Justin 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) reports 2QF12 earnings after the close of markets today. This stock is one of the cheapest out there and has been for a number of years. It is not because of performance, as operating income has averaged 10% annual growth over the past five years. It is not because it is forgotten or unloved. Most of the sell-side has a buy rating and 87% of the Motley Fool CAPS Community give it an outperform rating. So what is holding this stock back?
Microsoft is the largest maker of enterprise and consumer software products with more than $60 billion in revenues. The main business divisions are the Office suite, Windows operating systems, Server and Tools, Entertainment (XBOX), and Online Services. Each of these units has had a period of uncertainty surrounding it in the past decade. The online division is probably the most noteworthy and has been unable to gain traction. That division only accounts for 4% of sales, and while it may be written about often, the company has churned out consistent earnings growth in its core businesses.
The Big Picture
Sure there is competition in the space and new up-and-comers that investors salivate over. But the fact about business is that it isn’t easy to turn a new concept into a multi-billion dollar company. Some do, but many fail. Microsoft remains the best of breed regardless of the number of new start-ups that make headlines. Sure it is big, but it was big five years ago and yet operating income has grown 65%.
The valuation has grinded downward for more than a decade, and at 10x trailing earnings, it is incredibly cheap. The stock was in the low-$30s 10 years ago and now it is in the high-$20s, all the while growing at a double-digit rate. The EV/EBITDA is now 5.4x, something you would expect from a company with a return on capital close to their cost of capital, not the 35% or more that Microsoft has generated in each of the last five years.
You want cash flow and they have it -- $24 billion in free cash flow (operating cash flow less capex) in the fiscal year ended in June. The chart on this is awesome with a nice upward sloping trend starting in the early '90s. That FCF amounts to 35% of sales and 12.8% of enterprise value, both staggering indications of how cheap the stock is.
Is it a trick?
When you look at Microsoft from a fundamental perspective, it is one of those instances where it is almost too good to be true. Then you start to question your logic and end up moving on to some other stock. But this is one of those stocks where you can say with great conviction that “it’s already priced in.” I look at Microsoft now and I think back to McDonald’s in 2002. McDonald's was a best of breed trading as if they were going out of business. That stock has gone up more than seven-fold since then.
For anyone other than short-term traders, Microsoft presents a very logical and compelling case for addition to your portfolio.
The Motley Fool owns shares of Microsoft. market8 has no positions in the stocks mentioned above. 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.