Friday, December 16, 2011

Boring Microsoft...Boring Apple?

Here's a good article by Vitaliy Katsenelson on Microsoft. It points out Microsoft's price to earnings ratio ended the 1990s at 50x but recently traded for less than 7x if you take out the $ 6/share in net cash.

IBM (IBM) has received plenty of attention after Buffett decided to buy a large stake in the shares. A case is made in this recent Barron's article that Microsoft (MSFT) is better than IBM by every metric.

Katsenelson additionally made the following points:

- Valuation offers a margin of safety
- P/E expansion a significant source of returns
- The company should trade at premium, not a discount, to the market

In my view, Microsoft doesn't have to be a better business than IBM at its current valuation.


At 50x earnings a little over a decade ago, there was little chance investors would get a decent return even if Microsoft executed reasonably well. Since then, the company has tripled its earnings (actually nearly quadrupled on a per share basis since shares outstanding has dropped from 11.1 billion to 8.5 billion via buybacks).

So there's been plenty of per share intrinsic value created. It's just that the value had to catch up to the stock price.

With Microsoft now selling at less than a 7x enterprise value (market cap minus net cash) to earnings, an awful lot has to go wrong for the stock to not produce very nice returns for owners over the next decade or so.

In fact, at that valuation and with sound capital allocation, Microsoft wouldn't even need to grow (it could actually afford to shrink a bit) to produce solid returns.

Now, Microsoft has been less than impressive when it comes to capital allocation. They have also, in fact, missed some important strategic opportunities over the past decade.

To the company's credit, the share count has been lowered by a material amount. Still, considering the exceptional free cash flow and balance sheet, a more aggressive buyback seems warranted while the stock remains cheap.

I won't be holding my breath.

Yet, while plenty of chances to create value have been missed*, eventually the price gets low enough to account for all but the most catastrophic future economic outcomes. For long-term holders of the stock to do poorly going forward, a series of extremely dumb capital allocation decisions or material damage to a core Microsoft franchise would have to occur.

Maybe that is a possibility, but an investor has to decide when the market price compensates enough for those risks.

Microsoft is far from my favorite business.

They're probably not going to suddenly getting wiser on the capital allocation front.

They'll likely continue to miss opportunities while some of their toughest competitors do not.

That doesn't change the fact that the valuation is not something you expect to see everyday.

Of course, amazingly Apple (AAPL) also has a single digit earnings multiple after backing out the $ 87/share of net cash and investments on the balance sheet.**

Not exactly expensive.

I mean, considering some of Apple's capabilities, a more inflated earnings multiple would seem hardly surprising.

(Whether it would be wise to pay it is another story.) 

In any case, when it comes to tech stock valuations, what a difference a decade or so makes. 

Still, as I've previously explained, there's just no technology business that I'm comfortable with as a long-term investment.

In other words, the discount to conservative value generally needs to be quite large -- an extreme mispricing --  for most tech stocks to be worth the trouble.

Adam

Long MSFT and AAPL


Related post:
Technology Stocks

* Missed opportunities? Certainly. Still, any company that can quadruple earnings per share in a decade despite missteps probably has something going for it.
** Apple is selling at $ 380/share minus the $ 87/share  = $ 293/share. Consensus estimates are running at nearly $ 35/share so the enterprise value to earnings is a bit over 8x.

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