Microsoft's Undervalued Cash Machine

A monopoly is a license to print money -- until it's not.

That reversal hasn't yet come to Microsoft, whose 90%-plus share of the personal computer software market has made it a cash machine. The stock, though, is acting as if the day of reckoning isn't far off. In the past 12 months, Microsoft stock is down 42%, comfortably underperforming the 25% or so declines at other blue chip tech names such as Apple, IBM and Oracle.

Microsoft shares are trading around 9.6 times consensus fiscal 2009 earnings, a little below IBM, at about 10, and well under the others.

Steven Ballmer, chief executive officer of Microsoft Corp., listens during a news conference at the 3GSM World Congress in Barcelona, Spain, on Tuesday, Feb. 17, 2009. Photographer: Xabier Mikel Laburu/Bloomberg News

That may create an opportunity for investors near term. Microsoft still generates plentiful free cash flow -- $15 billion this year, estimates Credit Suisse -- and sits on net cash of nearly $19 billion. So even though earnings are expected to dip this year, the dividend, which offers a 3% yield, is super safe. That can't be said for many other companies.

What's more, the stock may get a boost ahead of the release over the next nine months of Microsoft's latest operating system, Windows 7.

The reality that Microsoft's operating system monopoly is gradually slipping away will, of course, continue to weigh on the stock. But it's easy to overstate the immediacy of the competitive threats facing the company.

Yes, Microsoft has lost market share, including to Apple, but only by a percentage point or so. Google's free applications software may one day be a viable alternative to Microsoft Office -- but it isn't now. Smartphones will eventually erode demand for laptops, hurting Microsoft, whose Windows Mobile has only 12.4% market share, according to Gartner. Again, that could take years to play out.

A more serious threat may be the expected shift among businesses to use shared computer services run in a "cloud," paying for the service rather than for PC software. Microsoft wants to be a major player in cloud computing. It has the deep pockets necessary to invest in the data centers required, as do rivals including Google and IBM. But IDC projects cloud will account for only 9% of business software and infrastructure spending by 2012.

The experience of other industries undergoing structural shifts, such as broadcast TV's loss of market share to cable networks, is that the secular changes take a long time to seriously undermine a business model.

Admittedly, to protect its market share in the meantime, Microsoft likely will have to cut prices, hurting operating margins that now reach 70% in some products. Already, it gets only half its usual price for Windows on low-cost laptops called netbooks. That will hurt profitability.

Microsoft has plenty of ways to cut costs, however, including cutting investment in some areas. Microsoft's online business lost about $1 billion in the first half of fiscal 2009, despite massive investment in recent years to build a presence in the search market dominated by Google.

This isn't to say Microsoft should hunker down and be run for cash. Microsoft has successfully built a server business in recent years. But new business successes have to be huge to make a meaningful contribution to a company generating $20 billion-plus of annual operating profit.

It needs to pick its investment spots carefully for its $9.5 billion in annual research and development spending -- and be willing to change tack when businesses, such as search, fail to gain traction.

This sort of retreat isn't likely to happen under the current management, which is likely to keep swinging for the fences. A more disciplined approach to costs and investment likely won't happen without some outside pressure. But with Bill Gates' stake gradually declining -- it's now down to 8.5% -- that day will come eventually.

Microsoft's Undervalued Cash Machine - WSJ.com