Microsoft: Margin of Safety Plus Great Guru Sponsorship

Seth Klarman bought an interesting position last quarter in Microsoft (MSFT, Financial). And he made a very good move. As we can see in the chart, Klarman initiated a considerable position in MSFT at an average price of $25.








Today Microsoft Corporation (MSFT) trades at half the price it traded in 1999, when the technology industry reached its highest point. In 12 years, its EPS has had a fourfold increase from $0.71 (’99) to $2.69 (’11). The price-to-earnings (PE) ratio for this 12-year period is near 10 with a very low estimated P/E.


What about earnings? In the current year, earnings grew at an 18.52%; in the last five years, 13.63%; and in the last decade, 18.81%. Interesting, isn't it? And despite the growth rate that I have just shown, the P/E to Growth ratio (PEG) comes well under 1.


Undoubtedly, the price of the stock is undervalued. I would like to explain the key factors of why I think Microsoft offers margin of safety plus quality growth.

• Low payout ratio:
  
  

September 2011: 25% increase in dividends (16 cents to 20 cents). While the dividend's annual run-rate is $0.80 cents per share, the forward-earnings estimate is $3.13. Thus, the payout ratio can be calculated near 25%. The large supply of cash makes investors think of future dividend increases in the short and medium term. Figures speak for themselves. Since 2003, dividends have been increasing at nearly 11%. The growth rate in the last five years has been an impressive 15%.

• Software upgrade cycle: MSFT foundations are three:
  
  
  

1. Windows and Windows Live Segment,
   
   
   
2. Business Segment (Office, Dynamics), and
   
   
   
3. Servers and Tools Segment.
   
   

Why is this a key factor? First, these three segments are a steady source of income; second, they ensure a periodic jump in revenue; and third, products are frequently updated. Besides, customers will choose MSFT rather than start purchasing products from other provider.


Least but not least, MSFT is expecting to launch the Windows 8 upgrade cycle in October 2012, and good comments have been made on it.

• Cash in the balance sheet: Microsoft has over $40 billion (near $5 per share) cash in the balance sheet. Most (more than $30 billion) is overseas. Microsoft has one of the strongest balance sheets in the industry with very little debt.
  
  
  
• Well protected downside: Today Microsoft has a market value of $218 billion. It also has $57 billion in cash. After subtracting the cost of Skype ($8.5 billion) and considering Microsoft probably needs $20 billion in cash to be comfortable operating and making future acquisitions without fear of a material drop in its credit rating, I can say Microsoft has about $28.5 billion in excess cash that can immediately be taken out of the business. Subtracting the excess cash from the market value, Microsoft is really selling at $190 billion. If I add the annual dividends plus the earnings stability this company has, I think the shares offer a considerable margin of safety.
  
  

With earnings of $23.15 billion and a market cap of $190 billion, Microsoft is selling at 8.2 times earnings. The stock appears very cheap given Microsoft’s strong competitive position in each of its profitable divisions, the consistency of earnings, the commitment management has made to return cash to shareholders through share buybacks and dividends, and the opportunity for earnings growth in the upper single digits.


The undervaluation is evident in the charts below. The EV/FCF multiple (one of the key measures to value a tech stock) is in the low end range in both 5-year and 15-year trend. I think that will change fast as soon as the market gets convinced that MSFT has a clear strategy in cloud computing and it performs better in the online segment.