Sunday, May 29, 2011

Microsoft - Competitive Advantage

As I posted before, Microsoft appears to offer decent value at it's recent price.  You can find a decent description almost anywhere on the web that says Microsoft (MSFT) is cheap.

To summarize the idea, the entire company is selling for $208 billion.  At the end of Q1 they had slightly over $50 billion in cash equivalents, so net of cash the company is selling for $168 billion.  Over the trailing twelve month the company has earned approximately $21 billion.  So at today's prices the whole company is worth about 8 times trailing earnings.

If you take some time and look below the hood, the company has one division, online services, that is a money loser.  In the lastest quarter that division lost $0.7 billion dollars.  So excluding this unprofitable division annual profits would increase by $2.8 billion, to nearly 24 billion.   So if that division could break-even the company would be selling for 7 times earnings and annual profits would be over 13% higher.

Now 8 times earnings is good for an earnings yield of 12.5%.  At 7 times earnings the company is good for a 14.3% earnings yield.  Regardless of your future expectations about the economy that is a very cheap stock especially for a company with large very profitable divisions.  

If we further tinker under the hood we find that they have absolutely huge gross margins of 80% and net profit margins of 30%.  There are so few companies in the world that have such absolutely huge margins like that.  Over the last 10 years the revenue and profits PER SHARE have grown at 13.5% and 11% respectively, not too bad for largecap.  The market obviously does not believe the company has a very strong future, I beg to differ.  I think the speculators have watched the P/E ratio come down from the nose bleed levels of 50 times in 1999 to today's modest level and are frustrated by the flat share price. 

I have even seen some analysis that suggest the market is currently pricing in low single digit declines in earnings for the foreseeable future. If you capitalize the earnings at 10%, assuming zero growth indefinitely, the company is worth $25/share (it's current price).  Now the company may well be worth this amount, or significantly more or less depending on what the future holds.  If the company has a poor future, something like print newspapers, the company may be worth much less.  So what about Microsoft, does it have any competitive advantages?

Competitive Advantage

With all that as introduction, I have been reflecting quite a bit lately on whether Microsoft has a strong competitive advantage or not.  First off, you don't have to be all that intelligent to realize that if a company has gross margins of 80% they clearly have a strangle hold on the market.  Competition may exist but they have a strangle hold on the market.  That is a clear starting point. 

It's funny much you hear people complain about Microsoft's products but what do you really expect?  In the PC market they have something like 95% market share in operating systems.  I don't know anyone that owns or uses a different operating system (except maybe a few Mac's).  So then it really doesn't surprise me that you don't hear people complaining about other systems... what other system is there to complain about?  To be clear, if 95% percent of people eat red apples over green ones, I would bet a very large percentage of complaints would be about the red ones.

In the same way I have read that many people are indifferent to Microsoft Office suite.  The biggest exception is Excel.  It seems a lot of individuals and companies couldn't live with Excel.  At the company I work at we are so tied to Microsoft Excel and Access databases we really couldn't make a change to anything else.  Excel is so embedded in so many procedural and company processes it would require so much work to make any change.  I can only imagine how that is also the case at millions of other companies.  As a company, we are far more tied to Microsoft products than we realize.

Beyond these small examples... the other major issue with making changes to computer software in the workplace is the huge amounts of work that would be require to train everyone on the new system.  I can think of one system, made by IBM, that we use at work.  A few years back a change was contemplated but pulled at the last minute because of the problems that would be created from a major change like this.  Software and certain computer systems have more competitive advantages that one realizes if you think about it.  (We are updating the IBM system this year, I will be watching the change-over with keen interest)

In the same way, I find it really interesting that Firefox so closely resembles Microsoft's Internet Explorer.  If you asked the average person what the difference is between the two they likely would have a difficult time explaining.  I find that remarkable as Firefox has to essentially copy IE and then begin to make minor changes to the browser so as not to upset the apple cart.  (I have tried Google's Chrome browser, but to be honest "it just doesn't look right")

The next reason why it is difficult to change from Microsoft is because of widespread usage.  Just think about it, can you really use ABC's generic word processor in the business world?  You wouldn't be able to communicate with any other business or get anything done.  Our company is still using an older office version and the newer versions are just not compatible.  This has created numerous headaches for us, but thankfully for us Microsoft allows free viewers for many programs.  We have the same issues with other software we use, you constantly have to stay up to date or you risk not being able to communicate effectively with other companies.  You just can't use old or uncommon software. 

Lastly, many businesses simply cannot afford to have major interruptions with computer issues.  Change, if any, would have to be gradual so as not to interrupt the normal course of business.  I could go on but enough said. 

Conclusion

We'll the case for the value in Microsoft is quite clear.  The stock is selling very cheap.  I like to say it's like buying a bond paying 12.5% interesting, whose coupons will likely increase in the future.  I believe the company has numerous competitive advantages, but I wouldn't want to be lulled to sleep.  Technology is constantly changing and things like cloud computing will change things no doubt. 

In the case of Microsoft, management is very shareholder friendly with current dividends are running at 2.5% and the company is buying back 4% or better of the share outstanding.  I know David Einhorn is calling for the CEO's head because he wants to make a quick buck.  Many shareholders are frustrated with the stagnant stock price but the the underlying performance of the company has been good.  The P/E has gone from 50 to the current 8 times, which means despite the flat stock price the company has performed very, very well over the past decade.  What more does he want the company to do?  All they can do is keep buying back the cheap shares and growing the business as they have with little to no capital.  Management can't make people buy the shares. 

I think if you gave a MBA student the last ten years of financial statements and removed the name "Microsoft" from them all and asked for an appraisal of the value of the company, they would all conclude the company is worth much more than the current price.  It's interesting how once you put the name Microsoft out there the company gets an undeserved discount. 

If I could get one final dig in.  Why would one waste time on such a difficult and risky investment like PBN when a Free Cash Flow machine like MSFT is available at a reasonable price?  The answer is mental bias that believe risk equals return (and overconfidence).  It's why people buy lottery tickets... what my brother calls a tax on the mathematically incompetent. 

Investing isn't difficult, but thinking clearly is.  Thinking clearly is far, far more difficult that you realize.  You likely disagree, thus proving my point.  If you disagree, your probably the type of person who always has the right answer.  Anyway, enough for now. 

Did I mention that Bing is my new favorite search engine?  


Best Regards,
Kevin Graham

Disclosure: Long MSFT (Both personally and for accounts I manage).

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