Microsoft Corporation

$395.6 Billion

Stock Review

In the history of Magic Formula Investing (MFI), there has been no more consistently screened stock than Microsoft (MSFT).

This blue chip tech stalwart has been a part of the screens almost since the day they were launched in 2006. And for good reason.

With a recent share price decline, is this great business cheap again? Let's take a look.

By the Numbers, An Indisputably Great Business

Microsoft is undoubtedly a great business, as measured by its returns on invested capital, one of the two components used by MFI to rank stocks. According to Morningstar, Microsoft's 10-year average returns on invested capital are an outstanding 32.2%, with returns on equity over that same period at 35.1%.

The company has also generated immense free cash flows, routinely well over 100% of net income. It has bought back a substantial number of shares (share count down 23% since 2005), and been a voluminous dividend payor (11 consecutive years of dividend raises).

Finally, Microsoft has maintained a rock solid balance sheet. The company carried no debt at all until 2009, and even today its debt-to-equity ratio is strong at just 30%, with over $100 billion in cash vs. $29 billion in long-term debt.

Despite this, The Market Remained Skeptical

Being a great business is just one half of being screened by MFI. The second half is having a quantitatively cheap stock. In this, also, Microsoft has "succeeded". Despite the strength of the business, the company's 5-year EBIT/Enterprise ratio (earnings yield) has averaged over 12.3%, far above the market average of about 7.5%.

Why is this?

The market, for a long time, saw Microsoft as a dinosaur, a company grasping on to its outdated business model of selling desktop software while failing abjectly while trying to enter new markets like paid search advertising, internet services, and device sales. Investors scoffed at the company's horrifically overpriced acquisitions, like aQuantive for $6 billion, Skype for $8.5 billion, and even the failed, $45 billion bid for Yahoo!. They predicted and then boasted when PC sales flat lined and then headed south, taking a portion of Microsoft's cash cow, Windows, with them.

But today, the narrative has changed, and the market is beginning to value Microsoft more like a market-average stock. What is changing, and with the recent decline in the stock, is it back into buy territory?

A Closer Look At The "New Microsoft"

Satya Nadella, a company veteran, took over for Steve Ballmer in early 2014. He has aggressively moved the company toward computing's future - cloud services and mobile - while trying to protect the firm's hegemony in operating system, business productivity, and middleware service layer software.

Recent results are showing this transition taking hold. In the most recent quarter, cloud revenue more than doubled, driven by subscription-based productivity suite Office 365, cloud development platform Azure, and Dynamics CRM Online. Cloud is now about 20% of Microsoft's revenue. Microsoft's devices efforts are finally bearing fruit, with Surface doing over $1 billion of revenue (up 24%) last quarter. Bing market share is up to almost 20%, largely driven by new default search deals. On the other hand, Office commercial sales declined 1% and Windows is expected to decline moving forward.

Wall Street has reacted positively to this new direction, sending the stock up to almost $50 and shifting it into a new valuation range. Over the past year, Microsoft has traded in an earnings yield range of 8.25% to 9.6% - much better than in the past, but still below market average.

So where are we going with all this? Let's use all this discussion to see if Microsoft is worthy of a buy after falling 10% post-earnings.

Is Microsoft A Buy?

Like most investors, I like Microsoft's new direction. The old model was clearly unsustainable over the long run. The company should be given credit for developing some of the best cloud services in the world - I think Microsoft has some new recurring revenue, wide moat, high switching cost businesses in Office 365 and Azure, to complement its enduring Windows monopoly. And we've already discussed the shift to a better valuation baseline - there is no need to assume MSFT will trade at a double-digit earnings yield anymore.

Microsoft is and will continue to be a great business - there is no doubt about that - but this business transition, while necessary, also carries disadvantages.

The problem I have is - there still isn't much earnings growth here. Sure, cloud and especially devices will drive 8-10% top line growth. But that growth is going to come at much lower margins. Maintaining cloud data centers and selling devices is far less profitable and more capital intensive than pure software development. We're seeing this already. Last quarter, Microsoft's gross margins came in at under 62% - just 2 years ago they were over 75%! Pre-tax earnings were almost flat against last year, despite an 8% increase in sales. As Windows royalties continue to decline, margins will continue to compress.

If we assume about 5% earnings growth for Microsoft over the next 5 years, combined with a target 9% earnings yield, I see Microsoft's stock worth about $46/share - about where it traded before the recent decline. For conservative investors, that is a decent 11% upside, along with a decent 2.6% dividend yield that will continue to be raised. But it is not quite enough margin-of-safety to consider Microsoft as a Top Buy pick at present.

Company Description

Microsoft Corp. develops and markets software, services and hardware that deliver new opportunities, greater convenience and enhanced value to people's lives. The company's products include operating systems for computing devices, servers, phones, and other intelligent devices; server applications for distributed computing environments; productivity applications; business solution applications; desktop and server management tools; software development tools; video games; and online advertising. It also designs and sells hardware devices including Surface RT and Surface Pro, the Xbox 360 Gaming and Entertainment Console, Kinect for Xbox 360, Xbox 360 accessories, and Microsoft PC accessories. The company operates its business through following segments: Devices and Consumer (D&C) Licensing, Computing and Gaming Hardware, D&C Other, Commercial Licensing, and Commercial Other. The D&C segments develop, manufacture, market, and support products and services designed to increase personal productivity, help people simplify tasks and make more informed decisions online, entertain and connect people, and help advertisers connect with audiences. D&C segments are made up of D&C Licensing, Computing and Gaming Hardware, Phone Hardware, and D&C Other. The D&C Licensing principal products and services provided by the D&C Licensing segment are: Windows, including original equipment manufacturer (OEM) licensing (Windows OEM) and other non-volume licensing and academic volume licensing of the Windows Operating System and related software; non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (Office consumer); Windows phone operating system, including related patent licensing; and certain other patent licensing revenue. The Computing and Gaming Hardware segment comprises Xbox Gaming and Entertainment consoles and accessories, second-party and third-party video game royalties, and Xbox Live subscriptions (Xbox Platform); Surface devices and accessories; and Microsoft PC accessories. The Phone Hardware segment comprises Lumia smart phones and other non-Lumia phones, beginning with acquisition of NDS. The D&C Other segment comprising resale, including Windows store, Xbox live transactions, and Windows phone store; search advertising; display advertising; Office 365 Consumer, comprising Office 365 Home and Office 365 Personal; Studios, comprising first-party video games and retail stores; and certain other consumer products and services not included in the categories above. The D&C Other segment's principal products and services provided by the D&C Other segment are: Resale, including the Windows Store, Xbox Live transactions, and the Windows phone store; search advertising; display advertising; Office 365 Consumer, comprising Office 365 Home and Office 365 Personal; Studios, comprising first-party video games and retail stores. The Commercial Licensing segment's principal products and services provided by the Commercial Licensing segment are: server products, including Windows server, Microsoft SQL Server, Visual Studio, System Center, and related client access licenses (CAL); Windows Embedded; volume licensing of the Windows Operating System, excluding Academic (Windows Commercial); Microsoft Office for Business, including Office, Exchange, Sharepoint, Lync, and related CAL (Office Commercial); Skype; and Microsoft Dynamics business solutions, excluding Dynamics CRM Online. The Commercial Other segment's principal products and services provided by the Commercial Other segment are: enterprise services, including premier product support services and Microsoft consulting services; commercial cloud, comprising Office 365 Commercial, other Microsoft Office online offerings, Dynamics CRM Online, and Microsoft Azure. Microsoft was founded by William Henry Gates III in 1975 and is headquartered in Redmond, WA.

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