Value Investors Club / Microsoft (MSFT)

Description

In this environment, owning self sustaining cash flow generating companies with defensible franchises and great balance sheets is more important than ever. MSFT is arguably one of the world’s best businesses. It boasts great margins and generates enormous free cash flow of $18.4 billion in F’08 and more than $17 billion expected in F’09. It has near monopolistic market shares on the corporate and consumer desktop and laptop markets, as well as great brand recognition. All of this combined with low capital requirements has lead to stellar returns on invested capital, 26% over the past 5 years and in the low 40’s more recently. The stock has never been cheaper on any metric, trading at approximately 10x F’09 net income. The current bear market is giving us the opportunity to buy a great company at a great price.

There are certainly risks associated with MSFT. Clearly consumer and enterprise spending will slow due to the recession. Longer term there are also risks to the franchise from competition from the likes of Linux and GOOG, among others, as well as questions regarding execution and strategy in areas like online search and consumer entertainment. There are also risks associated with capital allocation (YHOO acquisition, etc.). These concerns have all been widely documented and I believe at this valuation have been more than priced into the stock.

Despite these risks, I believe the stock is very cheap and its franchise value will endure for longer than the market is currently giving MSFT credit for. Even though the business is maturing sales and income growth has still been quite strong over the past few years. Historically MSFT has not been impacted to a large degree by economic cycles, although I expect this cycle pose more of a challenge to MSFT. The competitive threats are real, but MSFT’s market position is virtually unassailable in some of its key markets. Furthermore, online and consumer divisions have been masking overall corporate profitability because they are still in a heavy investment phase, so these have been a drain on earnings, but at some point could turn around. As for capital allocation, a dilutive acquisition is still possible, although it seems less likely at this point, and MSFT has a great track record of returning value to shareholders. The company currently has a 2.7% dividend yield and has plans to buy back $40 billion of stock. Over the past 5 years it has returned $115 billion to shareholders via buybacks and dividends

Price		$19.14
SHSO		8895.6
MCAP		170,262
					F2008	F2009
Cash		20,722			6.5	6.7	EV/EBIT
Equity and other investments		4,381			5.7	5.7	EV/EBITDA
Debt		1,975			12.5%	11.9%	FCF Yield

EVAL		147,134

						expected-->
	9/07	12/07	3/08	6/08	9/08	12/08	3/09	6/09
	1Q'08	2Q'08	3Q'08	4Q'08	1Q'09	2Q'09	3Q'09	4Q'09
Revenue	13,762	16,367	14454	15837	15,061	16,500	14,000	15,000
COGS	2,675	3,543	2514	2866	2,848	3,300	2,590	2,775
GP	11,087	12,824	11,940	12,971	12,213	13,200	11,410	12,225

R&D	1,837	1,885	2035	2407	2,283	2,459	2,212	2,370
S&M	2,683	3,392	3155	3878	3,044	3,746	3,332	3,630
G&A	718	1,066	2341	1002	887	1,139	966	1,035
Opx	5,238	6,343	7,531	7,287	6,214	7,343	6,510	7,035

Op Inc	5,849	6,481	4,409	5,684	5,999	5,858	4,900	5,190
DA	435	481	532	608	585	627	532	570
EBITDA	6,284	6,962	4,941	6,292	6,584	6,485	5,432	5,760
SBC	333	360	373	413	443	396	378	405
EBITDA2	6,617	7,322	5,314	6,705	7,027	6,881	5,810	6,165

				expected
	2006	2007	2008	2009
Revenue	44,282	51,122	60,420	60,561
COGS	7,650	10,693	11,598	11,513
GP	36,632	40,429	48,822	49,048

R&D	6,584	7,121	8,164	9,324
S&M	9,818	11,455	13,039	13,752
G&A	3,758	3,329	5,127	4,027
Opx	20,160	21,905	26,330	27,102

Op Inc	16,472	18,524	22,492	21,947
DA	903	1,440	2,056	2,314
EBITDA	18,528	19,964	24,548	24,261
SBC	1,715	1,550	1,479	1,622
EBITDA2	20,243	21,514	26,027	25,883

CFFO	14,404	17,796	21,612	20,591
Capx	-1,578	-2,264	-3,182	-3,028
FCF	12,826	15,532	18,430	17,563

My 2009 estimates are based on weakening PC demand, continued share gains by netbooks, and deteriorating consumer spending trends. Management has guided revenue to $64.9-66.4 billion. F2Q’09 appears to be shaping up fine, but management will most likely have to lower guidance for the balance of the fiscal year. Client revenues will probably end up declining in the mid single digits for the year, as netbooks take share and PC’s are weaker. OEM will also decelerate based on weaker PC shipments. The business segment should also feel the pain of the recession and credit environment, but it can still post mid single digit revenue gains. Server and tools should be relatively strong even with the prevailing headwinds as it has a large recurring portion and a strong balance of unearned revenue. Online and consumer should continue to grow, albeit at a much slower pace.

I have taken a realistic worst case scenario cut to management’s guidance, but this still leads to nearly flat revenues. It also means that MSFT could generate operating income of almost $22 billion and free cash flow of over $17 billion. A DCF using a 10% cost of capital and 2% terminal growth yields a valuation in the high $20s for the stock, which seems reasonably conservative as it translates into roughly10x EV/EBIT and 8% free cash flow yield on F’09 estimates.

Catalyst

moat, valuation, div, buyback, the world not ending

show sort by

			2008	2009
Price:	19.14	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	170,262	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT