy on Microsoft 1) as an attractive way to leverage on a pure play emerging market themes ie cloud computing, smart phone and transition from Windows XP to Windows 7 due to the old cycle attrition 2) new rollout strategy of Nokia’s Windows Phone 7 3) Windows 8 tablet to rival that of Apple and Android 4) cloud computing growth 5) leverage on Xbox to increase economies of scale 6) shareholder friendly actions such as dividend yield and shareholder buybacks.
Microsoft currently trades at 9.39x, the lowest range compared to 10-year average low/high of 16.1x and 22.6x-from our proprietary valuation as S&P 500 industry average trade at 12x earnings. Ergo, when Microsoft closes its valuation gap, it should be trading near $32 (EPS $2.69 TTM), with upside of 28% (Microsoft currently trades at $25.25 at the time of this writing).
But, the crucial element in order for Microsoft to realize its intrinsic value may be as simple as increasing its dividend payout ratio, given the company's strong free cash flow profile delineated below. Value investors must exercise patience and given its current 2.42% TTM dividend yield to compensate for holding the stock, it may be worth the wait.
