Weekly Stock Call

July 24, 2011
Current Price – US$27.53

Microsoft Corporation (MSFT), arguably the world’s most prominent software company, earns annual revenues of US$69.9B on sales and licensing of operating systems, applications, development tools and video games. The company derives revenues across its five major business divisions; Microsoft Business (32%), Windows (27%), Server and Tools (24%), Entertainment (13%) and Online Services (4%).

Despite the company’s ubiquitous market presence, its traditionally dominant position in PC systems software (Windows) and business productivity software (Office) is being challenged by industry evolution towards hosted applications (“Cloud Computing”), evolving hardware platforms (tablets and smart phones) and the widespread availability of open source software. Investors have responded to the uncertainly created with these developments by discounting the company’s stock considerably (P/E of 10.8 vs. historical and industry ratios of 17.3 and 17.9 respectively).

While these evolutions may challenge Microsoft, competition with Apple, Google, Oracle, Amazon and host of others is sure to drive innovation, convergence and consolidation in the foreseeable future. The company enters into this period of renewed competition with distinct competitive advantages including; a large entrenched customer base and established partner/channel networks, superior profit margins (operating 39%) and free cash flow (FCF/Sales 35%), emerging opportunities for server products in “cloud computing”, and recent strategic acquisitions and alliances with companies such as Skype, Nokia, Facebook and Hulu.

It might take some time for Microsoft’s share price to correct, but value should become evident as competition intensifies in more currently sexy tech products (tablets, smart phones, …) and margins in those products are squeezed. 

Valuation

Based on a blend of valuation methods (discounted cash flows, dividend discount method and historical and industry price ratios) I arrive at a current valuation for Microsoft Corporation of US$33.11

Expected return should this price be realized in the markets within the next 12 months would be:

Price yield                      20.3%
Dividend yield                   2.3%
Total return                     22.6%


Risks

Listed below are some of the key risks faced by the company. This list is by no means comprehensive. For a more complete discussion of risk, refer to the company’s annual report and 10K filing.

Global Economic Conditions – sales to OEM partners and Enterprise licensing revenues are strongly linked to general levels of economic activity and prolonged economic slowdown could adversely impact earnings.

Slow or Ineffective Response to Market Evolution - being left behind in developing applications for and migrating to new hardware and delivery modes could result in loss of market share and diminished revenues.

New Market Penetration – the risk of being unable to effectively penetrate some emerging markets or of having market share eroded by lower cost imitations could hamper revenue growth and erode market share.

 
The Numbers

Share Price ($US)   27.53 
Market Cap ($US B)   231.5 
No. Shares (M)   8,668 
ROE   44.0%
ROA   23.6%
P/E Ratio   10.8
Price/Sales Ratio   4.4 
Price/Book Ratio   3.4
Current Ratio   2.8
Interest Coverage   113.1Total Debt/Equity   22.0%

Analyst – David Scollon

Disclosure - At publication of this analysis I hold no position in this security, but may take a long position in the future. I do not take short positions in any of the stocks reviewed on this site, nor do I receive any compensation from the companies studied for publication of my opinions.

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