Thursday, January 10, 2013

Stock Bought: MSFT

Today I bought shares of Microsoft (MSFT), the world's largest software maker. The company dominates the market for desktop operating systems (more than 90% of PCs still run Windows) and makes the popular Office productivity applications. Additional business components include server software, online advertising tools, and the Xbox video game system.

Microsoft is often derided as "dead money" because its stock price return for the past several years has been negligible. However, this ignores three important points. First, MSFT was overvalued at the turn of the century (P/E > 30), so the poor return mainly reflects the stock coming down to a more realistic valuation. Second, the focus on stock price return ignores the return from dividends that MSFT has been paying since 2003. Third, despite the lackluster stock price movement, the company's operating results have been quite good.

To elaborate on the last point (see also this article by Chuck Carnevale), Microsoft has had fairly steady revenue and earnings growth, with 10-year growth rates of 10% for revenue and 11% for earnings. The company has maintained high margins, strong operating and free cash flows, and returns on equity above 20%. Its financial position is excellent, with $66B in cash, $12B in debt, debt/capitalization of 14%, debt/equity of 18%, 59x interest coverage, and a current ratio of 2.7. Value Line gives it a safety rating of 1 and a financial strength rating of A++. It is one of just a few companies with an AAA credit rating from S&P.

For a tech company, Microsoft's recent dividend history is pretty good. The company has increased its dividend for 10 consecutive years and has a 5-year dividend growth rate of 15%, which also happens to be the size of the most recent increase, announced in September 2012. The EPS payout ratio is 50% (which is a bit misleading; see below) and the FCF payout ratio is 35%. The company also has a strong history of share buybacks, reducing the number of outstanding shares by more than 20% over the past 10 years.

I consider Microsoft to be undervalued at the current price. It appears to have a P/E of 14.2, but that reflects a large, one-time charge they took against earnings last year. Adjusting for that, Value Line reports EPS of $2.72 for 2012, which gives a P/E of 9.7. Other metrics include P/S of 3.1, P/B of 3.2, and PEG of 1.0. Using a Dividend Discount Model with a below-average dividend growth rate of 9% and an aggressive discount rate of 12%, I calculate a fair value of $33.43. Morningstar gives a fair value of $35.00 and a 4-star rating, whereas S&P gives a fair value of $36.90 and a 5-star rating. The average of those three estimates is a fair value of $35.11, which implies a 25% margin of safety at the current price. MSFT is flirting with its 52-week low and is 20% off its 52-week high. (For another informative look at its valuation, albeit from early 2012, see this article by Dividend Monk.)

I bought 55 shares of MSFT at the price of $26.30 per share, giving me a 3.48% yield on cost. At the current dividend rate, I can expect to receive quarterly dividends of $12.65, which will add a total of $50.60 to my annual dividend income. Microsoft is now the 26th stock in my portfolio and my second tech stock (the other being INTC). I continue to be wary of tech stocks in general, but I feel comfortable having MSFT in my portfolio, especially given the extent of its undervaluation and its continued innovation efforts (see this article by Catalyst Investments). However, I will likely keep the overall allocation of my portfolio to tech stocks below 10% (it is currently 8%).

It is a bit difficult to find undervalued stocks at the moment, so even though I have sufficient cash on hand to make another purchase this month, I may just sit back and watch what happens as quarterly earnings are reported. If there is a significant dip that catches my eye, then I might take advantage of it.

22 comments:

  1. You make a convincing case. I've been eyeballing MSFT since mid November because it is indeed cheap. I was hoping that it would fall to a 4% yield ($23), but it's been holding up quite well at the $26.50/$27.00 level. I might revise my entry point. I'm not a big tech fan myself; 3.1% of my portfolio is in tech stocks.

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    1. ADY: Thanks for your comment. I had not paid much attention to MSFT until recently, when I was updating my watch list for the new year and searching hard for new investment opportunities. If the stock were to fall to where it yields 4%, then I would increase my position. However, I did not want to wait and potentially miss the opportunity to get in at a 3.5% yield and nice valuation, which is why I decided to initiate a position today.

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  2. DGM,

    A compelling argument for owning MSFT. Valuation-wise, it has to be one of the cheaper opportunities available. I've watched it from time to time with varying interest but have not yet pulled the trigger. I've heard mixed results on Windows 8 and, like Intel, am a bit concerned about their future in the mobile/tablet space. MSFT obviously still has a lock on Office and the business side which should provide a solid revenue base for some time to come. Definitely an interesting play here! This has to be the highest yield it's ever had, so that provides a bit of a floor to the stock price as well. Good stuff.

    Best wishes.

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    1. DM: Thanks for your comment. I have heard mixed reviews about Windows 8, but from what I understand, its sales are on par with those of Windows 7. We should find out more when Microsoft reports earnings on January 24. There is definitely more risk when it comes to tech stocks, but I really like what I see in MSFT from a valuation standpoint, which helps temper the risk of capital loss.

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  3. I think you also need to mention that Microsoft during last decade also split their stock a few times (don't have the number right now with me, but I think it was during 2000 -2005 it split at least three times), so from today's point of view the stock look's like it didn't provide any appreciation which isn't true. (I checked it out and since 1994 until 2003 the stock split 5 times in 2:1 ratio, since then nothing happened, so if you invested in MSFT after 2003 then yes, you haven't seen much of a movement, but, as you said, we have dividends and we have options available to generate more cash).

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    1. Martin: Thanks for your comment and for the information about stock splits. I think most price charts adjust for stock splits, but I would need to check that out.

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    2. They do, and mark the day of split, but for an investor unfamiliar with the stock just pure look at the chart may look like the stock progressed nowhere. Let's look at MSFT in between 1990 and 2000. The stock split twice (I think). It traded at 30 (and now I am making those numbers up for illustration) and it split 2:1, the price was 15, but continued running up and soon it was again 30 and the company split second time and the price was again 15. If you held 100 shares, you now have 300 shares and tripled your money, but looking at the chart, it looks like the stock went nowhere unless you mark the splits. Look at full chart of MSFT on Yahoo, you won't even notice them.

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    3. Martin: I see what you mean now -- you make a good point about an investor having many more shares now than he would have had 20 years ago. And the best part is that each of those extra shares would be contributing to his dividend income.

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  4. Interesting purchase, you make a good case for it. I see INTC and MSFT as being similar. New MSFT operating systems should mean increased demand for INTC processors. New INTC processors should help MSFT with operating systems demand. I've always went the INTC route because I see potential in other areas such as servers and mobile. MSFT has some other opportunities too in mobile and video games. I like INTC's prospects a little more, but MSFT is better financially. Regardless you make a good case and will likely see rising dividends. I see Microsoft has a forward p/e of only 8.3. It's surely in the value right now.

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    1. Compounding Income: Good point -- I view my INTC and MSFT positions as being complementary, tapping into the hardware and software sides of the computer industry, respectively. I think both companies have favorable prospects, although I do agree that INTC may have more of an edge regarding growth opportunities.

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  5. I've been thinking about MSFT, but just never did pull the trigger since INTC makes up a good portion of my portfolio. I might add some as my portfolio gets larger though. Nice buy and it could give you some great returns from here.

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  6. I still haven't been able to justify to myself the investment thesis behind Microsoft, more from a dividend growth perspective (I think ongoing payment of the dividend is no problem). Things to monitor with Microsoft in my view:
    - Windows Phone penetration- Microsoft have been trying for a while with limited traction, they have limited mindshare with consumers
    - BYOD (Bring your own device) trends in the enterprise and what they mean for windows/office enterprise wide licenses. Employees are bringing their own PC's and tablets with them increasingly.
    - Declining PC penetration among consumers
    Monitoring the above will be helpful for the investment thesis in my opinion.

    Integrator

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    1. Integrator: Thanks for your comment -- you make some good points. I agree that Microsoft still has a lot of work to do regarding mobile phone market penetration. I don't think the obstacles are insurmountable, but I do recognize that progress on that front will take time. Regarding BYOD, I would be interested if you could point me to any articles that discuss the issue. As for declining PC penetration, I think there is too much focus on short-term declines and not enough recognition of continued long-term demand for PCs. Of course, when it comes to the tech industry, things change faster than in other industries, so monitoring is definitely an important aspect of investing in Microsoft.

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  7. I bought it myself a few months back at a higher price, around $30. Have to admit that unlike most purchases I make I was not convinced it was a good purchase and I'm still not sure. I'm going to stick it out for awhile yet (likely at least a year) and then reassess. I like MSFT's recurring business more than INTC's, but it is interesting to see the split views on these two.

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    1. Dining: Thanks for your comment. I generally approach every new purchase with the intention of holding it for at least a year, which I think is reasonable. There are certainly many people with divergent views about both MSFT and INTC, but that seems to be true of almost all tech stocks. To some extent you have to tune out the noise and make an impartial judgment based on personal research, which is what I have tried to do with my investments. I think it makes investing a more interesting activity.

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  8. I'm a big fan of MSFT and don't think you'll be disappointed with this buy. I recently did an analysis of MSFT as I'm also considering a buy at these levels. I already own some shares of MSFT but feel pretty good to adding to my position at it's current valuation.

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  9. I will take the other of the MSFT trade (no position in MSFT). MSFT has been one of, if not the biggest value destroyers in tech. They have repeatedly missed big consumers trends and step changes in tech. They missed the internet, mobile phone and tablet computing to name a few. They have a series of big wasteful acquisitions: Skype $8.5B, aQuantive $6.3B, Danger $500M, Greenfield Online $486M, WebTV $425M, etc. They almost bought YHOO for $33/share, but fortunately for them Jerry Yang was too dumb to take it. The good news is they seem to have backed away from making acquisitions favoring partnerships instead. Steve Ballmer, longtime CEO, is the big problem. Most of this happened during his tenure. The result of his leadership is a stock price with no appreciation for 15 years. Why would you expect this to change moving forward? Fundamentals, dividend growth metrics etc are all factors in making an investment decision. So is management. Ballmer's track record is terrible, and until he goes I wouldn't buy the stock. There are plenty of great alternatives out there, and that is where I will be investing.

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    1. BT: Thanks for providing your view on MSFT. I agree that the company has made some bad acquisitions over the years and was late to some important tech trends. Despite all this -- and with Ballmer as CEO -- they have managed to grow revenue and earnings at a decent clip, stay dominant in certain areas (e.g., desktop operating systems), and maintain a very strong balance sheet. Plus, they have a respectable dividend growth streak and good history of stock buybacks. I wouldn't regard that as a "terrible" track record. The lack of stock price appreciation over the past 15 years reflects overvaluation at the start of the period, during the tech bubble. Now I think MSFT is in a period of undervaluation despite many good operating metrics. Thus, I regard MSFT as a good investment, but I respect your opposing view.

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