Is This Technology Mega-Cap Stock Cheap?

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

As the market continues its unabated march to new highs, you might be frustrated at the lack of cheap stocks available. For income or value investors especially, times are tough. The combination of continually climbing markets and historically low interest rates makes the search for attractively priced dividend stocks a difficult one. The technology sector includes some highly profitable stocks that pay dividends to shareholders, and haven’t rallied to the extent of the broader market. One such stock is technology behemoth Microsoft (NASDAQ: MSFT). Is the tech giant cheap? Or, is it a classic value trap?

After a frustrating decade, it’s cheap on the surface

Microsoft has been labeled as both dirt cheap and dead money, depending on who you take your advice from. It’s true that the stock price has stagnated over the past decade, but that has less to do with Microsoft’s operating performance and much more to do with the market’s irrationally over-valuing technology stocks during the tech bubble.

Financial pundits love to call Microsoft dead money. In 2000, the stock reached almost $60 per share. After the tech bubble burst, the stock fell to less than $30, and indeed has traded at that level ever since. The fundamentals, meanwhile, paint a different picture.

In fiscal 2001, Microsoft booked diluted earnings per share of $1.32 on revenues of $25 billion. Investors buying at $60 paid 45 times those earnings. The fact is, over the next decade, Microsoft grew its sales and profits at compound annual growth rates of 10.7% and 7.4%, respectively. Last year, Microsoft booked adjusted diluted earnings per share of $2.73 --not exactly fitting the description of a “dead” company.

Ditto for large-cap tech peer Intel (NASDAQ: INTC). The stock traded north of $73 per share in the fall of 2000 before falling to the low $20s -- exactly where it stands today. Even using Intel’s most profitable year between 1991 and 2003, investors were paying more than 48 times those earnings at a price of $73. The company, meanwhile, grew its revenues by more than 7% annually during the 10-year period of 2001-2011.

Microsoft now trades for 10 times its 2012 adjusted diluted earnings per share, and Intel shares a similar valuation profile. Let’s not forget that Microsoft also has more than $63 billion in cash, equivalents and short-term investments on the balance sheet. It’s easy to make the argument that Microsoft is a highly-profitable (if slow-growing) company with a comfortable margin of safety thanks to its massive cash hoard.

Unfortunately for investors, the market seems to shrug off such ideas as a margin of safety when it comes to technology stocks. These companies are expected to be high-growth at all times. Only those stocks that can offer the best growth rates at the present time are being rewarded with valuations comparable with the broader market. Such a company is Qualcomm (NASDAQ: QCOM), which the market loves for its focus on the trend toward mobile communications solutions.

Indeed, Qualcomm has performed very well recently. The stock has risen more than 20% since the beginning of 2012. In its 2012 annual report, the company announced revenues and diluted earnings per share increased by 27% and 39%, respectively.  As a result, the market awards Qualcomm with a P/E in the high teens.

Microsoft can’t boast these kinds of growth rates, and whether it ever will again is in question. Excluding the company’s goodwill impairment charge, Microsoft would have reported 2012 diluted earnings per share growth of less than 2%, along with 5.4% revenue growth year over year.

Not so fast

Unfortunately, concerns abound among Microsoft’s non-performing business segments. The Online Services division, which includes the Bing search engine, continues to hemorrhage money. Microsoft lost $8 billion last year from its Online Services division alone.

A further concern is that the company’s Windows & Windows Live Division, which includes its Windows operating system, saw a revenue decline last year. After 2011, this was Microsoft’s second-largest division by revenue. This certainly won’t help the chorus of claims from the media that the PC is dead.

Fortunately, the company’s bread and butter divisions, Business and Services and Tools, continue to perform well, seeing full-year revenue increases of 7% and 12%, respectively.

Add it all up

Microsoft has a problem: it’s got a cash-generating machine of a business model that continues to churn out healthy cash flows. You might be asking yourself how this qualifies as a problem at all. While it’s a quandary many other companies would love to have, it’s still a problem because Microsoft has few outlets for this cash flow.

The company bought Skype in 2011 for $8.5 billion, and the benefits from this acquisition are yet to be seen. Microsoft has also tried buying back its shares and increasing its dividend, but that hasn’t convinced the market to reward the stock with a higher valuation.

In the end, what I think we have with Microsoft is a slow-growing company that should keep pumping out reliable cash flows to investors. The stock trades for an attractive P/E and pays a healthy 3.3% dividend. Unless an unforeseen catalyst comes down the pike, it’s unlikely for Microsoft to grow its earnings at a rate that will unleash a growth stock-type valuation for the stock. However, you could certainly do worse than a high-yield, high-quality value stock, which Microsoft appears to be.


Robert Ciura owns shares of Intel. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel, Microsoft, and Qualcomm. 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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