Breaking Down Microsoft

From a quantitative standpoint, Microsoft appears to be a great buy. As the annual report notes it was recently awarded a AAA rating from Standard & Poor’s in 2009, the first U.S. corporation in a decade to receive S&P’s highest rating. It has augmented its net income at a 10% compounded growth rate for the prior 10 years. Through repurchases of shares they managed a return on equity of above 30% for the last 5 years. Based on the trailing 12 months of free cash flows and a stock price of $24.23 the free cash flow yield is just about 12% and p/e of 11.6. 

Unlike most technology companies they have relatively more debt and relatively stable earnings. Even still net income exceeded interest expense 160x this most recent year so debt is being serviced with no issue. 

Some notable one time expenses included a $1.4 billion fine (2008) to the EU for penalties regarding bundling of the IE browser with the Windows operating system and a $4 billion fine (2009) to the IRS for the anti-trust issues of the early 2000’s. Though anti-trust issues may pop up in the future, regulators seem to be interested in Google at the moment. 

Below shows each segments' contribution to net income: 

Client (Operating System)	45%
Server and Tools	16%
Business Division (Office Suite)	42%
Online Services	-4%
Entertainment (Xbox, Zune)	1%

The million dollar question though is Microsoft a growth company or not. Will they be able to sustain growth of their Client and Business division segments? With the recession hitting, this would be appear their most vulnerable moment as cash-squeezed consumers and businesses would seemingly switch to low-cost or even free Linux based operating systems. But Microsoft managed to grow earnings and free cash flows to the highest they’ve ever been. Google Documents is in its infancy and may pose a real threat to the Office Suite, but for now there remains no real substitute of Excel for business users specifically. 

Microsoft received a favorable mention in Bruce Greenwald's Competition Demystified (2005). He wrote "there are only a few industries in which economies of scale coincide with global size. The connected markets for operating systems and CPUs is one example; Microsoft and Intel are the beneficiaries of global geographic economies of scale." Two others he mentions are Boeing and Airbus. He also observed that industries where market share does not change significantly over periods of time indicate barriers to entry. 

I very much share Mohnish Pabrai’s opinion that technology stocks should be avoided on the basis of a lack of any kind of moat, but Microsoft does have the competitive advantage of switching costs most technology firms can’t claim. Facebook has no such advantage; the cost of hoping on a new social network is close to negligible. Learning a more complex OS like Linux would be a little bit more of a deterrent for people who have used Windows or Apple most of their life. And even though Apple has gained a significant amount of market share, their pricing is in a different world than PC’s. The cheapest Apple Macbook goes for $1000 on Best Buy while the cheapest laptop sells for $329. An interesting graph from Free Exchange shows the necessity of the computer for the consumer : 

 

The investor Glenn Greenberg was quoted as saying “if you could buy a decent - not great, but decent quality business with a 10% free cash flow yield - my experience is that you would rarely lose money.” Microsoft at the moment does have a 12% free cash flow yield and can very much be argued is a decent if not very good quality business. 



Via: http://www.gurufocus.com/news.php?id=105285