The Lost Decade in This Stock is Over

By Chad Henage - November 11, 2012 | Tickers: AAPL, GOOG, MSFT, ORCL | 0 Comments

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I'll admit it, I haven't liked much that Microsoft (NASDAQ: MSFT) has done over the last few years. In fact, the company lost me as a lifelong user of their two most popular offerings a few years ago. I was a diehard Windows and Office user until about 2008. I got my first iPod, which led me to later getting an iPhone, and after that I bought a Macbook. I began using OpenOffice since I didn't want to pay for Office for Mac, and haven't looked back. Since using my original Macbook I've only briefly used a Windows computer at home. I've stuck with Apple (NASDAQ: AAPL) and I've been very satisfied. However, there comes a time when you have to realize that whether I like Microsoft's products as well as I used to or not, the company stock is a ridiculously compelling value.

What a Difference 10 Years Makes:

There's no question the competitive landscape in the software industry has been ever-changing. Companies like Oracle (NASDAQ: ORCL) used to be one of Microsoft's only real worries. However, with the advent of cloud computing, both of these companies have had to diversify their product offerings and make cloud access a major part of their future product lines. In addition, companies like Google (NASDAQ: GOOG), have stepped up their competition with Microsoft. The move towards mobile computing has created a new threat as well since users aren't tied to their PCs. One of the best examples of a competitor that Microsoft clearly did not give enough credit to is Apple, and that company's ability to become a mobile device manufacturer. However, even with all these competitive challenges, Microsoft has continued to refresh its main products, and Windows 8 is clearly the company's biggest risk in the last several years. While it's true that Windows 8 might not be a huge success, there are multiple factors at work that suggest Microsoft could be an excellent long-term choice for patient investors.

Current Earnings Mask Potential:

Looking at Microsoft's current earnings, some might focus on the fact that both revenue and net income were down. However, there were multiple strong points even in this "weak" quarter. In fact, I'm going to go against the grain and suggest that one of Microsoft's most "exciting" businesses should probably be closed down in favor of focusing on more profitable divisions. To be blunt, Microsoft doesn't need to be everything to everyone. The three most important divisions are its Windows unit, the Server and Tools Division, and its Microsoft Business Division. These three units are the prime reasons the investors should consider Microsoft as an investment.

Windows 8 – Microsoft is Finally First at Something:

The company's Windows & Windows Live Division represents 27.49% of total revenues. At last check, Windows still is running over 90% of PCs worldwide. The simple truth is Windows 8 is a change, but one that the PC industry desperately needed. The software's touch capabilities is leading PC manufacturers to produce more touch capable devices that generate interest among consumers. In addition, the new software lends itself to the production of more hybrid laptop-tablet computers, which seem a much more viable alternative given the popularity of tablets. While it will take a consistent marketing push by Microsoft to make customers more aware of what Windows 8 can do, the company has billions of dollars sitting on its balance sheet available for just that purpose. Though Apple and Google both have designs on taking market share from Microsoft, neither company has software like Windows 8 that promises the same experience across PC, tablets, and smartphones. This has the potential to be game changing, and in rare form Microsoft is the first company offering this experience. If executed properly, the company could challenge the seemingly insurmountable lead that both Android and iOS have built in the tablet and smartphone arena.

Server & Tools and Microsoft Office are Key Divisions as Well:

Each of these units saw positive revenue and income growth during the quarter, and each have major revisions of their software being released. Many companies rely on Windows Server to run their business on a day-to-day basis. Considering this unit represents about 28% of total revenue, Microsoft just needs to make sure that it stays current. The recent release shows the company realizes that it needs to make its Server flexible enough to utilize both local-based and cloud-based options for businesses. Microsoft's Business Division showed relatively slow growth with revenue up 1.16%, and income up 3.43%. However, Microsoft Office is still the most widely used office software. Office 365 is a step in the right direction to integrate local software and cloud capabilities.

Online Services Needs To Go:

I know some would suggest, that one of Microsoft's most exciting divisions is its Online Services Division. However, Online Services has been a consistent money-losing proposition for the company, and the Bing search engine has already lost the battle to Google. I have my doubts that the Online Services Division will ever be profitable on a consistent basis. Given that this unit represents less than 5% of total revenues, it might be time to spin off this money-losing division and then let it either thrive or die on its own.

The Most Exciting Thing About Microsoft:

The most compelling reason to consider Microsoft shares has to be the company's cash flow generation. Considering that in this "disappointing" quarter, the company generated nearly $8 billion worth of free cash flow, there's just no question investors should benefit. The stock already pays a yield of more than 3%, and the company used just 21.27% of its free cash flow on dividend payments. In addition, the company can afford to be more aggressive with share repurchases. Microsoft actually bought back less in shares than they paid in dividends. In addition, the company can immediately improve its financials by continuing to pay down its long-term debt. Most of the company's debt carries interest rates far above what the company is earning on its cash and investments. The bottom line is, Microsoft is a cash generating machine, and with its dominance in multiple large divisions this doesn't appear to be changing anytime soon. 

Conclusion:

Investors looking at Microsoft should look at the company as both a growth and income play. With a dividend over 3% and expected EPS growth around 9% in the next few years, this is a wholly different value proposition than Microsoft of years ago. In fact, 10 years ago not only was Microsoft overvalued, but the company paid no dividend and growth was clearly slowing down. Though many investors avoid Microsoft due to this "lost decade," trying to pick winning stocks looking in the rearview mirror is rarely a good idea. With the stock selling for a single digit forward P/E ratio, expectations are low, and cash flow is high. If the company is even moderately successful with Windows 8, patient investors should be handsomely rewarded.

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