World’s Largest Software Company Offer Excellent Yields
A company people love to hate has doubled profits in five years.
Oh, how far the mighty have fallen. If you had put $10,000 into this beaten-down technology leader when it went public in 1986, that investment would have been worth more than $4 million in just over a decade.
In fact, an economist hired by this company estimated at least 10,000 of its employees became millionaires. The economist described the wealth impact on this corporation's home state as "staggering."
The New York Times reported a curious phenomenon. When the stock hit new highs, the employee parking lot would sparkle with new sports cars.
One former employee used his newfound wealth to buy the Professional Bowlers Association. No, not a team—the entire league.
Then came a series of struggles that distracted and deleveraged this wealth-creating machine. Anti-trust troubles dogged it in the U.S. and particularly in Europe.
All told it spent billions to resolve litigation brought by states, other companies and federal governments.
Seven years ago last month, the company traded at more than 60 times earnings. Today that figure rests below 14.
That means the company trades at 80% of its peer group even though it is by far the largest star in its galaxy.
But the tide is turning for Microsoft Corp. (MSFT:NASDAQ). The company has a sparkling new search engine to challenge Google that could mean hundreds of millions in new revenues.
Microsoft also is set to release a critically important update to its dominant Windows computer operating system. It plans to introduce game-changing technology that could transform the burgeoning, multibillion-dollar interactive entertainment market.
This is a momentum play: The company has a device that turns a standard tabletop into a computing surface and recently raised $3.75 billion it can use to acquire other companies. It is firing 5,000 workers to cut overhead and improve cash flow.
Nickels, Dimes and Quarters Mean Profits for Investors
Microsoft as a stock came across my radar screen several weeks ago when it was selling for about 11 times earnings and just under $19 a share.
I cross-checked it against Google and saw that Google was selling for more than $400 a share. That disparity just seemed too great.
In 2008 Google had one-third Microsoft's revenues and one-fourth its profits. But its stock costs 15 times as much—and pays no dividend.
I knew then that Microsoft was poised for a rebound. The company supplies the operating system for most of the world's personal computers.
Despite increased competition, the Office suite of products and Outlook e-mail remain the de facto U.S. business standards. It's a $19 billion business for Microsoft with a gross profit margin of 65%.
Microsoft also sells dozens of software applications and entertainment packages for consumers. The popular interactive game Xbox 360 boasts millions of addicted users.
Steadily over the last several weeks, Microsoft has trended up. Mind you it's sometimes no more than 5 cents a share but the stock is now above $22. But don't worry. There's still plenty of upside.
On June 6, Jason Zweig, who pens the “Intelligent Investor” column for The Wall Street Journal, listed Microsoft as an undervalued stock. He quoted a stock analyst as saying the company offered high returns with little debt.
Then on June 16, Jefferies & Co. increased its target price for Microsoft by $4 to $26 a share. Jefferies recommended "buying shares of the world's largest software company ahead of a possibly large, rapid corporate PC upgrade cycle starting in late 2010."
I'm convinced Microsoft will go above $34 a share in the next 24 months. History is on our side.
The industry average for software companies is a P/E ratio of 17. In the last 10 years Microsoft had an average above 20 in eight of them and above 30 in five of them.
Granted Microsoft will probably never return to its glory days with a P/E above 50. But I see a flight to quality building in the market overall and a renewed interest in technology leaders.
Thus, if Microsoft just traded at 20 times its 2008 earnings of $1.87 a share, that would mean a price of about $37.40.With a dividend of 52 cents it currently yields a return of roughly 2.3%.
Fifteen analysts tracked by Zacks Investment Research rate Microsoft as a "strong buy," a 25% increase in three months.
Two each list it as either a "moderate buy" or a "hold." None lists it as a sell.
Release of Windows 7 Aims to Shore Up Profit Margins
Although Microsoft continues to broaden its product portfolio, Windows remains at the heart of the franchise. It is after all the operating system on about 90% of the world's personal computers.
It also accounted for roughly one-fourth of $60 billion in sales last fiscal year. Unfortunately for Microsoft, the last version of Windows received generally poor reviews despite sales of more than 180 million licenses in fiscal 2008.
Launched in late 2007, Vista met with strong resistance from corporate buyers. As the economy entered the recession, many simply did not see the need to update Windows. And in some cases Vista would have required costly hardware upgrades.
At the same time, consumers complained about compatibility issues with other software applications and hardware components. Microsoft hopes to solve these issues with the release of Windows 7.
Indeed, the company moved up the release from 2010 to this October. That gives Microsoft several weeks to make a splash with the software before the crucial Christmas retail season.
In Europe, Microsoft tried to skirt anti-trust issues by offering to release the operating system stripped of its Internet Explorer Web browser. At press time, the company was still awaiting a decision by European regulators, who could still levy more fines.
In the U.S., Windows 7 will have the popular Web browser. Nevertheless, Microsoft faces challenges to its more than two decades of PC dominance.
The popularity of "netbooks," stripped-down laptops designed primarily for Internet use, undermines profit margins. Analysts estimate Microsoft gets about $35 in sales for netbooks that use a thinner version of Windows.
The company gets about twice that with sales of full-fledged PCs. No matter how smoothly the launch goes, netbooks will remain a long-term challenge for Microsoft.
Some netbook manufacturers will no doubt decide to use a new Web-based operating system from Google, which already had Android for smaller mobile devices.
Reviewers generally applauded early versions of Windows 7. In part that's because the new operating system emulates a popular Apple feature called a "dock," where icons of applications appear in a conveniently located row for easy access.
Windows 7 also makes it easier to set up home computer networks and manage such external devices as music players. Microsoft says computers with Windows 7 should boot up and shut down faster, operate with improved stability and improve battery life on laptops.
Challenging Nintendo in the $68 Billion Video Game Market
Last December marked a turning point for the video game industry. Despite the soft economy, sales that month topped $5 billion for the first time ever.
The market research firm NPD Group says annual sales for all of 1997 just barely beat the December 2008 monthly numbers. Clearly video games represent a hot market with exponential growth.
PricewaterhouseCoopers says the global gaming market will grow from $42 billion in 2007, the base year of the consulting firm's report, to $68 billion in 2012.
Look at it this way: Video games now outsell movie box-office receipts, musical recordings and DVDs combined.
No wonder Microsoft recently hatched a plan to catch up with industry leader Nintendo. That company boasts the hottest-selling console of all time, the Wii.
Ironically, the Wii is low-tech compared with Microsoft's Xbox 360, which provides dazzling high-definition graphics.
However, the Wii debuted at Christmas 2006 with game-changing technology—a hand-held controller with a built-in motion sensor. This allows users to play realistic video versions of baseball, golf, tennis and bowling.
Nintendo now dominates the market with more than 55% of worldwide console sales. Avoiding violent themes, Nintendo marketed the Wii to moms as a family entertainment platform.
Now, Microsoft hopes to turn the tables on Nintendo by getting rid of a controller altogether. Microsoft has not announced a release date but recently unveiled new Xbox technology, code-named “Natal."
Based on 3-D technology, the console tracks individual movements of arms and legs and even accurately determines use by multiple players.
If the new generation Xbox lives up to its billing, it will almost certainly mean Microsoft will gain market share from its current 25% penetration.
Even while remaining in second place, Microsoft could add several hundred million in gaming revenues.
Since releasing Xbox earlier this decade, Microsoft has sold 30 million units for total global sales of $14.5 billion. In the first quarter 2009, game division profits grew 16%.
Last year, the Xbox helped Microsoft turn around its ailing Entertainment and Devices Division. The unit had $8.1 billion in sales, up 34% from 2007, with $426 million in operating income. The year before the division lost nearly $2 billion.
And Microsoft plans to add more sales by building online communities and making the Xbox more of an all purpose digital entertainment portal.
Launched last year, the online Xbox Live Experience now includes 20 million active players. Besides challenging other gamers on the Web, Xbox users can download movies from services like Netflix.
The New Search Engine Bing Looks Great, Delivers Content... Even The New York Times Agrees
From a user standpoint, my relationship with Microsoft remains ambivalent. I use Microsoft Office but am a big Apple fan. Microsoft products will do just about anything, but frustrate me with their lack of intuitiveness.
However, after just a quick test spin of Microsoft’s new search engine—Bing—I became a convert.
When I fact-checked my story on Oracle Corp. for BreakAway Investor, Google was a supreme disappointment, in some cases linking me to information more than eight years old.
But on Bing, I got exactly what I needed in the first three or four results and usually on the first click. Furthermore, on the left side of the screen, Bing kept a record of my searches.
Click on “See All” and it takes you not only to the search term you entered but the exact address of the Web site you visited.
I have now all but stopped using Google for searches. I have Bing installed as my browser's home page.
Each day Bing serves up a beautiful photograph with some subtle hints that lead you to mouse over a section of the photo.
These in turn tease users with questions about geography and culture.
On July 9 Bing carried a photo of Baltimore shot at night from across the Inner Harbor. Bing asked you to figure out which city served as the inspiration for the “Star Spangled Banner” and was the birthplace of Babe Ruth and the death place of Edgar Allen Poe.
In fact, pop-ups play a big role in the full Bing experience. Go to Bing.com and type in a search term.
When you move your cursor over to right side of the link a gray vertical line with a yellow ball appears. Mouse over that and a window appears with information from the link. This makes it even easier to decide if you want to click to that page.
Microsoft Plans to Grow Its $3.5 Billion Online Business
I was really surprised at how well Bing handles photos and videos. Both yield elegant results far superior to Google.
Furthermore, I prefer Bing's Earth function to that of Google's, which requires you to download an application. My wife loves her Google home page and all its widgets but even she raved about Bing's superior travel results.
Thus, I consider Bing to be one of the more important new products from Microsoft in years. That's because a whole generation of youngsters are coming of age with the Internet and are hooked on Google.
In a recent review, The New York Times raved about Bing. Of course, the paper dinged Microsoft for playing catch-up—again. Then the paper said this:
"Here’s the shocker, though: in many ways, Bing is better. That’s quite a statement, of course—almost heresy. But check it out yourself. It’s easy to compare the two, thanks to sites like bing-vs-google.com."
Google clearly dominates the search business with 64% share followed by Yahoo with about 20% and Microsoft coming in at about 8%.
For Bing, the question isn't the quality of the search but whether it can convert users to paid clicks that generate revenue.
However, Microsoft officials are determined to step up their sales of online products and services. That's why Microsoft last year bid about $45 billion to buy Yahoo, a deal that died after months of tense negotiations.
Company officials believe buying the number-two search engine would have greatly expanded their online advertising revenues. Last year, the online services business brought in $3.2 billion in revenues.
The figure represented a one-year increase of 32%. And yet, Microsoft still lags in this area. Last year, its
online losses totaled $1.2 billion.
More than 70% of that drubbing came from the increased cost of adding data centers, related equipment and new content.
But what if it turns around the division the way it did the Xbox unit? Holding the line on revenues and getting costs under control could produce several hundred million in operating income.
And even if Microsoft doesn't really monetize Bing, it could still hurt Google's ad sales, which have cooled in the past year.
Federal Stimulus Plan Could Help Microsoft's $13 Billion IT Unit
By almost any measure, Microsoft had a great fiscal 2008. The company registered double-digit growth in all its business groups.
Operating income jumped 21% to $22.5 million. Net income climbed 26% to $17.7 billion. Not only was that a 29% return on sales, it represented a five-year increase of 115%.
Microsoft remains highly liquid. It closed fiscal 2008 with $23.7 billion in cash, equivalents and short-term investments.
During the year, Microsoft made at least 10 acquisitions covering searches, mobile computing and consumer headsets. The company had a little fun.
It launched Surface, a device that transforms a tabletop into a computing surface. The technology allows users to interact with digital content using hand gestures.
Now Microsoft hopes Obama's $787 billion stimulus plan will add sales to its sprawling Information Technology business.
Under the investment act, the federal government expects to spend several billion dollars on cyber security and health IT alone.
Microsoft does not break out its sales to the federal government. However, I profiled the unit last year for another publication and estimated federal sales at more than $1 billion, a figure the company did not contest.
Moreover, last year the head of the unit won a Federal 100 Award sponsored by an influential trade journal. The award recognizes executives who significantly influence how the federal government buys, uses or manages information technology.
Indeed, federal agencies already rank as some of Microsoft's larger enterprise customers. It does business with virtually every federal civilian and defense unit.
Technically the IT division is known as Server and Tools. This suite of products—applications, tools and services—makes IT professionals more productive.
Of course, its federal sales remain a fraction of that $13 billion total. But the company clearly remains poised to grab some of that Obama IT cash.
Resolving Legal, Anti-Trust Battles Will Increase Cash Flow
Once the darling of the investment and computing communities, Microsoft came under fire several years ago. Much of that stemmed from continued allegations, many of them proven true, that Microsoft engaged in anti-competitive behavior.
Now it's the company people love to hate. One consistent criticism: Microsoft just can't keep up with the pace of innovation in the Internet era.
In other words, critics contend Microsoft just didn't see how the Internet would change the world and threaten software sales.
The problem lies elsewhere. Microsoft executives couldn't help but turn inward while fighting so many legal battles.
Every CEO I have ever interviewed about litigation told me it was a productivity killer. It's hard to focus on the grand strategy when you are preparing to be deposed.
Microsoft will always face legal challenges just by virtue of its size and scope. However, in the next two years, the company should be able to rein in legal battles and associated costs, which could free up hundreds of millions in cash flow.
Consider that in June 2008 it spent $1.4 billion to pay a European Commission fine. Also that month, it recorded an additional charge of $900 million, more than half of its exposure related to settling cases in Canada, Arizona and Mississippi.
The company also faces potential costs of $2.7 billion if it honors all the customer vouchers covering settlements in 19 states and the District of Columbia.
For the past several years, Microsoft has battled Alcatel-Lucent. Both sides accuse the other of patent infringements. Microsoft faces potential damages of $512 million in one of the cases but vows to appeal.
But with so much momentum and cost-cutting moves, Microsoft is ready to turn the corner and offer investors excellent yields.
Call it Microsoft 3.0. Version one was the rising young upstart that fueled the boom in personal computing and business productivity.
The second edition was the Evil Empire that squashed competitors like bugs and lost billions on legal challenges.
Now, a year after Steve Ballmer has officially replaced Bill Gates as CEO, the company seems to have learned the joys of détente while scouring the Earth for profitable technology plays.
If you're looking for a tech stock to add to your portfolio, consider Microsoft (MSFT:NASDAQ) for your portfolio up to $28.
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