Friday, April 29, 2011

MSFT, INTC and thoughts on MSFT and AAPL

So, MSFT has disappointed and INTC has surprised. I own both stocks and purchased both before their respective earnings reports.

Of the two, I believe MSFT is the better value, though not by a wide margin. I will most likely purchase more if the weakness continues. The market does not agree with me, pushing INTC above some resistance points and on way to at least $24, though based on the fundamentals, it could be much much more. I believe the stock to be worth at least $30 per share, given the earnings power of the company. Fortunately, like MSFT, you are paid well to wait for Mr. Market to realize this.

MSFT is a company whose valuation baffles me. It is clear that tech stock buyers, who are fad-chasers as a rule, don't see the story in MSFT products. As a result, they are ignoring solid fundamentals. Value investors, who should be favoring the earnings stream they can purchase, are generally reluctant IT purchasers, and have shunned the stock. It is true that IT firms have short product cycles and require constant CapEx to maintain their market position, but MSFT has no issues making capital expenditures, in fact, they have the luxury problem of not having enough attractive investments for their cashflows.

Look carefully at the financial statements released with their recent earning report. They are on track to earn $26bn this fiscal year, slightly above my own DCF model (which valued the stock at $35). They are doing this with assets of $100bn - which is a return on assets of 25%. I will repeat that their ROA is 25%. This is an incredible multiple. Most firms would be ecstatic to earn this on equity.

The story is actually better than that. $50bn, half the balance sheet, is cash and short term investments - and cannot be said to be capital employed. So their actual ROCE is closer to 50%. Amazing.

Moroever, those earnings are growing, even if they will be slower growing in the future. (My DCF assumes a growth rate of 6% with a final perpetual growth rate of 2%).

This enables MSFT to comfortably raise their dividend at double digit rates for the foreseable future, while repurchasing gobs of stock. At current rates, MSFT reduces common stock about 250mm shares per year (after accounting for new issuance and for stock options, which mercifully are all about expired). They could be far more aggressive with the repurchases, actually, and so long as the stock is cheap, there is no reason not to do so.

I contrast the earnings power with AAPL, which everyone loves. This is a stock which also has about $90bn in assets, and which earns $20bn - or 22% on assets. So far, quite similar results. AAPL has "only" $30bn in cash and equivalents, however, which means that it employs $60bn in the business. Thus its ROCE is a "mere" 33% - an awesome number, to be sure, but well below that of MSFT. AAPL is growing earnings faster, but it is also retaining all of those earnings, presumably for bigger and better things, but possibly only to earn a low return. Hard to argue that they aren't investing well, given the popularity of their products, but successful IT companies have a history of making questionable acquisitions - look at eBay and Skype, Google and YouTube and the like.

To my thinking, MSFT deserves a higher price on book value than AAPL, since it earns more on assets and capital employed and has greater opportunity to return cash to shareholders.

Obviously, for others, the risk of the stock losing ground in PCs, and having it's Windows architechture undermined scares alot of people. But the fact is that in a connected world, systems have greater power than ever. Even AAPL, which loves to have a totally controlled architecture, has had to adopt MSFT software because of the importance of MS Office. Meanwhile MSFT is gaining ground in several other businesses, including gaming and, crucially, online search.

All in all, I think people who count MSFT out are really very, very premature. They remind me of the marketing professor Theodore Levitt, who asked in 1960 "What business are you in" and famously "demonstrated" how the buggy-whip makers died out because they failed to see that the automobile would make buggy-whips obsolete. He went on - in 1960! - to explain that Exxon (Standard Oil of New Jersey) would be out of business in 10 years because the electric car was about to make motor oil obsolete! Imagine taking his advice in 1960 and selling your Exxon stock, which had a single digit PE. You gave up a fortune because you made a possible and uncertain future the enemy of the present facts. (Note that Levitt actually never proved that the buggy-whip companies actually failed to adjust, he just observed that no one made them anymore. Never trust a marketer to do research).

This is not to say that it cannot happen. Eastman Kodak and Xerox were also large companies with long histories of good earnings that were ultimately unable to move to new technologies. But MSFT is not simply reinvesting in it's core business. It is also moving forward with mobile and online services. (In contrast to EK which clung to film when digital cameras came out, arguing for higher quality).

Personally, I think MSFT will struggle with mobile, but it has the resources to play. And the company learns, much faster and much better than people give it credit for. It knows how to spot promising technologies - it saved AAPL, don't forget, and did so along with archrival Larry Ellison.

Unlike AAPL, which requires new product introductions in new categories to sustain its revenue and growth, MSFT has a core cash cow it can use to fund a variety of alternatives and acquisitions. Of course, AAPL also has awesome cashflows and strong reserves, a failed product launch is not going to kill the company. But, and this is crucial - a failed product launch from AAPL would have much greater impact than one for MSFT. MSFT has stumbled multiple times (Windows Vista, anyone?). AAPL is the "cool kid". When he makes a misstep, people look elsewhere. Investors expectations of MSFT are low, clearly and that gives them a big advantage: they are far more likely to exceed them and reward investors.

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