DJIA Analysis - Microsoft
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinions of our bloggers and are not formally edited.
Finding the Intrinsic Value of the Market
In this investing series, I seek to find the intrinsic value of the Dow Jones Industrial Average through a brief fundamental analysis of each of the 30 companies included in the average, with the goal of deriving an intrinsic value for the market as a whole through a ‘sum of the parts’ analysis. I will also attempt to make recommendations on how to play each company on the DJIA for optimal investing performance.
In this article, I will attempt to analyze Microsoft’s market prospects for 2012 and beyond with a brief fundamental analysis:
Business: Microsoft (NASDAQ: MSFT)
Microsoft is the tech giant of old. Once the major power in its industry, it is facing increasing pressure as companies such as Apple (NASDAQ: AAPL) and Google (NASDAQ: GOOG) take increasing levels of market share. Microsoft has a somewhat stable economic moat in three main areas of its business.
First, Microsoft’s operating system, Windows, pervades the modern computer world, even with the intrusion of the Mac OS X operating system, and open source operating systems such as Linux, into the competition.
Second, Microsoft’s main software suite, Microsoft Office, continues to hold control over its market. While competition has entered in Apple’s iWork and Google’s Google Docs, Microsoft Office has maintained control over the majority of market share, even being bought by a large number of mac users.
Third, Microsoft holds these many advantages to an even higher level in international markets. Unlike Apple, which has yet to completely enter the international markets past the US and China, Microsoft has been selling products to the rest of the world for ages, and it has established a wide following throughout the world.
Microsoft is a cash-cow, and is entering many different markets varying from mobile to video gaming in an attempt to maximize cash flows. With entry into the search engine industry via Bing, and the video game industry via the Xbox and the Kinect, Microsoft is moving into newer markets in search of a new identity. Altogether, Management has shown incompetence in ability to raise market prices and MSFT stock has range bounded for the last decade, down 22% in the last 10 years (excluding dividends).
Growth/Prospects:
Not quite a Dividend Aristocrat, Microsoft has been making consistent dividend payments since August 2004, and currently posts a healthy 3.07% dividend yield. Ultimately that is where investor returns are fueled, Microsoft’s cash inflow and outflow, and that is where Microsoft’s share weakness lies as well. Fool.com expects 7.69% revenue growth and 14.69% EPS growth in the next 5 years, which is relatively strong for a company selling for 9.35x earnings. However, this strong 10.5% earnings yield is due to the expected decay in Microsoft’s main sources of cash. Over time, Microsoft’s Office Suite and Windows operating system are losing ground, and Microsoft’s cash flows should decline as they become more affected by their competition.
Microsoft is, however, a healthy company at present, and expectations of cash flow decay may be a bit overdone. With $3.24 per share in working capital surplus over total liabilities, Microsoft has a strong enough financial position to make some pushes towards higher level growth. Recently, Fitch gave Microsoft debt a AA+ rating, and made a stunningly accurate analysis of Microsoft’s current state:
“Fitch expects declines in PC unit volume in 2012 reflecting hard disk drive shortages and macroeconomic concerns which should lead to declines in Microsoft's Windows revenue. Fitch expects this to be offset by continued strong business and server segment revenue growth reflecting enterprise demand.
Fitch believes Microsoft's position in the handset and tablet market has improved significantly over the past 12 months owing 1) to licensing agreements with Android device manufacturers and original design manufacturers that now cover in excess of 50% of all Android unit shipments and generate an estimated $5 to $15 per unit, and 2) a revamped version of the Windows phone and the expected launch of Windows 8 in 2012 which is tailored for tablet computers. Additionally, Microsoft's partnership with Nokia should meaningfully contribute to market share gains in FY 2012.
Fitch believes that Xbox sales could trail off as consumers begin to delay purchases in anticipation of a new platform. However, Fitch believes that Microsoft's current positioning in the entertainment space bodes well for its competitiveness over the next 12 to 24 months, particularly as Xbox's hardware platform, Xbox Live, and Kinect controller become integral pieces of a longer-term strategy of consumer-oriented offerings...
Fitch expects Microsoft to continue to produce strong FCF, in excess of $15 billion per year, which the company utilizes to fund its share repurchase and dividend programs. Fitch expects cash generation from operations to be strong enough to pay for modest annual increases in both dividends and share repurchases over next several years excluding potential for meaningful acquisitions. Microsoft has $11.2 billion remaining under its current share repurchase authorization that expires in September 2013. Fitch expects all repurchases will be done within the context of free cash flow.”--http://www.marketwatch.com/story/fitch-affirms-microsofts-idr-at-aa-outlook-stable-2011-12-21
While Microsoft is not valued as having the brightest of future prospects(8.78x FCF), it recently purchased Skype, implying plans for expansion of Microsoft’s target market, and its huge cash influx may push management to finally improve shareholder returns via buybacks and higher dividends, giving me the impression that Microsoft may be ready to bounce soon.
Intrinsic Value:
In my Discounted Cash Flow analysis, I used an FCF growth rate of 5%. With a compounded annual FCF growth rate of 7.5% in the last 4 years, I used 5% as a conservative measure as well as to emphasize the decline in strength of Microsoft’s FCF generation. With a WACC discount rate of 13.96%, I used a discount rate of 15% to truly value Microsoft’s future cash. Using a perpetual 2% loss in FCF after 10 years, due to Microsoft’s large cash hoard, it has an intrinsic value of $53 per share. However, this may not reflect the market value of MSFT for quite some time because the value of MSFT is so buoyed by cash, which is not generating returns for investors. On the other hand, MSFT remains extremely cheap at this valuation, and is undervalued by 51% according to this valuation.
Recommendation:
With 11.2B remaining in Microsoft’s share repurchase plan, share buybacks should buoy shares by 5%, more than the 3% dividend yield being offered to MSFT shareholders. Ultimately this convinces me that the leverage offered by call options, which will be buoyed by 2% via buybacks over dividends, offer the best method of capturing Microsoft’s undervaluation. I would recommend buying LEAPS MSFT call options to make the safest bet on MSFT’s valuation changing for the better. Specifically, buy Jan 2014 call options with a strike of $15 at a cost of $11 (Bid10.7Ask11.00Volume5). This is an extremely well clean option-stock replacement because you are buying 24 months of time value for $0.24, giving you the leverage of a call option for 1% of the cost of the stock in time value.
Series Tracking:
3M: +.2% (including covered call premium)
Alcoa: -4.8%
Wal-Mart: +6.06%
Coca-Cola Company: +1.7%
Fool Blogger Nikhil Shamapant does not own shares in any company mentioned above and will not purchase shares in the next two trading days.
