Checking in on Microsoft
I have been a holder of Microsoft shares since the financial crisis in early 2009. I have added to my position since then, and it is one of my four largest positions, along with ExxonMobil (holding and adding since 1998), Berkshire Hathaway (holding and adding since 2009), and Apple (holding and adding since 2011). Unlike those three, most of my Microsoft stock purchases over the last three years have strongly underperformed the market.
The issues are of course well-known. First, Microsoft is the epitome of “dead money.” The stock price has gone nowhere since July 1998, nearly fifteen years. I was in college in 1998. Bill Clinton was President. AOL and Timewarner had not merged. That is a long, long time. Second, the Wintel monopoly on the corporate and even moreso on the consumer market is ending. Duh. Thematically, Microsoft doesn’t work. It puts out crappy products like Zune, and overpriced (sorry, but it’s true) products like Surface.
It’s CEO looks like a titanic oompa loompa. He is anti-cool. He is kryptonite to cool. Worse, he does things like try to purchase Yahoo for too much money, pay tons of money for an ad company that leads Microsoft to the write-off billions of dollars. And of course the attempt to compete with Google in search has largely been a failure. Etc., etc.
So why do I own? Why do I continue to own? It’s important not to check one’s brain at the buy button. And it’s even more important not to check one’s brain once one has hit the buy button. Is my thesis wrong? What is my thesis? My thesis is fairly simple: The company still makes a bunch of money, will continue to make a bunch of money, and even as the Wintel monopoly ends, this is not the end-of-the-line for Microsoft. And because everyone thinks it is the end-of-the-line and Microsoft is going to go the way of Research in Motion, it’s cheap as hell.
Even during the disastrous fiscal year that ended in June 2012, the company generated record free cash flow of $29.321 billion, and $3.44 of free cash flow per share, also a record. And record revenue. Against around $11 billion in long term debt, it was holding over $50 billion in cash and cash-equivalents.
These aren’t really new facts to anyone who follows Microsoft. More recently, earnings-per-share were down from $0.78 per diluted share in 11/2011 to $0.76 per diluted share in 12/2012. The future is all that matters. The trend is all that matters. What’s the saying? — I’d rather pay up for a quality business than get a bad business for a good price. Something like that.
Well, let’s see more concretely what this last year hath wrought. I last checked in on Microsoft’s valuation in April 2012. (I’m a long term kind of guy, I don’t follow the ticker every day.) At the time, as you can see in that sheet, I assumed 4% yearly free cash flow growth for ten years and 1% thereafter. I assumed a WACC of 9.2%, and a share count, then-existing, of 8.593 billion diluted shares. I discounted the cash (less debt) that Microsoft was holding by 35% to assume Microsoft would eventually have to pay taxes on all of the cash it holds overseas, or else will blow some of its money on stupid acquisitions, and lose some to inflation. That gave me a valuation of around $45/share, give or take. (This isn’t a science, and anyone who tells you otherwise probably wants you to pay for some worthless subscription or newsletter.)
Note, by the way, that although I assumed 4% yearly free cash flow growth, in this actual first of my ten years from the above calculation free cash flow actually grew 19% from year-end 6/2011 to year-end 6/2012, from $24.639 billion, to $29.321 billion. We can’t really expect to see that repeated this coming year-ending 6/2013, but we shall see.
Now this year, from the 6/2012 starting-point, we have only 8.444 billion diluted shares outstanding, because of share repurchases. The WACC is still about the same. Some sources say only 9%, but I’ll stick with 9.2%. Note that debt is now up from last year, to over $14 billion, because Microsoft has taken advantage of stupid-low interest rates. And cash is up to $68.312 billion as of 12/2012. I continue to just write-off 35% of Microsoft’s cash when making my analysis, for the same reasons as above. The result I get is that Microsoft is now worth around $54.60/share, more than it was last year, and that it is nearly 50% discounted. Even if you completely write-off all of its cash, it’s still way undervalued by this analysis.
Can this be? Can Microsoft really be so cheap? I think so. That’s why it’s such a large position for me. If you think its earnings are about to fall off a cliff, as is its cash generation, you may disagree. But I’ve been covering Microsoft pretty extensively for four years now. If you think that now, you have probably thought it for four years, and that time, during the advent of the iPhone and the iPad and Google Chromebooks, etc., Microsoft has grown its free cash flow from $15.9 billion at the bottom of the financial crisis, to over $29 billion, yo.
So what say you? I still say it’s a buy. And while I wait for the market to agree with me, and hope that my thesis is correct, I’m happy to collect the 3% dividend yield, and happy to see that so far its actual free-cash-flow generation confirms my thesis.