Everything You Need To Know About Microsoft

 

Although Microsoft continues to make money on its monopoly products – operating
systems and applications – I believe these lines of business are still ex-growth
for another year or more. Everything else seems to be losing money for the company,
at least for now. (However, that situation could change favorably for Microsoft
in two-to-four years time, with growth from wireless and a bunch of other
areas).

 

Most investment opinions I read emphasize the cash generation and balance sheet
cash at Microsoft, and as a result the analysts rationalize MSFTs luxury of
trading at a higher multiple. In response to such opinions I agree that Microsoft
generates a ton of cash. I don’t discount the company’s cash generation
ability or it’s mountain of balance sheet cash – $56 billion plus on the
balance sheet was a ton of money. But, it’s the OCF growth (rather than
the absolute level of balance sheet cash) that I prefer to look at, and Microsoft’s OCF growth has been slowing pretty dramatically the last four or five years.

 

If I were to balance out 1) the potential for the areas were Microsoft can grow,
2) handicap the stock for the company’s inability to sell, and 3) add in the
amount of potential loss of existing business to Linux (a high probability over
the long-term, there) then there seems to be little chance of much growth at
Microsoft. I don’t see top line growth exceeding low to middle single
digits for the next year or two — possibly longer. On this basis, I believe
that MSFT, which is trading at around 9 times sales, is a stock that is priced
too high for this scenario. I see fair value at somewhere around 5 times sales,
but owing to its huge institutional ownership together with its increasing value-oriented
ownership, realistically I see a floor at around 7.5 to 8 times sales.

 

The basic problem with Microsoft is that IT budgets are not going to grow very
fast over the next several years and the company already owns large chunks of the
market. So there is limited ability to increase revenues from the Office business
because Microsoft risks ticking people off and driving more people off license.
Growth in new PCs, and therefore operating system sales, is likely
to be constrained to three-to-four upgrades for laptops and four-to-six
year cycles for desktops. Creation of new markets for other sorts of operating
systems will probably be constrained by the reluctance of many potential partners
to get into bed with Microsoft.

 

Microsoft does have some areas where it can grow. Databases and analytical services
are two, as well as in the small business end-user segment. But there is no
way in my mind that Microsoft’s existing Enterprise Resource Management (ERM)
and Customer Relationship Management (CRM) software for businesses will be ready
to be competitive with SAP, Oracle, or PeopleSoft anytime in the next decade
or so. It’s not clear that this is even an attractive option. There is the possibility
of getting billions more dollars out of mid-size companies (500 to 5,000 employees),
though, because this market has been under-penetrated. Unfortunately, there
don’t seem to be enough people in the Redmond group that really understand how
to make this happen.

 

Some are claiming that Microsoft Business Solutions (MBS) is growing faster
but I think the comparison these analysts are using is not “apples to apples.”
In last year’s fiscal fourth quarter, management added the Microsoft branded
software sold through the Microsoft partner channel (as opposed to Great Plains,
Navision, Solomon, etc. brand) into the segment revenues when they reorganized
with Ayala running MBS sales. The numbers in the quarter are shown net of inter-company
transactions, and therefore are “apples-to-apples.”  So that
part of the business will appear to slow down almost certainly by the first
fiscal quarter of 2005. That said, since it’s so small, no one will care. But
this is yet another area in which Microsoft’s growth is slowing.

 

 

A one-time special dividend of $3 per share,

A $32 billion buyback over four years, and

An increase in its dividend from $0.16 per share annually, to a quarterly dividend
of $0.08 per share, or $0.32 annually, and which essentially double the annual
dividend to around $3.5 billion. This lifted the dividend yield to one percent,
although management could have been bolder here… for a yield of two percent
or higher.

 

Going forward, I suspect the cash will just pile up again. I do think Microsoft
could have been more aggressive raising its quarterly dividend – or maybe just
doubling it is a signal that there may be “regrets” in the future.
Why commit to something it may regret in the future?

 

The special dividend rewards existing shareholders and the increased quarterly
dividend is attractive to the more income-oriented shareholders and will probably
attract new income-oriented investors to MSFT. So, there was something there
for everyone.

 

I believe a special dividend is almost always going to be a better solution
— that way, a company like Microsoft is not tied to the dividend. It is certainly
difficult to lower a regular dividend once it has been established. Unless a
company is in a consistently cash generating business for which it has no other
uses for the cash (share repurchase, acquisitions, etc.), I don’t really
see the point of a regular dividend. However, if a company has a business like
that which is also reasonably low growth then the new dividend tax laws make
it attractive to distribute cash capital out to shareholders via a dividend,
or in the case of companies already paying dividends then via a higher dividend. Without
the tax break, it seemed to me to be more economically beneficial to do stock
buybacks (which permit shareholders to choose whether or not they want the capital
back).

 

The market reacted positively in the aftermarket to Microsoft’s July 20
announcements. From a close of $28.32, the stock popped nearly 4.5 percent to
open the July 21 trading session at $29.58. Going forward, it will be interesting
to see how the market values a Microsoft “value” stock that pays
big dividends and focuses on cost controls.

 

The matter of the optimal capital or equity structure for a company is a matter
of debate. But in my view a special dividend is smarter in some respects than
boosting the quarterly dividend. For a start, there’s no reason for management
to make a commitment they might someday regret.

 

While it’s the right thing to do in general, I don’t have an opinion on
whether it’s a little more or less than it should be. If MSFT stock were really
cheap, then all of that buyback would make the most sense. But then the company
probably wouldn’t be able to do that. If the stock were rich, then all of that
special dividend would be more sensible. (I happen to think the stock is rich,
based on the company’s growth outlook.) It could be argued that raising
the regular dividend is a much stronger signal from management that they expect
the strong cash flows to continue for a long time going forward. It’s very bullish.
I guess that by doing all these things — the buyback, the special dividend
and the higher quarterly dividend — management saying it’s about fair value.

 

In this case, it would have taken a long time for Microsoft to deploy its excess
cash, so my opinion is that a special dividend was about the only way to go. The
company should have followed the advice of so many and distributed this cash
over time, rather than just let it pile up. I’m glad that it didn’t spend it
on some overpriced acquisition, though. This was s a good move, just long overdue.

 

 

On this basis and over the long-term, I believe that MSFT trading at 9 times
sales is a stock that is priced too high for this scenario. I’d consider somewhere
around 5 times sales to be a more appropriate reflection of its growth outlook.
That said, I’d be more comfortable with the stock trading at around 7
times sales than 9 times. This is one of the most over owned names in the market
so I think market sentiment and breadth of ownership will keep a relatively
high “over inflated” floor under the stock.

 

At the end of the day, I guess if you just simply must hang in the software
space then it gets down to this. Tech tape heading north, then more leveraged,
smaller cap software names work better and provide more investment upside than
MSFT. Tech tape heading south, then MSFT is a more stable “safe haven”
software name to own than most other names.

 

The MSFT chart looks quite good, with short-term support (over the next few
days) at $26.94. But there’s huge resistance at $27.5, above which it’s
a new 52-week high. But it’s overbought right now if according to stochastics,
so I’d give them time to work off the latest ramp. It may stay in
range $27 to $27.5 for a day or so before breaking either way, but below $26.9
looks like a breakdown.

 

Medium-term (two to three months), MSFT looks like it is ready to pullback. The
chart is forming a double top and selling has been above average. Therefore,
the sellers seem to be dominating. If this continues and the market weakens
then I think a pullback to $26 is likely – more sellers will pile in (they always
do). The stock should catch support at $26. If MSFT holds between $25 to $26
and does some basing, then it has a chance of making an attack at its recent
high and breaking the longer term pennant it has been forming for the greater
part of the last year. If all that plays out, then an up-move from $26
to $29 is possible. I don’t like it long-term, unless it breaks $30, which
I doubt: it’s a lot of shares to move to get to $30.

 

Melanie Hollands