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Collapsing Value Trap or Sleeping Giant?

Joseph is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investing in Microsoft ) can be controversial. Some see it as dead money or don't like the company's management. Others feel it is a sleeping giant, ready to unlock shareholder value. Let's take a closer look at Microsoft's current situation.

Strengths:

<table> <tbody> <tr> <td> </td> <td>price</td> <td>p/e</td> <td>forward p/e</td> <td>debt to equity</td> <td>div</td> <td>yield</td> </tr> <tr> <td><span><span><span><span>MSFT</span></span></span></span></td> <td>26.74</td> <td>14.43</td> <td> <div>8.31</div> </td> <td>0.1736</td> <td>0.92</td> <td> <p>3.40%</p> </td> </tr> </tbody> </table>

  Data from ycharts and Yahoo Finance

Microsoft has traded sideways for what seems like forever, but is extremely strong financially with its fortress-like balance sheet. The company pays an excellent, safe dividend with a sustainable payout ratio, while generating $7.88 billion in free cash flow. With relatively no debt, Microsoft is also sitting on over $66 billion in cash and short-term investments, according to ycharts. Microsoft also enjoys dominance in the enterprise world, and has a near monopoly with its Office products- such as Microsoft Word and Excel. Microsoft's Xbox console is also a leader in gaming as well, and the company is looking to integrate the Xbox further into the living room.

Weaknesses:

Declining PC sales, as tablets and smartphones increase in popularity, are a big weakness for Microsoft. Microsoft is betting big on Windows 8, but they are late to the game with mobile device offerings. Windows 8 (which is said to transition the company into mobile) is still unproven as Microsoft's Saviour. They are also entering into a mobile market already dominated by Apple's ) iOS and Google's ) Android operating systems, especially in smartphones:

<img height="184" src="/media/images/user_14543/capture_2_large.PNG" width="481" />

  Source

Microsoft is making an effort to transition into mobile, and has the pieces to form a successful, succinct puzzle- what matters now is whether or not they can execute their plans to compete with the current duopoly of Apple and Google.

Opportunities:

Microsoft is a diversified company with many offerings (Xbox, Office software, Kinect technology, Azure cloud services, etc.) and with Windows 8 as the glue, they could unify all of their miscellaneous components into an ecosystem that is hard to duplicate. If Windows 8 does pick-up speed, their ecosystem will be further re-enforced, attracting more app developers. 

China provides a huge opportunity for Microsoft. Microsoft's Windows phone, produced by Nokia ) recently scored a huge deal with China Mobile. By partnering with the world's largest carrier, Nokia will provide their high-end Lumia 920T smartphone (which runs Windows Phone 8 software) to millions of users. 

Windows 8 and Microsoft's Azure cloud services also create an opportunity to monetize the company's Office software in China, by offering it as a service instead of a pireatable commodity. Office as a service will eliminate the possibility for pirates to obtain illegal codes that enable them to generate and sell bootleg copies of the software. Microsoft will no longer offer Windows 8 boxed in China, as consumers will have to purchase and download it online, or receive it pre-installed on a new Windows 8 device. Office 365 will work as an online service that charges a monthly subscription fee. The Chinese government is also a supporter- deciding to spend $160 million on licensed copies of software, which should benefit Microsoft tremendously. 

The Department of Defense recently adopted Windows 8 as well, in a 3 year licensing deal worth $617 million. This is the first time that three major DOD agencies (the Army, Air Force, and Defense Information Systems Agency) have entered into a single agreement with the company. Government spending on Windows 8 should give the new operating system some credibility and exposure.

Threats:

Google wants to steal away 90% of Microsoft's Office users. This is a huge threat even if it sounds unrealistic- because Office is one of Microsoft's core money-makers. Google's Android has an established ecosystem already, and the company is working to expand on its enterprise apps to compete and eventually unseat Microsoft from its enterprise throne. 

Another potential threat, at least to shareholders, is the fact that much of Microsoft's enormous cash horde is held overseas. This money will most likely remain there until (or if ever) corporate tax reform comes to the United States. Trapped overseas, this money can't be returned to shareholders right away, and there is always a threat that the company may begin spending it on unfavorable acquisitions and ventures abroad. 

The Bottom Line:

Microsoft is a cash-generating machine that needs to adapt to the times. Windows 8 is their bridge into the modern landscape, connecting the company's various components together into one ecosystem. While many analysts and reports have claimed that the OS is a bust, the numbers are not officially out yet and Governments have shelled out cash to adopt the new Windows platform. Windows phones have a huge opportunity to gain market share in China, and so does Microsoft Office and Windows 8. 

In the States, Windows 8 is gaining more support from its OEMs like Dell, who are betting on the Windows 8 OS to revive PC sales and spark sales of tablets. Samsung is also looking to diversify away from its heavy reliance on Android, and will soon begin releasing Windows 8 devices in the U.S. as well. Windows 8 does not appear to be the bust that Vista was, but may take some time to see wider adoption. As more devices with Windows 8 come to market, and more apps are created, the new OS should pick up some steam. Overall, Microsoft is very attractive at these levels and an eventual expansion of Windows 8 and Office should bolster the bottom line. While waiting for capital appreciation, investors can also enjoy a relatively high yielding, solid dividend as well. 


Jharry1 owns shares of Microsoft and Nokia. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple, China Mobile, Google, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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