THE DUMB MONEY

Microsoft: A Brief Checkup on My Largest Position Says It’s A-OK

For some time, Microsoft has been the largest position in my portfolio.  I first added around $19/share during the financial crisis.  That was based on more of a knee-jerk “holy crap that’s cheap and no the world is not ending” analysis.  Subsequently I did a lot more real analysis, after which I added around $24/share, and I added in late 2010 at around $28/share, in March 2011 at around $25.50/share and last Fall around $27/share.  Today the stock is still either: 1) stupid-stupid-stupid-stupid cheap (as in, undervalued by 30% or more); or 2) Windows 8 and everything else is actually going to fail and it is going to go into terminal decline.  You pick.

But first, how did we get here.  Well my original thesis went like this, written on February 20, 2010, though developed before then:

In yet another sign of the insanity of the late 90s, and the myopia of today, MSFT is selling now at about what it sold for twelve years ago! Except now it is vastly more profitable, pays a decent and growing dividend, and has diversified its business somewhat from the Windows/Office core. The dividend is nearly 2%, and growing, and the payout ratio is quite low, leaving significant room for growth. I bought in for the first time at around $19/share during the market bottom, and may add to my position on further weakness. P/E is sub-16. MSFT is the “uncool” tech company now. AAPL is a better company, but shareholders face HUGE risks b/c so much innovation comes from Jobs, who just had a liver transplant and may not be around much longer — look what happened to AAPL the last time he went away.

(Note that I subsequently resolved my worries about Apple, and bought in 2011, late, at $365/share for my first purchases, then again at $390ish in 2011 and again on 4/23/2012 at $570ish, and Apple is now my fourth largest position.  I got rid of the false dichotomy, too, of thinking everything had to be either Apple or Microsoft, or Google or Microsoft, etc.) 

Then on September 28, 2010 I wrote this:

I believe MSFT is, as of today, the most undervalued stock in my portfolio. DCF, assuming an 11.1% [which is too high] weighted average cost of capital, and 3% terminal growth, yields an intrinsic share value of $34. That may be a bit high, but MSFT is worth at least $28 or $28/share, as of today today.

On February 7, 2011 I wrote:

The market appears totally convinced that MSFT is on the verge of losing its Windows and/or Office moat, and/or that growth in that area will be so low that the company will not grow, and/or that MSFT’s failure thus far to get involved meaningfully in the mobile market means it cannot succeed in doing so. I have never seen so much negativity surrounding one company that had not been involved in a major oil spill (XOM shortly before I bought it), major litigation (MO, shortly before I bought it). With MSFT I am just going to have to continue to trust the numbers. Revenues are growing, free cash flow is exploding, margins remain solid, triple-A rating, issues debt at stupendously low rates….I’m going to put this another way: If you assume a discount rate of 12%, which is more conservative than either Morningstar or S&P use when evaluating MSFT, and you assume MSFT will grow free cash flow 5% for ten years (which is less than the previous 10-year average of 6.9% annually, and less than half what MSFT has managed (11+%) since 2007), with 2% perpetuity growth, then counting MSFT’s cash on hand, netting out its debt, the company is worth $34.68/share today, implying a 20% discount. Even if you change the discount rate to 14% it would be undervalued. If at a discount rate of 12% one assumes it can grow FCF simply at 6.9%, which is its average over the last ten years, and is also its recent rate of revenue growth, then the stock is worth $38.35/share, for a 29% discount. This is not rocket science. At a 12% discount rate, even assuming only 2% FCF growth from now until eternity, you would be getting more than a 5% discount by buying MSFT today. Am I smoking something? Seriously, am I just spank out of my mind? What is going on with this stock?

So where are we now?

Well, unless I have totally screwed up my free cash flow spreadsheet, which you can link to and view here (if you ask I’ll give you editing rights so you can look at my formulas and mess with things), Microsoft is still basically priced for Armageddon.  I’m still thinking and saying the same things I was saying a year ago and two years ago.  If you assume a calculated WACC of 9.2% for Microsoft, then to be fairly priced today you have to believe that Microsoft’s free cash flow will basically contract from here on out.  Seriously, play with the sheet.  The numbers are right there.  (That’s assuming free cash flow growth starting from June 2011’s annualized figure, even though June 2012’s, to which we are closer, will be significantly higher.)

If you assume Microsoft can grow its free cash flow by just 4% per year for ten years (which is one third of what it has grown it on annualized rate through the past four years — during the “iPhone Era” I might add), then Microsoft is around 28% undervalued.  (The sheet is presently set up to reflect this assumption.)  Under those assumptions, it is a buy up to about $36.20/share. 

Not only that, dear reader, but to get there there are more conservative assumptions.  In my sheet I discount the $59.3 billion in cash and equivalents on hand by 35% to account for repatriation tax, even though not all of it is held abroad, and no tax may ever be paid even on what is held abroad.  AND I only give MSFT a post-ten-year 1% perpetuity growth rate, which is a population growth rate that is below inflation.  In short, this is a conservative calculation.

What’s going on here?  I suspect people would say (note, I suspect this because they DO say it), that: a) Microsoft is going to go the way of Research in Motion and that b) relatedly, the WACC is too low, whatever the math seems to say, because it’s just not as stable as it seems, and c) Microsoft wastes its free cash flow so you can’t count all of it.

This is where you have to put on your English major and tech analyst hat.  This story doesn’t make sense, or it only makes sense in part.  Yes, there is cash flow wastage.  Bing, et al.  And attempted wastage: failed Yahoo acquisition.  Yes the PC market is mature, and being eroded by the iPad.  But there is a lot of organic growth left to be had around the world.  Microsoft has grown healthily even during the iPhone era so far.  Many businesses have not even upgraded to Windows 7 because they are happy running Windows XP (service for which will shortly be phased out) and have delayed upgrades.  So even if businesses don’t want Windows 8, they’ll be upgrading to Windows 7 for years to come.  And at least at this point Microsoft still has a chance in tablets and phones.  It has expanded its gaming business.  Office is going strong, cloud notwithstanding.  Servers and tools is now something like more than 1/4 (without rechecking) of the company, and growing.

So you have a choice with Microsoft: do you think it’s going to fail?  Or do you think it’s going to be fine, and is stupid cheap?  I very well could be wrong, but I think the latter, and have thought it for two years.  Believe me, I watch the numbers carefully to see if I’m wrong.  I believe that there will be pretty clear signs that Microsoft is truly losing its Windows and Office franchises, if it happens.  But so far, in the two years I have been closely following it (including this past quarter), I have seen nothing to indicate Microsoft is going down.  And I still do not.

On a broader note, I am sick of fads masquerading as themes.  I have been around the block a couple of times by now.  In 1998 tech companies were God.  They were unassailable.  Drug companies were god.  They too were unassailable.  In 1998 Altria/Philip Morris was a turd pile (it crushed the S&P index from then until now, just crushed, including spinoffs).  In 2004-2007 houses were God.  In the 1990s the big thing was for oil companies to merge, and to “vertically integrate.”  Now COP’s split into two companies is hailed as visionary and people want Exxon to do so as well.  Waves and tides, nothing more.  Now, too, the Sophisticated Investing and Blogging Elites think tech is “inherently unstable” and a “no moat industry” and that every company no matter how big is inches away from some tiny competitor blowing them up.  The pace of change is now scary, not exciting.  Anyway, all of this is why most of the tech and drug companies were a crap place to invest in in 1998 (when I was buying Philip Morris), why houses were terrible in 2007 (when I was putting my life savings in a 5% one year FDIC-insured CD) and why, astoundingly, Google, Microsoft, and Apple are all simultaneously some of the most undervalued stocks in the market today.  We need to get rid of the fad and themes, people, and just look at the numbers.