Microsoft, a Compelling Value Play

Marcial: Microsoft, a Compelling Value Play - BusinessWeek:

A strong balance sheet and cash flow, new products that should attract fresh investor attention, a low risk profile and underpriced stock...It all spells opportunity

By Gene Marcial

With savvy investment pros increasingly talking about the stock market circling toward a bottom, value and technology issues are getting the thumbs-up. After the drubbing they've taken in the past two years, the pros say, these sectors are poised to lead the parade when the market turns.

John Linehan, who manages asset manager T. Rowe Price's (TROW) $6 billion Value Stock Fund, says value stocks have become more compelling on the basis of their depressed valuations as measured by several metrics, including price-earnings ratios.

Investors could play the coming value-tech upturn by buying just one stock: Microsoft (MSFT).

The world's largest software company, with a market cap of $158 billion, is not only an undervalued tech stock but is also a safe and enticing value play, according to Linehan.
Buy or Hold

True, the stock has been a disappointment, having slid from a 52-week high of 32.10 a share on Apr. 24, 2008, to 16.75 on Jan. 23, 2009. But it has since edged higher, to 19 on Feb. 6, even after reporting disappointing earnings in January for its fiscal second quarter ended on Dec. 31, 2009. The company posted a profit of 47¢ a share on revenues of $16.6 billion, vs. analysts' consensus forecast of 49¢ on revenues of $17 billion.

Still, none of the 34 Street analysts who track Microsoft recommends selling the stock. In fact, 22 rate Microsoft a buy and 12 tag it a hold.

Linehan says Microsoft, trading at just 9.5 times his 2009 earnings projections, is undervalued because it deserves to trade at a higher price-earnings ratio. He figures that in a 'normal' stock market, Microsoft merits a p-e ratio of 13 to 14. He expects Microsoft will earn around $1.85 a share in 2009 and $2.25 in 2010.

Microsoft is a compelling value stock play, says Linehan, in part because of its strong balance sheet. It generates free cash flow of about $1 billion every month and has $23.7 billion in cash and investments as of June 2008, even after paying out $116 billion in dividends and share buybacks in 2008. That suggests the stock's 3% dividend yield is pretty safe, he adds. Microsoft has also been slashing costs, including reducing its personnel count of 91,000 by 5,000,
A Smartphone Ahead?

Microsoft's new products, says Linehan, which include the new Windows 7 system, should attract fresh investor attention. Microsoft plans to launch the new version of its Windows operating system in 2010, followed by an improved version of the Office suite of applications. It is also moving into new fields, including cloud computing, where Microsoft runs its products on computers at its own data centers for customers without their having to purchase additional software.

Rumors are swirling that Microsoft plans to launch its own smartphone—a cell phone that features more advanced functions, including Internet access. A Microsoft smartphone would compete head-to-head with Apple's (AAPL) iPhone and Research In Motion's (RIMM) line of BlackBerry devices. If the new phone gains widespread consumer attention, Microsoft's stock could pop, at least in the short term.

Analyst Kevin Buttigieg of investment firm Stanford Group notes that in the past four years, Microsoft's stock traded at an average p-e of 19. The high was 23 and the low 15. While the economy has had a negative impact on Microsoft's operations, the stock's current valuation more than discounts this weakness, he argues. Buttigieg rates the stock a buy with a 12-month price target of 24.
A Safe Financial Bet

Analyst Jim Yin of Standard & Poor's says Microsoft is focused on creating 'seamless user experiences across multiple devices, from PCs to PDAs and to home entertainment.' (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).) He adds that Microsoft maintains a dominant position in the area of desktop operating systems. Nevertheless, he rates the stock a hold because of his concerns about the worsening global economy.

What makes Microsoft an attractive buy, says analyst James Ragen of investment firm Crowell Weedon, is its currently depressed valuation and financial strength, which helps the company cope with the economic slowdown and financial crisis. He rates the stock a buy, with a 12-month price target of 30. 'Microsoft's balance sheet and cash flow strength is a strong competitive advantage,' he points out.

'While we concede that Microsoft shares appear to have limited catalysts over the near term, we believe that the risk-vs.-reward trade-off at current levels is compelling,' says Ragen. Microsoft is a 'survivor,' he notes, and is a financially safe bet. He says it has the capability of continuing to dominate the software sector.
Window of Opportunity

The stock's upside appears significant. Dan Natoli, managing director at independent research firm MatrixUSA, which rates the stock a buy, says Microsoft's 'strong performance,' coupled with its very low risk profile, represents 'a very high overall risk-adjusted potential to create value.'

There was a time when most institutional investors, along with a big cohort of individual investors, had Microsoft as a core holding in their portfolios. Recently a lot of big investors have bailed out of the stock, including American Funds' Capital World Growth & Income, which sold 16.9 million shares on Dec. 31, 2008. But while some pros headed for the exit, plenty of other institutional investors were buying in. Among them: Franklin Resources, which bought 108.9 million shares on Dec. 31, 2008, and Vanguard Group, which acquired 2.4 million shares, also as of the same date.

Microsoft's global brand continues to be a tremendous asset for the stock, and its valuation remains at historic lows. Investors looking for windows of opportunity may want to take a closer look at the software giant.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

Marcial writes the Inside Wall Street column for BusinessWeek. In 2008, FT Press published the book Gene Marcial's 7 Commandments of Stock Investing."