MICROSOFT CORP MSFT
March 11, 2011 - 2:30pm EST by
Bill
2011 2012
Price: 25.60 EPS FY: 2.35 FY: 2.61
Shares Out. (in M): 8,402 P/E 10.9x 9.8x
Market Cap (in $M): 215M P/FCF 10.0x 9.0x
Net Debt (in $M): -31,600 EBIT 26,380 28,000
TEV ($): 183,692 TEV/EBIT 7.0x 6.56x

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Description

Thesis: MSFT is a compelling buy and is one of the most fundamentally undervalued stocks in the market today, with a variety of catalysts that could move the stock up by 75%+. MSFT is dramatically undervalued on virtually every metric on both a relative and absolute basis, currently valued at an estimated 2011 P/E, EV/EBITDA and FCF yield of 9.7x, 5.1x and 11%. Relative to MSFT's peers, the market, historical valuation and a DCF analysis, I calculate the stock is anywhere between 40-100% undervalued, with downside potential of only about 10% in a reasonable worst case scenario. There are several catalysts that I expect to help move the stock up over the next 12+ months including; 1) a change in perception of the stock from a secular decliner to a growth company; 2) potential for accelerated share repurchases and a dividend hike; 3) the release of Nokia's Windows Phone 7 products; 4) further development of Asian and 3rd world economies that will gradually result in the migration of 400+ million windows users that currently use unauthorized versions of the software, to begin to pay for Windows as they demand higher reliability and cloud services; 5) the growth of cloud computing in which MSFT has the potential to be the market leader; 6) continued success of the Xbox/Kinect product; 7) continued market share gains and growth from Bing; and 8) the release of the company's tablet solutions.

I am going to keep this write-up short and sweet due to time constraints, and will not go into great depth. I encourage all readers to do your own work and let me know what you think of the stock. I challenge anyone to give me a rational reason why the stock should be valued at such depressed levels?

Microsoft's Divisions: The company has five primary divisions which include; 1) Windows (46% of operating income (OI)) which makes money through the sale of every PC that uses the Windows operating system; 2) Microsoft Business (40% of OI) which makes money from the sale of every component of Microsoft Office software sold; 3) Server and Tools (21% of OI) which targets enterprise customers; 4) Entertainment and Device (2.5% of OI) which includes sales of Xbox and Kinect products; and 5) Online Services, which has been losing about $2.4 billion each year, and primarily sells add space through the Bing search engine. Each of these divisions has been growing significantly over the past several years and I expect continued growth in perpetuity, the rate of which will depend on both macro and company specific factors. I expect Microsoft to achieve average EPS growth over the next ten years of anywhere between 10-20% off of its 2010 CY base of $2.35, with a basis toward the high end of this range. My bias is towards 20% EPS growth for Microsoft because the company has a history of consistently buying back a significant amount of stock, and has the capability of achieving 10%+ EPS growth per annum on flat revenues due to share repurchases alone.

Why is the stock undervalued? The most obvious question anyone could ask is why would MSFT be undervalued, because one would think that a company this well known would likely be fairly valued? After much thought and research my conclusion is that investor sentiment is irrationally negative on the company due to a couple of criticisms, which has caused a dramatic imperfection in the price of the stock. These criticisms are either not based on reality, and/or are not a rational reason to stay away from the stock at the current depressed valuation. Moreover, even if these criticisms have some merit, MSFT stock is still 40-100% undervalued, and if they prove to be wrong as I suspect the stock may have significantly more upside.

Criticism 1: MSFT has no viable phone or tablet product.

Response: My initial response to this criticism is it is simply not true, and even it if were MSFT stock is tremendously undervalued given its other businesses and their cash flow and growth characteristics. In terms of Microsoft's phone strategy, the company recently introduced their Widows Phone 7 (WP7) operating system which has slowly gained traction and has had very favorable reviews. Furthermore, Microsoft recently announced a partnership with Nokia which calls for Nokia to use WP7 as the primary operating system for their next generation of smart phones. To note, Nokia has about 30% share of the global smart phone market, and I would thus expect a vast increase in Microsoft's WP7 share (currently around 2%) as Nokia begins to roll out WP7 phones, anytime between late 2011 and early 2012. This partnership has the potential to propel WP7 into a viable competitor with Android and Apple phones. If Microsoft is successful gaining significant share in the smart phone market, MSFT stock has significantly more upside than I currently forecast. In terms of tablets, Microsoft is currently working diligently on a new operating system which I expect to be released either late 2011 or early 2012, which I expect to target business customers where the company should have a significant advantage over Apple and Android. Again, any success in either or both of these initiatives is incremental upside to my upside targets.

Criticism 2: Tablet growth will negatively impact PC growth which will hurt Microsoft's Windows and Business divisions.
Response: I also think that tablet growth will have a slightly negative impact on PC growth rates going forward, but this factor has been dramatically more than reflected in Microsoft's valuation, and is factored into my estimates. Moreover, all of my research indicates that tablet's are not a replacement for PCs and will only have a slight impact on PC growth rates, as an incremental PC buyer might decide to buy a tablet instead of a 2nd laptop. Every expert I have spoken with in the field continues to expect PC growth over the next 10 years of 3-10% driven by the developing world, which should be one of the many drivers of Microsoft's EPS growth. Furthermore, Microsoft has several other growth drivers that should propel EPS including the movement towards the cloud, Bing growth, Xbox/Kinect growth, share repurchases, and potential WP7 growth.

Conclusion: My conclusion is that there is an irrational negative perception regarding MSFT stock, that has given astute investors a once in a cycle opportunity to own one of the best companies in the world, poised for significant growth, at bargain basement prices.

Risks: The primary risks I see for MSFT are just headline related, because under any reasonable worst case scenario the stock is tremendously undervalued on a fundamental basis, and long-term investors will very likely make a significant amount of money over time. The primary risk for MSFT's numbers is an economic or secular slowdown that results in lower PC sales than expected. Although from a value perspective MSFT is significantly undervalued with any reasonable PC assumption, even with a meaningful slowdown.

Catalyst

1) a change in perception of the stock from a secular decliner to a growth company; 2) potential for accelerated share repurchases and a dividend hike; 3) the release of Nokia's Windows Phone 7 products; 4) further development of Asian and 3rd world economies that will gradually result in the migration of 400+ million windows users that currently use unauthorized versions of the software, to begin to pay for Windows as they demand higher reliability and cloud services; 5) the growth of cloud computing in which MSFT has the potential to be the market leader; 6) continued success of the Xbox/Kinect product; 7) continued market share gains and growth from Bing; and 8) the release of the company's tablet solutions.
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