The Rebirth of Microsoft?
Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Microsoft (NASDAQ: MSFT) was like all of the rest of the IT stocks that saw their moment of exuberance come and go in the late 1990s. Yes, gone are the days when shares were trading around $60. Or are they? With a new operating system and its first in-house piece of hardware in recent memory, Microsoft is positioning itself for a Renaissance. Microsoft recently announced its Surface tablet to go head-to-head with Apple (NASDAQ: AAPL) and, more importantly, to show developers and manufacturers how to extract power from the new Windows 8 operating system.
Assuming a decent economic outlook, Microsoft is a buy for me and, for the first time in a while, a strong buy at that. Though I would be more cautious as a long term 3-year investor in this super-competitive technology market, Microsoft is propelling itself to achieve impressive earnings over the next year, and perhaps beyond. Given its competitive valuation, Microsoft has quite a bit of breathing room to realize a significant upside, and the company has strong fundamentals.
At $30, share prices are nearing their 52-week high of $33, but there is significant upside even from here. In all, Microsoft shares are historically undervalued. The EV/EBITDA for Microsoft is 7.3, which is below the sub-sector average of 8.7 and is below the five-year lagging range for the company, 7.5 to 9.5. The lagging P/E for the company is 11, whereas other enterprise-level, large-cap IT companies like Oracle (NASDAQ: ORCL) and SAP AG (NYSE: SAP) have earnings mutiples of 14 and 15, respectively.
The company’s price/cash flow is at 9.57, which is well below both Oracle and SAP AG. Even more interesting, this figure is toward the lower end of its historical range, which roughly spans from 6 to 16 over the past five years. In all, if Microsoft follows through on the imminent developments described below, the present valuation for Microsoft shares makes them a bargain buy.
Yammer, Windows 8, and the Surface tablet
On June 26, Microsoft announced that it will be acquiring the social network utility Yammer. Like other enterprise-level companies, Microsoft is recognizing the need to become more agile by sucking in some of the “youth” of start ups like Yammer that could revitalize their software and platforms. For companies like Microsoft, Oracle, and SAP AG, enterprise solutions are the principle drivers of profitability; the global enterprise market, after all, is worth about $280 billion (i.e. Greece’s annual GDP).
Windows 8 will be released later this year and will pose a significant threat to both Google’s (GOOG) and Apple's widely-used operating systems for tablets and computers. That in itself is an interesting aspect of this new OS: Its intuitive interface is both “point and click” and “point and touch” friendly, making it an innovative crossover or hybrid operating system. On a technical level, both PC and mobile versions run on the same kernel, thus having a very similar user interface and build.
But there’s a problem with Microsoft’s roll-out scheme for both Windows 8 and the Surface, a problem many call the Osborne Effect. In the 1980s, the Osborne Computer company went under because it made a major product announcement for an item that was not yet available for purchase. Microsoft has been whetting the appetite of Windows users since February, when it put out a major pre-release of the new OS. It just added on top of this the hopes for a Surface tablet release. In my estimation, this release method is counterproductive, not to mention a little embarrassing. It indicates that Microsoft needs to hurry to make an announcement merely to indicate that it’s still “in the game.” Three weeks ago, I ordered my new Retina MacBook Pro on the very day that Apple released it. Why can’t Microsoft begin to show this level of agility in its product release schedule?
Works in Progress
Luckily, Microsoft already has a number of horses in the tablet race already. It recently struck a deal with Barnes & Noble (NYSE: BKS) over its Nook tablet franchise, buying a 17.6% stake in the business for $605 million. This resulted in a spinoff “NewCo” subsidiary, giving Microsoft a leg into the content delivery part of the tablet business; additionally, Windows 8 will likely have a Nook applet incorporated directly into the OS. Though the Nook presently uses Google’s Android mobile OS, since Windows 8 mobile has the same kernel as Windows 8 for PC, it would not be a surprise to see the Nook run Windows in the future.
Microsoft Office is one of the most ubiquitous and vital aspects of Microsoft’s sales. Presently, however, there is strong competition from Cloud services available from Google, Apple, and Adobe. The Office Suite is currently the number one productivity suite available, holding about a 94% market share in 2011. This is expected to decrease as hosted services like Google Drive attract users to the cloud, but Microsoft has been proactive, releasing the Office 365 hosted service in the middle of 2011. Still, Microsoft cannot rely on its Office franchise for long-term profitability. According to Trefis.com’s analysis, the Office Suite had an operating margin of 64% in 2011, which will decline by a little less than one percent in 2012. However, the purchase price for online hosting will be significantly lower than it is presently for dedicated, machine-specific software licensing, and increased competition will generate a fair amount of price erosion. Additionally, licensing prices for tablets will be well less than half of that for PCs. Thus, its operating margin will likely drop to around 54-58% over the next five years. And this assumes that things merely proceed at the present pace.
Bottom Line: Execution
Microsoft will probably make at least $2.70 a share this year, giving it a 2012 forward PE ratio of 11. The stock's earnings per share will approach $3.10 next year. So, the stock is growing its earnings by around 10% and has a 2013 PE ratio in single digits. Apple is in the same boat. The stock is expected to make around $48 this year and grow its earnings by around 20% next year. We think Apple is a slightly better bet than Microsoft but both stocks are actually very attractive. Hedge funds noticed this too. Apple is the most popular stock among hedge funds and Microsoft ranks third (see the 10 most popular stocks).
With all of its promising projects and upcoming releases, Microsoft must execute in delivering quality products to the end user. Recently, this has not meant producing higher quality products; instead, it has meant integrating products into a coherent package and advertising these products to give them the “allure” that shiny aluminum casing and the quasi-utopian branding does for Apple. That said, given its overall universe of high quality products, management would need to be close to negligent in order for Microsoft shares not to realize significant gains.
This article is written by Brian Tracz and edited by Meena Krishnamsetty. Meena has long positions in Apple, Google, and Microsoft. The Motley Fool owns shares of Apple, Microsoft, and Oracle. Motley Fool newsletter services recommend Adobe Systems, Apple, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.