Monday, December 13, 2010

Van Den Berg on Microsoft

Arnold Van Den Berg is a student of Ben Graham with a very good long-term investing track record. In his latest newsletter, he had the following to say about Microsoft (MSFT):

As one of the few remaining AAA rated companies, Microsoft has a financial statement so well respected that the bond market recently priced its bond offering almost on par with U.S. government notes and bonds. In total, Microsoft borrowed $3.75 billion in long‐term debt that carried with it an after‐tax rate to this company of just 2.3%. One of the tranches sold was a three‐year note that carried a 0.87% coupon. This was just 0.25% more than a three‐year U.S. Treasury note. On an after‐tax basis it will only cost Microsoft 0.66% per year. When you consider this company earns more than 30% on its capital, this is a very good deal for shareholders.

Van Den Berg goes on to say...

While it is quite possible that Microsoft will grow faster over the next five years, we are only assuming a 5% growth rate. Under this scenario, we believe it has future earning power of $3.95.

The stocks current sells for just over $ 27/share and has nearly $ 4 in net cash and is expected to earn ~ $ 2.40 this year. In his analysis, Van Den Berg argues that considering the quality of Microsoft's business that it deserves a much higher multiple. While that may be true, it doesn't need to for this to work out reasonably well as an investment.

Below, Van Den Berg uses the six month average stock price of $ 24.50 for his calculations.

If you want to be extremely conservative, and just use the last two‐year average, albeit depressed, P/E for Microsoft of 13.65, you will still have a 5‐year annualized return of 17%. Add the dividend, and your total return potential is an annualized 19.7%

With a free cash flow yield of 9.1%, a dividend yield of 2.1%, plus our conservative future growth rate of 5%, we believe that Microsoft stock is a great value and a great investment. Furthermore, we do not believe the disparity between its value and price will continue for long; eventually the value will be recognized.

Given the return potential of this company, along with its AAA financial security, we have to ask the following question: Why would investors buy its bonds, or for that matter U.S. Treasury bonds, instead of Microsoft stock?

Even if some of Van Den Berg's assumptions turn out to be too optimistic, the downside risk versus potential reward doesn't seem to bad at all.*

One big question is whether Microsoft finally runs into serious challenges to its core franchises. Something along the lines of meaningful declines in profitability not simply slow growth. I mean, at or near today's market valuation, Microsoft doesn't need much growth.

Also, if management were to make questionable capital allocation decisions. For example, something like paying way too much for a "strategic" acquisition of considerable size.

Adam

* I am a current Microsoft shareholder.
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