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Author: TMFGebinr Big gold star, 5000 posts Old School Fool Supernova Phoenix 1
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Subject: Re: MSFT on the radar Date: 12/9/2010 10:22 AM
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- Recent event or events that make the company/stock disliked by the market.
- Once that event fades away, good growth expectations, or massively undervalued based on fundamentals.


Hi Marcos,

Thanks for your comments. You certainly raise some good points about whether or not Microsoft would be a good fit for the MUE Port. And the MUE growth numbers seem to back you up. The current MUE numbers for Microsoft are 6.4 / 3.2 / 2.5 at 15%, while for others I've been looking at, that terminal rate has been 0%, instead of 2.5% (see the list of screen results a few posts back, as well as what I've actually purchased). Even with a low 2.5% terminal rate, that puts a lot of the value of the company into the far future of more than 10 years. 50% in fact. If I change the MUE terminal rate to 0, then the numbers are 7.7 / 3.9 / 0. That 7.7% 5-year CAGR is quite close to the 8.4% it's managed for the past five years.

For operating systems and office software, Microsoft is, by a huge margin, the world leader. Market share in excess of 90%, I believe. Yes, Apple has been making some inroads, but it's a very small percentage of the market, on the order of 5%. (Apple is also a relatively small player in cell phones, even smart phones, despite all the coverage the company gets. That's based on total number of phones sold.) Microsoft can justify charging $200 or whatever ($150?) every 2 - 3 years because the market accepts that. But even Mr. Softy can see the move to the cloud and they've launched a cloud version of their software and that's been gaining traction from what I've read (at least Windows Azure has, Office cloud is coming). Plus, don't lightly discount the power of inertia. People do and buy the same thing because it's comfortable, it's familiar, and "it's always been done that way." That's part of what gives a company a moat -- high switching costs (not only in dollars, but lost productivity, grumpy workers, having to learn new software, etc.). Microsoft has maintained the dominant position despite two decades of Apple and open source attempts to break in. Will the cloud break the strangle hold? No idea. But I would not be surprised if the answer turned out to be, "No."

An aside on Apple's market share, specifically smartphone share. I noted in covering Apple's last quarterly conference call the following on the Stock Advisor Apple board: "Steve Jobs came onto the conference call, something he usually doesn't do. He wanted to crow over RIM, saying that Apple sold iPhones faster than ITC's 64% growth for smartphone market. They've now surpassed RIM. Then he had some (not so complementary) comments about Google. He highlighted Google's comment about unlocking 200,000 Android phones per day and Apple activates 275,000 iOS devices per day (without commenting that this includes iPhone, iPad, and iPod)."

The flat trading level that companies go through at times usually isn't a sign that the company has lost its way, but that the stock price had gotten ahead of itself. Back in 2001, when that plateau started, Microsoft traded at an average PE of 41 for the year. The high that year was 60.3 and it closed at 57.5. Major growth company PE levels, indeed. Since then, as Microsoft transitioned away from being a growth company, the PE has dropped to where it is now, averaging 28.9 in 2003, 25.4 in 2005, 22.5 in 2007, and between 13 and 14 for the past 2 years.

With a steady stock price, that means earnings have increased drastically -- from $0.57 per share for 2001 to $2.33 TTM. Part of that is decreased share count (10.8 billion at end of 2001 vs 8.9 billion today), but the majority of that is increased net income ($6.1 billion vs. $20.6 billion). Over those 8.75 years, net income has grown an average of 15.4% per year. Very healthy, but nowhere near the torrid pace of 27.8% per year on average of the prior 10.5 years (Jun 1991 through Dec 2001 -- limits of my data source). Yes, it's earnings plateaued for a bit between 2007 and 2009, but TTM, it's grown them by 27% compared to 2009 and by 50% compared to the comparable year-ago period.

This kind of flat trading behavior for Microsoft reminds me strongly of what happened to Coca-Cola back in the late 1970s - early 1980s. The company's share price went nowhere from late 1974 to early 1982 -- 7.5 years -- while the company's earnings doubled (or more). That meant a PE contraction. It then proceed to climb over 6,000% in the following 16 years. Mark Twain reminds us that history doesn't repeat, but it does rhyme a lot. So, will the same thing happen to Microsoft? Of course not. Will something similar happen? Very possibly. (Though I'm sure there are examples of share prices plateauing for several years before dropping.)

Does all this make Microsoft a MUE holding? I don't know yet. The numbers are a bit high, as noted above, but that mechanic shouldn't be the primary determinant. I'm still thinking about it. In Microsoft's favor is the strong performance of Bing as the search engine behind Yahoo! and the expected strong performance of Kinect and Xbox. Are those its strengths, though? Not at all. Windows, Office, and Servers are, by far, the engines running the Microsoft ship. The three divide, roughly equally, 80% of the company's revenue. For profit, though, it's all about Windows and Office -- 98% of operating profit between the two (Server's operating profit covers losses from regular corporate activities and the online division). What the company will do with those segments going forward will determine its fate.

Cheers,
Jim
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