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Microsoft Corp. (MSFT) – an Undervalued Stock with Strong Business Predictability

August 28, 2011 | About:
Preamble: Technical analysis

Microsoft (MSFT) certainly looks like a dividend play, with its price range from around $15 in March 2009 to its climax of over $37 in May 2007, ex dividend yield and share buybacks. It also withstood the slings and arrows of outrageous fortune (2000: dot-com boom and bust; 2001: 9/11 attacks on World Trade Center; and 2007: subprime mortgage crisis).



Guru Holdings with Microsoft



These are the top 11 mutual/hedge fund gurus which have more than 12 million shares outstanding as at the June 30 filing, bearing in mind they are not reflective of a fund’s entire portfolio. Hedge funds may have hedged their positions with derivatives/short other capital structure as an arbitrage play. A cursory glance at Gurus' latest trades revealed that investors currently have the opportunity to buy the stock at a slightly higher price ($25.25 at the time of this writing) than smart money, i.e., Einhorn, Klarman and Yacktman’s average trade price of $25.04.

Part I: Company background

Microsoft Corporation develops, licenses and supports a range of software products and services for various computing devices worldwide. The company’s Windows & Windows Live Division segment offers a PC operating system that primarily includes Windows 7 and Windows Vista operating systems; Windows live suite of applications and Web services; and Microsoft PC hardware products.

Its Microsoft’s Server and Tools segment provides Windows Server operating systems, Windows Azure, Microsoft SQL Server, SQL Azure, Windows Intune, Windows Embedded, Visual Studio, Silverlight, system center products, Microsoft consulting services, and product support services. This segment also offers enterprise consulting services, and training and certification to developers and information technology professionals, as well as builds standalone and software development lifecycle tools for software architects, developers, testers, and project managers.

The company’s Online Services Division segment provides online information and content through Bing, MSN portals, and adCenter, as well as Atlas online tools for advertisers.

Its Microsoft Business Division segment offers Microsoft office; Microsoft Exchange; Microsoft SharePoint; Microsoft Lync; Microsoft Dynamics ERP and CRM; and Microsoft Office Web Apps, as well as office 365, an online service, offering Microsoft Office, Exchange, SharePoint, and Lync.

The company’s Entertainment and Devices Division segment provides Xbox 360 entertainment platform, which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories; Mediaroom, an Internet protocol television software; and Windows Phone that provide Microsoft Office and Xbox LIVE functionality. It markets and distributes its products and services through original equipment manufacturers, distributors, and resellers, as well as through online. Microsoft was founded in 1975 and is headquartered in Redmond, Wa.

Note: Revenue and operating profit breakdown by segment is provided below:

Part II: Analysis of Business





Fig. 1: Revenue for Twelve Months Ended June 30, 2011



Fig. 2: Operating income (loss) for Twelve Months Ended June 30, 2011

Part III: Fundamentals/Catalysts

Fundamentals

1) Cheap valuation (S&P 500 industry average trade at 12x earnings, and 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). 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).

2) Book value per share of $6.64 (recent TTM).

3) Improving ROE trend from 16% (FY02) to 45% (TTM) despite noted reduction in financial leverage from its high of 2.03 (FY07) to 1.9x (current TTM), signaling lowered risk profile.

4) The cash return on total assets (operating cash flow/average total assets) has increased over the period from 25.3% (FY09) to 27.7% (FY11), which justify the recent acquisitions evidenced from registered goodwill (see point 1 under the Catalysts heading below).

5) High margin of safety at 69% providing downside risk protection

Catalysts (note: we are citing credible sources as empirical evidence to bolster our case for Microsoft).

1) A doubling of its dividend to approximately 5% dividend yield from its current $0.61 per share/2.53% dividend yield ($0.08 per share in FY03) and/or share repurchases for shares to unlock value and entice more value investors in a low-yield market milieu. Further, an inspection of goodwill (as a percentage of total assets) revealed that it had declined from 16.1% (FY09) to 11.6% (FY11); indicative of management’s lack of acquisition appetite. TTM Cash and cash equivalents of $51 billion (net cash of $9.6 billion) from $38.7 billion (FY02) bolstered the case for returning capital to investors unless Microsoft is able to invest in higher ROE projects to spur growth.

2) Windows & Windows Live Division segment: The release of Nokia’s Windows Phone 7 products as third ecosystem. Noted Nokia’s smart phone Symbian has 22.1% share of global smart phone market, and Nokia-Microsoft partnership which Nokia plans to use Windows Phone 7 as an operating system for next generation of smart phones should catalyze growth. See, Nokia looks to Mango Windows Phone for boost, Analysts confirm Windows Phone 7 as the third ecosystem, but remain guarded and Smartphones With Touch-Screens Set to Dominate Market

3) Windows & Windows Live Division segment: Microsoft’s “new tablet reportedly would borrow Microsoft's branding strategies from such products as the hugely successful Xbox 360, the lackluster Zune media player, and the very short-lived Kin smartphone” by end of 2012 to rival that of Apple and Android. See, Microsoft Readying to Own Windows 8 Tablet?

4) Microsoft’s Server and Tools segment: Azure to be a dominant player in public cloud computing space and collaboration with Chinese OS firm could pave way for penetration into China market. See, Microsoft to Co-develop Cloud Products With Chinese OS Firm and A Quick Look at Cloud and SQL Azure

5) Entertainment and Devices Division segment: Leverage on other business segment such as Entertainment and Devices Division segment to increase economies of scale (see point three above on Xbox).

Part 2 continues here.

About the author:

beta.hedge
Graduated with BA Economics from National University of Singapore. Passed Level 1 of the CFA examination and CAIA Level I Candidate. Long-biased US equities, with strong focus on small to mid-cap stocks (NYSE, NASDAQ, AMEX, OTC & ADR) utilizing fundamental and technical analysis.

Agnostic investor, trader, writer and perpetual student of the market.

Visit beta.hedge's Website


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