I'll admit that for a long time I pretty much ignored Microsoft Corporation (NASDAQ:MSFT) as an investment. I saw the company's fall from grace in 2000 when the shares sold carried a P/E of more than 50. Some of their terrible operating systems like Windows Me and Windows Vista over the years didn't help matters. Since switching my personal computer to a Mac, I have only owned one Windows computer in more than ten years.
That being said, I used Windows at work every day, and Windows 8 got my attention. The company's vision of using the same software on PCs, tablets, and smartphones made sense. However, there are at least three things the company needs to do better.
Bold Ambitions In Microsoft's last earnings report, CEO Steve Ballmer referred to Windows 8 as, “Our big, bold ambition.” Changing from the traditional start menu to live tiles is jarring at first, but I believe over time this issue will fade away. Customers have gotten used to apps through their smartphones and tablets, so what better way to change your operating system than to make it a field of apps? But Microsoft is relying on several factors to work in their favor. They need the Intel inspired Ultrabook concept to draw customers to buy a new computer. They also need either their own tablet (Surface), or other Windows tablets to take market share from iOS and Android. They also need to gain respectable market share in the smartphone industry. By all accounts, most of this will happen, it just may not happen on the timetable that impatient commentators want.
How Is the Company Really Doing? For all of the hand wringing over Windows 8, the company's quarterly results were pretty good. Microsoft's Windows division showed revenue up 24%, and operating income increased 14.44%. In the server arena, Microsoft is still battling old foe Oracle Corporation (NASDAQ:ORCL). The fact that Microsoft saw revenue increase 9% and operating income was up 8.77% suggests that the company is winning some of these fights. Results from the company's Business Division (i.e. Office) were the real problem. This division reported operating income down almost 15%. More than likely this was due to companies delaying purchases due to the recently released Office update and Office 365. Some might say that Google Inc (NASDAQ:GOOG) and their suite of Google Apps is taking market share from Microsoft Office. Google would love to see users adopt Google Chrome and eliminate Microsoft Windows completely. While Google owns the domestic search market compared to Microsoft's Bing, in the operating system and office software battle, Microsoft is the clear leader.
The Company Is Better Than This One of the keys to success in the technology field is spending money on research and development. In this respect, Microsoft needs to do more. In the current quarter, Microsoft spent 11.78% of their sales on R&D. By comparison, both Oracle and Google spent over 13% of their sales on R&D. It may not seem like much, but Oracle and Google are already beating Microsoft to the punch in certain areas, and the company can't afford to fall behind. A second issue I have with Microsoft's performance is their use of cash flow, specifically as it relates to share repurchases. In the last year, Microsoft retired just 0.25% of their diluted shares. By comparison, Google retired 1.78% of their shares, and Oracle bought back 4.98% of their shares. It would be one thing if the majority of Microsoft's cash flow were used up paying dividends, but that isn't happening either.
A 3% Yield Is Not Enough In the current quarter, Microsoft generated $6.46 billion in free cash flow and paid $1.933 billion in dividends. While this sounds like a lot in dividend payments, it equates to a free cash flow payout ratio of just 29.94%. Since Google pays no dividend, we can't compare them on this measure, but Oracle's cash usage is instructive. Oracle used just 9.43% of their free cash flow to pay dividends this last quarter. While this sounds like Oracle is doing less than Microsoft, don't forget Oracle retired almost 5% of their shares compared to Microsoft retiring just 0.25%. Just to reinforce this point, last quarter Microsoft used about 53% of their adjusted free cash flow buying back shares or paying dividends. By contrast, Oracle used just over 98% of their free cash flow in paying dividends and buying back shares. The bottom line is Microsoft looks like a decent value with a 3.29% yield and expected growth of 8.38%. However, Oracle is expected to grow faster at 11.97%, and even with their 0.68% yield, the total return to investors in theory would be higher. Google is expected to outgrow both companies with a near 14% EPS growth rate, and their stock reflects this fact. Based on Microsoft's huge cash flow, they can afford to do more. In theory, spending more on R&D would create better products. Increasing share repurchases would result in better earnings per share growth. A larger dividend would make the stock worth more from the higher yield. Better products, a better yield, and better earnings per share growth -- now that sounds like what investors should expect from an industry leader.