On Friday, Mr. Market was down on the world’s largest software company, Microsoft Corporation (NASDAQ:MSFT).
Shares of “Mr. Softy” fell nearly 12% after it reported its fourth-quarter earnings. The company missed analysts’ expectations on both earnings and revenue. Sales of its Windows software disappointed. And Microsoft Corporation (NASDAQ:MSFT) took a $900 million accounting charge related to its Surface tablet.
In contrast to Microsoft Corporation (NASDAQ:MSFT), airline companies are flying high. Shares of companies like Southwest Airlines Co. (NYSE:LUV) and United Continental Holdings Inc (NYSE:UAL) have basically doubled in price over this past year.
Mr. Market and Mr. Softy
Mr. Market is the manic-depressive business partner that legendary value investor Ben Graham created in his book The Intelligent Investor. Graham said investors should think of the market like an erratic business partner who every day offers to either buy your stake in the business or sell you his share.
When Mr. Market is happy, he’s willing to overpay for your shares. But when he’s sad, he’ll sell at almost any price. It’s a simple way to remember that markets aren’t rational, they’re driven by emotion. And you can profit by taking advantage of the extreme optimism and pessimism. Right now, the market is extremely pessimistic on software and Microsoft Corporation (NASDAQ:MSFT), and extremely optimistic on shares of airline companies. We can take advantage of both situations.
A case of extreme pessimism
Mr. Softy is virtually a monopoly in the operating systems market. It holds roughly 92% of the operating system market. Most people believe Microsoft is all about Windows. But Windows hasn’t been the No. 1 source of sales or profits for three years. If you took Windows away from Microsoft, the stock would still be a bargain today. It would still generate more than $20 billion in operating income.
I’ll go even further. If you took away everything but the two biggest parts of the business (by revenue), Microsoft Corporation (NASDAQ:MSFT) Business Division and Server & Tools, you’d have a stock trading at an enterprise value of less than 8.5 times operating income. Those two divisions now make up nearly 60% of sales and 70% of operating income.
The beauty of this lies in the simplicity. Software is a high profit margin business. Less need for capital expenditures means more profit in the pockets of shareholders. Microsoft’s operating margin and profit margin are 35% and 28%, respectively.
In 2003, investors were willing to pay $26 in share price for every dollar of profit that Microsoft generated. The terms of investing in Microsoft are much different today. As of Monday’s close, Microsoft Corporation (NASDAQ:MSFT) traded at $32 per share while generating $2.60 in annual profits, $0.92 of which get returned to the owner each year for every share you hold. That’s only 12x earnings and 10.5x next year’s earnings.