Microsoft: Left in the Dust - and Brimming with Value

As we watch the Facebook saga unfold in somewhat predictable fashion (see HM Payson Research Note: "Facebook: Buyer Beware," May 17, 2012), we cannot help but notice some compelling values at the other end of the large-cap technology pond. Although widely perceived as a boring - or even dying - destroyer of shareholder value, Microsoft strikes us as one of the more compelling investment propositions in any market sector today.

Microsoft Windows is the dominant operating system in the personal computing market, with a 92% global share. This has been both a blessing and a curse for shareholders as the proliferation of mobile computing platforms (tablets and phones) has caused PC growth to slow dramatically and fueled the popular perception that Microsoft will become irrelevant. The company's fundamental performance tells a very different story, however. For example, over the last five years, Microsoft's revenues have increased by 44%, equating to an 8% compounded annual rate - an impressive feat for any company during this challenging economic period. Even in the fiscal year ended June 2012, in the face of a product cycle lull and Apple's meteoric success, Microsoft's revenues rose by almost 6%. Meanwhile, both net profit margins and returns on capital presently exceed 30%; hardly symptomatic of a dying company!   Underpinning this strong fundamental performance is the reality that Microsoft is much more than just Windows. Its end-markets extend well beyond consumers and the PC. The company has a very strong presence in the corporate environment, including business applications and other related software running workstations, servers and "the cloud". The Business division (the Office application suite) and the Server and Tools division (corporate servers and cloud installations) comprise nearly 60% of total revenue, are growing at healthy rates and are very profitable. Meanwhile, the Windows 8 launch due in October is expected to give the PC business - both consumer and corporate - a significant boost. Despite this strong performance, Microsoft shares have been moribund for more than a decade. In fact, the stock today languishes in the $30 range, 40% below its all-time peak in late 1999. Of course, technology valuations generally were irrational in 1999, but the end result is that today Microsoft represents an impressive investment proposition. The P/E ratio stands at a mere nine times the estimate of the coming year's earnings per share, and the price-to-sales ratio of 3.5 is very reasonable for such a profitable franchise. Using the methodology described in our earlier communication on healthcare stocks (See "Healthcare Stocks: Attractively Valued No Matter What Happens in Washington" July 10, 2012), our conclusion is that the current price implies a growth rate of negative 6%. Granted, Microsoft's growth rate has slowed, and will likely continue to moderate, but this strikes us as overly pessimistic.   What we like most about Microsoft is its balance sheet quality and potential to produce a growing stream of income for our clients. The company holds more than $60 billion in cash and equivalents, and carries very modest levels of debt. The dividend yield today stands at 2.6%, and has grown by an average annual rate of 15% for the last five years. Yet, with a 9% free cash flow yield, the company is capable of committing to a much larger dividend and/or stepped-up share repurchases. In fact, we estimate that a yield of 7% on today's price (combined dividends and stock repurchase) is well within reach, if management is willing. Though the pace of such actions has been frustratingly slow, we suspect Cisco's recent actions (a 75% dividend hike, causing an immediate 10% jump in its share price) have not gone unnoticed in the Redmond, Washington executive suites. Investors are both skeptical about Microsoft's future growth and justifiably impatient with a management team whose acumen for mapping and executing on a strategic direction has been rightly questioned. Failed efforts to organically develop new growth businesses, as well as some ill-advised and expensive acquisitions, have drawn the ire of many critics and caused the stock to fall out of favor with growth-oriented investors. But once again, uncertainty and unpopularity represent the source(s) of many outstanding investment opportunities. For those seeking income, a healthy total return, and quality in an otherwise uncertain, low return environment, Microsoft stands out.

Europe: Uncertainty and Opportunity

The sovereign debt crisis in Europe and subsequent worldwide economic slowdown has been the top news story and at the forefront of many investors’ minds for nearly 3 years. Fiscal austerity, likely restructuring of the debt of the peripheral sovereigns, and a reluctance to implement needed structural reforms within the European Union (namely, more centralized control of member country finances) will present a persistent headwind to global economic growth. Yet, in this environment of uncertainty and pessimism, we believe there are excellent investment opportunities; one simply needs to dig a little deeper to unearth them.

Securities markets are forward looking and often discount good or bad economic news well before the actual economic numbers are published. This swift incorporation of a changing economic outlook into securities prices makes investing based on the timing of economic trends notoriously difficult. For a vivid example of this phenomenon, we need only look back to the market’s behavior leading up to the 2008-2009 financial crisis. Table 1 shows the performance (price only) of the S&P 500 from the end of October 2007 to the end of March 2009. The market fell by 53%, with much of the fall coming well before the National Bureau of Economic Research declared the recession.

A basic tenet of our core investing philosophy is that a bad economic outlook does not always equate to a bad investment outlook. Usually it’s quite the opposite. This is so because investment success or failure is largely determined by the price an investor pays relative to the future cash flows he can expect to receive. A poor economic climate almost always provides great investing opportunities in the way of depressed equity prices rendered by pessimistic market psychology.
In March 2009 the economic outlook looked grim for the United States. The bursting of the housing bubble and melt down in the mortgage market engendered a massive liquidity crunch that froze credit markets. Economic activity fell precipitously; and with so much bad debt in the system, it was hard to imagine business activity wouldn’t continue to deteriorate – never mind see improvement. And yet, as Table 2 illustrates, an investment in the S&P 500 in March 2009 provided a return of 85% (price only) through June of this year. Historic rallies are born in the depths of crises.

Today the MSCI Euro Index, comprised of the countries that use the Euro as their currency, is in the throes of a severe bear market. As Table 3 shows, this index is down 48% from its October 2007 high (price only, local currency), in a bear market similar in size to the 2008-09 S&P bear market (see above). At these levels we see some interesting investment opportunities emerging.

Our process of identifying opportunities begins with yield, which we define as value inuring to the benefit of shareholders – including earnings, cash flow, and dividends – divided by the price of the investment. In times of economic stress and foreboding headlines, markets sell off and yields rise providing opportunity. Conversely, with good economic environments and cheery headlines, prices rise and yields fall, reducing prospective investment returns. As Warren Buffett says “you pay a high price for a rosy outlook”.
A specific example of a European stock that we have liked for several years now is Diageo. It has provided excellent returns since the beginnings of the Greek crisis in October of 2009. As Chart 1 shows Diageo (Ticker: DEO) has provided a total return of almost 72% since October 30, 2009, far exceeding the MSCI Euro Index total return of -1.9%. At the time we found the valuation of the shares of this high-quality company very attractive: the cash flow yield was 8.5%, the earnings yield was over 7%, and the dividend yield approached 4%. This is a perfect example of a great company with attractive yields providing a wonderful investment opportunity in a horrible economic environment.


Looking forward, the MSCI Euro Index looks attractive to us. Table 4 compares where the MSCI Euro Index was in October 2007 and where it is today. Good relative investment returns might come from eventual margin expansion, and the index’s high current earnings and dividend yields.

We continue to look for high quality European companies whose price has fallen more that their business fundamentals warrant. Many large global companies based in Europe generate a majority of their revenues outside of the Euro zone and offer attractive valuations.

We are also finding companies with healthy businesses (using the discounted cash flow models in a method described in detail in our last Research Note, “Healthcare Stocks: Attractively Valued No Matter What Happens in Washington”- July 10, 2012), that are priced as if they are in permanent decline. Two examples that fit this description are in Table 5.