Wednesday, September 15, 2010

Microsoft: An Underleveraged, Low P/E Stock

Late on Monday Microsoft (MSFT) announced it is planning to issue more debt.

Two articles from Barron's:
Microsoft, like many other large tech companies these days, seems hardly expensive and has quite a balance sheet. In an environment with extremely low borrowing costs, issuing some debt looks like a smart way to utilize that exceptional balance sheet (and hopefully avoid using the cash on pricey acquisitions).

Microsoft has 8.9 billion shares outstanding and, at the current price of $ 25/share, a market cap of ~$ 223 billion. Prior to the debt offering, Microsoft had over 30 billion of net cash (cash of $ 36.7 billion minus debt of $ 6 billion) giving it an enterprise value (EV) of:

EV = market cap - net cash = $ 223 billion - $ 30.7 billion = ~ $ 192 billion

That $ 192 billion buys a company with $ 19.4 billion of free cash flow (FCF = Net Income+Depreciation+Amortization-CapEx) this past year for a EV/FCF of ~ 10x (and obviously a free cash flow yield of 10%).

A franchise with very high returns on capital and ~ 30% net margins selling at a 10x multiple? The threats to Microsoft are far more difficult to assess than Coca-Cola but few businesses generate so much excess cash while requiring so little capital.

Is there a plausible thesis describing how Microsoft's competitive advantages will become materially impaired? Will capital be used for expensive acquisitions? As always, those are the crucial judgments that need to be made but near current prices it doesn't seem expensive even with little or no growth prospects.

The company can easily borrow money for ten years at less than 5.0%* (so after tax cost would be more like 3.5%) and the stock generates a greater than 10% free cash flow yield. So, unless a material decline in earning power is in the cards, the buyback should directly benefit continuing long-term shareholders.

Microsoft's cash on the balance sheet (earning essentially nothing) could also be used to buy back shares. That cash pile is growing at a $ 5 billion clip each quarter.

What a difference a decade makes when it comes to tech stock valuations.

Adam

Long position in MSFT

* Microsoft is one of the four remaining publicly traded U.S. companies with a credit rating of triple-A. The others are Johnson & Johnson, ADP, and Exxon. Current 10-year triple-A bond rates remain on the rather low side. Johnson & Johnson recently sold 10-year bonds with a nominal interest rate of 2.95%.
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