Is Microsoft a good stock to buy for the rest of 2012? Microsoft (MSFT) has travelled a long way on the software boulevard with elegance and style. From its early days of MS DOS to its current sophisticated operating system coupled with its office suite, MSFT has a long history of success. To complement a maturing product line, MSFT has made a variety of inroads in the video game market via Xbox and Xbox 360 consoles followed by cloud-based services of Bing and Windows Live Essentials suite.
We place a buy rating on the stock thanks primarily to the Bill Gates philosophy combined with a continuous history of high value earnings on the back of strong market standings, product innovation, diversification, asset efficiency and technological flexibility. Our buy rationale incorporates potential benefits arising from acquisition of $8.5 billon Skype Communications and VideoSurf. The growth of the smartphone industry in the latter half of the last decade saw Microsoft working in tandem with smartphone manufactures such as Nokia, however, it will take some time before MSFT can make a notable difference in presence of giants like Apple and Samsung. Going forward, we expect an upside for the firms’ revenues and cash flows, making this software giant a strong pick for most portfolios.
Key Thesis Points
1. MSFT is the market leader in desktop operating systems, whereas Apple (AAPL) OS and Linux have a long way to go if they are to match the demand for MSFT. With gross profit (76.62%) and net profit (31.96%) margins higher than its industry average (75.45% and 24.01%, respectively), we can say that MSFT is in a position to withstand competition and/or external shocks, since it is operating at standards beyond those required of OS industry players. Two of its competitors, APPL and GOOG, are both operating at lower gross profit and operating profit margins. MSFT is also performing better than Oracle (ORCL), which has a net margin of 26.89%. Consequently, ROE of MSFT stands at 38.2% while that of ORCL was reported at 23.8%. Going forward, we expect MSFT to face strong competition from GOOG and AAPL in its noncore segments but predict it will continue to capitalize on the software segment with minimum resistance from its competitors.
2. MSFT’s management efficiency, measured via income per employee and revenue per employee, is again above par for its industry. Asset turnover is exactly at the level of the industry, depicting the optimum possible use of assets in generating sales. Sales have increased from FY10 to FY11, despite an increase in operating expenses. It is pertinent to note here that MSFT’s research and development expenditure has increased, signaling the company’s focus towards always trying to bring newer products to the market and improving upon the existing ones.
3. Both MSFT’s current and quick ratios are higher than the industry benchmark, showing the company’s strong liquidity position. In other words, should any contingency arise with regard to the company’s current liabilities, they are fully covered and then some. All categories of current assets have increased, the most notable of which are inventory, short term investments, and cash and cash equivalents. Current liabilities have also increased, but by a lesser proportion than the increase in current assets. Conversely, MSFT has a debt to equity ratio which is slightly lower than the industry’s, showing that the company could take on more debt without compromising its profitability. If more debt is taken on in the near future, the company’s cash flows will be able to service it.
4. Return on investment has three varying measures, and it is heartening to note that Microsoft is again ahead of the industry’s average in all three, i.e. return on assets, return on equity, and return on capital. This simply goes on to show that assets, equity, and capital invested in the firm are being utilized efficiently and effectively. Not only is its asset utilization good, but it reflects the management’s competency as well. In fact, in terms of market capitalization, annual dividend yield, and return on equity, MSFT stands at number one, two, and three, respectively with respect to its competitors.
Brief Valuation
MSFT is a growth stock with Price to Book value of 3.63x and a current PE ratio of 10.86, with a forward PE multiple of 9.69. Its Enterprise Value to EBITDA is at a stable 6.65, depicting good valuation prospects for the firm. The firm’s beta is 1.03, which explains the volatility profile of the stock as being just a little more volatile than the market. This is because the industry environment is vulnerable to very fast changes. Change is the only certainty in this type of industry. Going forward, based on strong fundamentals emanating from a dominating market position, efficient asset utilization, and expected PE multiplier, we value MSFT at $35. Billionaire Ken Fisher is also bullish about the stock, boosting his stake in the company by 16% to nearly $570 million at the end of March (see Ken Fisher’s favorite stocks).
Microsoft is undervalued based on its expected growth rate and earnings multiple but other mega-cap tech stocks are also very attractively priced. Apple has a single digit forward PE ratio excluding its huge cash hoard. Google’s PE ratio is slightly higher than both Microsoft’s and Apple’s, but the stock has a stronger position in its core business and faces relatively weak competition. Google also has a large cash hoard and, excluding cash, the stock’s forward PE ratio is less than 12. Hedge funds noticed these low valuations and flocked to them. Apple, Google, and Microsoft are the three most popular stocks among hedge funds since the end of last year (see the 10 most popular stocks). We can’t speculate on the short-term gyrations but we strongly believe that these three stocks are excellent choices for long-term investors.