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Guideline to Frugal Investing
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Stock Recommendations
Disclaimer
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Microsoft (MSFT) dominates the operating system and office products market yet it gets little
respect from Wall Street. Companies even as big as Microsoft can even be neglected by Wall Street.
Perhaps it is because large cap stocks have been out of favor for so long. In either case,
is very reasonably valued at its current price of $31/share. Microsoft consists of 5 divisions shown
below.
Client includes include Windows XP Professional and Home, Media Center Edition, Tablet PC Edition,
and other standard Windows operating systems.
Server and Tools includes Windows Server operating system, Microsoft SQL Server, Microsoft Consulting Services,
product support services, Visual Studio, System Center products, the Forefront security family of products, and Biz Talk Server,
among others.
Online Services Business includes MSN Search, MapPoint, MSN Internet Access, MSN Premium Web Services,
MSN Mobile Services, and Windows Live.
Microsoft Business Division include Microsoft Office, Microsoft Project, Microsoft Visio, SharePoint
Portal Server CAL, Microsoft Live Meeting, One Note, Office Communication Server, Microsoft Dynamics AX, Microsoft Dynamics CRM,
Microsoft Dynamics GP, Microsoft Dynamics NAV, Microsoft Dynamics SL, Microsoft Dynamics Retail Management System,
Microsoft Partner Program, and Microsoft Office Small Business Accounting.
Entertainment and Devices Division Products include Xbox 360, Xbox, Xbox Live, CPxG (consumer software and hardware products),
IPTV, Windows Mobile software platform, Windows Embedded device operating system, and Windows Automotive.
The chart below shows the sales and income (excluding corporate expenses) generated from each of the 5
divisions.
The chart shows 3 divisions that are cash cows and 2 divisions that are real dogs. Fortunately for
The impact negative impact to the bottom line of the Entertainment and Devices and Online Services are small. The
fattest cow of them all is Client services. This is what contributes to MSFT enormous gross margins. The release of Vista
operating system will drive growth for the next few years. In fact, MSFT believes that
fiscal year 2008 revenues will be about 11% higher compared with 2007. This is a fantastic growth rate
for such a large company. Behind the growth are 85% of windows sales going to Vista and
78% of Vista sales going to the higher priced premium edition. The client division has a near
monopoly on the PC operating system market with 95% of PCs having Windows installed.
Not only is the client division doing fantastic, the Business Division and Server and Tools
should enjoy continued growth as companies continue to invest in IT resources. The Office product
suites still enjoy a near monopoly. The Server and Tools division should also show good results going
forward. Its next-generation Windows Server software -- formerly known as "Longhorn" will
be released in 2008.
In the best of all worlds, Microsoft will spin off the Entertainment and Devices Division and the Online
Services Business. However, this is not likely and the only hope is that
management will not go too far in wasting investor's money in these divisions. It is our expectation
that these sectors will continue to drag on earnings for the forseeable future. Luckily, management has
been able to deliver on its core products. Given the strength
of Microsoft's key cash cow divisions, the stock remained undervalued.
| Company: |
Microsoft |
| Trading Symbol: |
MSFT |
| Date of Recommendation |
5/16/2007 |
| Risk |
Moderate |
| Stock Price as of Recommended Date |
31.07 |
| Fair Value |
40 |
| Discount of Price vs Fair Value: |
20% |
| If you win on this stock |
Reward yourself and us by clicking the link below and buying a big ticket item at Amazon
|
| Bears Say |
We Say |
| Insiders have been selling. This is a red flag |
The biggest insider sales are from Bill Gates though he
has been selling off his stake for years. He still has nearly 9% of the float and it is perfectly reasonable
for him to sell some of his ownership to diversify his holdings. There is no statistically significant correlation
between the amount of insider sales of MSFT and the performance of MSFT shares vs the Nasdaq QQQ index over
the past two years. Therefore this is not a concern.
|
| Research firm IDC forecasts PC growth will slow to just over 10 percent over the next several years. This is lower
than the historical average of 15% per year. That growth slowdown will negatively impact MSFT revenues. |
Lower PC sales will definitely impact MSFT revenues. However, it is not the full part of the equation. Even with
lower PC growth, customers are opting to buy the Vista Premium edition 78% of the time. This means higher revenue
per PC sold. However there are many factors that weigh on revenue and nobody knows the business better than
management. We built assumptions of MSFT revenue growth
of 11% for 2008 because management expects about 11% growth in revenues - and management is usually conservative in
its own estimates. We anticipate that growth will decelerate over the next 10 years to 5% annual growth by forecast year 11.
This deceleration is due in part to potential new technologies that may replace the PC over time.
Even with our conservative estimates, MSFT is truly an undervalued company.
|
| Assumptions |
| Expected Revenue Growth Over Next 12 Months |
11% |
| Expected Change in Earnings Growth Year over Year |
-5% |
| Expected Future Gross Margins |
81.5% |
| Future Beta |
1 |
| Assumed Capital needed to grow sales by $1 |
$2.20 |
| 10 Year Bond Yield and Weighted Cost of Capital |
4.6% and 7.7% |
| ROIC in excess of WACC for 120+ months forecast |
2% |
| Depreciation and Depletion Life |
5 years for PP&E, 10 years for R&D |
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