Software // Enterprise Applications
Commentary
3/25/2004
06:22 PM
William Schaff
William Schaff
Commentary
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Taking Stock: Cheaper, Yes--But Is Microsoft A Value?

Profitable growth has been difficult to come by in newer divisions.

The unthinkable may be happening: The growth stock of all time is in danger of becoming a value stock. That would mean its appeal lies more in its low stock price than its revenue-growth prospects. Yes, I'm talking about Microsoft, the stock that went public in 1986 at 9.5 cents per share (split-adjusted) and rose to the giddy heights of almost $60 in January 2000. That's a return of more than 63,000%, which is quite astonishing. Since then, its fortunes have changed a bit. The stock price has dropped to around $24 per share, flat from a year ago.

What's going on at Microsoft that would lead investors to the conclusion that it may be a value stock?

Microsoft generated $32.2 billion in revenue during fiscal 2003, ended June 30, up 13.5% from the year before. The company is divided into seven segments: Client (Windows 2000, Windows XP, etc.), 32.3% of revenue; Server and Tools (MS Server, SQL server, Exchange Server), 22.2%; Information Worker (Microsoft Office and related applications), 28.7%; Home and Entertainment (Xbox and computer games), 8.5%; the MSN Web portal, 6.1%; Business Solutions (including the acquisitions of Great Plains and Navision and focusing on enterprise resource management, customer-relationship management, and supply-chain management for small and midsize companies), 1.8%; and Mobile and Embedded Devices (Windows Mobile software for Pocket PCs, cars, etc.), 0.5% of revenue.

Microsoft has faced the reality of slower revenue and earnings-per-share growth for a while. The PC market is maturing, with high penetration rates in the developed world. Growth from the developing world hasn't been enough to offset the maturing markets elsewhere. Fewer reasons to upgrade to the latest version of Windows or Office contribute to this slower growth. Analysts estimate the underlying growth rate for PCs is around 10% per year. I believe Microsoft's growth rate will likely be around this number, which means that for EPS to grow significantly faster, the company must cut costs or operate more efficiently.

Profitable growth has been difficult to come by at the newer divisions of Microsoft. Business Solutions, MSN, and Home and Entertainment have for the most part posted inconsistent revenue growth. None of those divisions is profitable, though Microsoft is working on that part. Take, for instance, Home and Entertainment, which produces the Xbox. It's seeing little revenue growth and lost almost $1 billion as Microsoft battles Sony and Nintendo.

Microsoft's stock trades at about 19.5 times June 2005 First Call earnings estimates, a bit higher than that of the S&P 500--in my opinion, probably a fair premium given the financial strength of the company. Looked at from another angle, I believe, the current valuation implies high-single-digit growth in perpetuity. When you think about it, not an unreasonable assumption for a large, maturing company. Now if Microsoft would just distribute some of its $50 billion-plus in cash in the form of a nice big dividend giving me a yield of, say, 4%, then I could really call Microsoft a value stock.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.

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