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Buy Microsoft MSFT: This is as bad as it gets

posted on July 24, 2009 at 2:23 pm
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Nothing like shooting yourself in the foot while the global economy is pushing you toward a cliff.

That’s the pretty picture that Microsoft (MSFT) painted when it reported fiscal fourth quarter earnings on July 23.

And that’s exactly why I’m buying shares of Microsoft for Jubak’s Picks with this post. If you’ve been waiting to see when this classic growth stock would become a value stock, well, the moment has arrived.

I think this quarter marks the worst of the damage that the global economy will inflict on Microsoft. Intel and other companies in the PC supply chain have reported that they see the market for PCs stabilizing or actually turning upward.

And I also think that this quarter–or the next—represents the high point in the damage that Windows Vista has done to Microsoft. Customers’ negative reception of that product certainly added to the expected drop in sales from the global recession. But the next 12-18 months are loaded with new products—including Windows 7, a replacement for Vista, due later this year—that should reverse the stock’s tumble since it traded at $30 in mid-2007.

The news on July 23 was grim. The company did manage to scratch out 36 cents in earnings per share, just enough to match Wall Street projections. But that was still a 22% drop in earnings per share from the fiscal fourth quarter in 2008. Revenue plunged 17% year over year. Sales of the company’s flagship Windows and Office software fell by $1.7 billion.

Part of this wasn’t the company’s fault. Because of the global recession, sales of PCs have dropped in 2009 as consumers and companies decided to hold onto cash. In the first three months of 2009, global shipments of PCs fell by 6.5%, according to the Gartner Group. In mid-July iSuppli projected that global shipments would drop about 4% for all of 2009. That’s in line with Microsoft’s own estimate of a 5% to 7% drop in PC shipments.

If fewer PCs are shipped that means fewer copies of Windows are bought by computer makers and fewer copies of Office are sold to new PC owners.

But a significant part of Microsoft’s bad news was self-inflicted. Yes, PC shipments fell by 5% to 7% according to the company, but OEM (original equipment manufacturers—the folks who build computers and load Windows at the factory) licenses of Windows fell by 10%. Even worse than the slight drop in OEM licenses was the drop in the average selling price of these licenses. During the quarter computer makers opted to install fewer premium-priced copies of Vista and more lower-priced copies of the older Windows XP.

Partly this reflects the rise of the netbook segment, the fastest growing part of the PC market this year. These smaller and cheaper machines by and large use Windows XP rather than Vista.

And partly it reflects the market’s unwillingness to adopt Vista. According to a study by Forrester Research, 86% of corporate PCs continue to run XP, now eight years old, instead of Vista.

This bad news didn’t suddenly materialize this quarter out of nowhere. It’s been pounding and pounding at the value of Microsoft’s stock quarter after quarter until, now, shares are trading way below the stock’s historical valuation and even below the valuation of the average stock in the Standard & Poor’s 500. For example, On July 24 Microsoft traded at just 12.8 times projected earnings of $1.83 a share for fiscal 2010. That’s well below the stock’s average price-to-earnings ratio of 21.4 over the last five years and also below the average forward price-to-earnings ratio for the S&P 500 of 14.8.

Now stocks that are cheap aren’t any bargain if they’re going to stay cheap. Before you buy Microsoft or any other value stock, you need to see something that’s going to lift that value in the future. The market can decide that current assets are really worth more than it now seems, for example. Or that new products are going to re-invigorate a company’s fortunes.

That’s what I see for Microsoft over the next 12 to 18 months. Windows 7 is due in October—and early reports say that this software will do a lot to fix the problems with Vista. The improvement doesn’t need to be huge either since, as the Forrester study noted, such a large portion of the corporate world is still running Windows XP  that there’s huge built up demand for a new operating system. Another big piece of software, Windows Server 2008 R2, is due in early 2010. The server and tools segment generates about as much revenue for Microsoft as its Windows business. Office 2010 will probably ship in early 2010 and that segment is even larger in revenue at Microsoft than Windows or server software. The move to cloud computing, largely now seen as a threat to Microsoft’s PC-centric business, is equally, however, a big opportunity for the company. Microsoft gets that—the company recently announced pricing for its Windows Azure cloud computing platform.

None of this means that the challenges facing Microsoft go away. The popularity of netbooks will continue to eat away at margins for software and hardware makers. Google continues to attack Microsoft’s core businesses whenever it sees an opening. And even though Bing is an improvement, Microsoft remains third in the search business.

But with the stock trading at just 12.8 times projected fiscal 2010 earnings, investors won’t have to see perfection to get rewarded. While the market may get prices largely right most of the time, those of us who have invested through two boom and bust cycles know that it does run to excessive enthusiasm and excessive pessimism.

Right now you can cut the pessimism about Microsoft with a plastic knife. Analysts are projecting just 7.8% earnings growth for the company in fiscal 2010—a year when the company should start seeing the benefits of a raft of new products and a year when PC sales should be showing some kind of recovery.

As of July 24, I’m adding the shares to Jubak’s Picks with a target price of $31 a share by June 2010.

(Full disclosure: From May 1997 to May 2009,  I worked for Microsoft’s MSN Money. I no longer do. I do not own any shares of Microsoft nor any options on Microsoft shares. In all those 12 years, even though I worked in New York and not in headquarters in Redmond and even though the online business wasn’t exactly privy to inside information about the rest of the company I never wrote about Microsoft or said “buy” or “sell.” Too many conflicts of interest real or perceived. Now, I think I’m free to treat it like any other stock and say “buy” when I think it will make some money for Jubak’s Picks. And as I would do with any other stock, I’m disclosing here that I will buy shares of Microsoft for my personal account three days after this is posted.)

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  • terryw on 24 July 2009

    Thanks Jim, just got in at 26.27. I wish I bought some when it was 18 a few months ago! I am looking forward to watch Bing vs Google, .Net vs Java, and the performance of the Xbox, Office, and Windows divisions.

  • shunngai on 24 July 2009

    I have been reading review about the Window 7, it seems to get a good review from most people. Hopefully that will actually help their top line earning, but I am not sure how MSFT can deal with Google in search engine though…

  • Dave on 24 July 2009

    Hey Jim,
    It’s great to have you back … especially with your new blog and constant posts – I love it!!!
    Quick question – you seem to have changed your tune since the spring when you felt the market comeback was a short-term phenomena before another, perhaps larger, drop. Since you are now supplying a number of ‘buy’ recommendations, do you now feel that March was the bottom or is there still risk of another large drop?
    Also, if we are following your 12-18 month portfolio – what % of our assets should we put towards each buy recommendation?
    Welcome back, and thanks a ton!!

  • Algalli on 24 July 2009

    While I think your picks are great most of the time, there must be better stocks than MSFT. They have no ability to innovate and they are led by a sales guy. For their industry this is the kiss of death. There track record for new products over the last 5 years is abysmal.

  • Jim Jubak on 24 July 2009

    Dave, I’ll try to address your question in a post on Monday or Tuesday. The open question is whether this is a cyclical bull rally in a bear market or a new bull market. I’m inclined toward the former but the reading and reseach I’ve been doing since March has shown me that cyclical bull rallies in secular bear markets can last for a lot longer than I thought. I’ll try to explain and I’ll give you a more exact cash read. Roughly I’m at about 38% cash after today’s buy.

  • Jim Jubak on 24 July 2009

    Algali, you raise a very interesting queston: What exactly is a “better” stock. For me it comes down to a stock that offers me the best combination of high gain and low risk. If I were evaluating MSFT as a company, I don’t think I’d strongly disagree with you. They may be so big that they can’t innovate or execute. And in the long run, if true, that’s a disaster. But in the 18 months or so of my holding period for Jubak’s Picks I don’t need them to be anything more than competent brand managers. The market is so convinced that they’re going down to tubes tomorrow that I think there’s very little downside risk–in my time period–and a decent upside. Peter Lynch used to say (perhaps he still does) Pick companies so simple to run that an idiot can do it because some days idiots will. One of the things that Lynch meant was that it’s really, really hard to kill off a brand, especially one, like Window, that has better than 90% of the market.

  • russellt00 on 24 July 2009

    So glad to have you back, Jim! I tell all my investment-minded friends about you…thank you for sharing the results of your hard work with us.

    Your assessment that MSFT’s current share price is compelling…but when all that is said and done, today’s pullback still only reverses 9 trading days worth of gains. Timing stock purchases precisely can be difficult, but are you not tempted to think that the share price can decline 10-20% further, and at a more significant rate than the broader market, especially if the two week rally in the broader market takes a breather?

  • slee12dent on 24 July 2009

    I believe microsoft is getting less and less money for its OS. We are still currently using XP in our office and do not want to upgrade to vista. Why? Because xp is reliable and works well with our software, and there is absolutely no need to upgrade our software. I think the trend for pc is going simple…less is better. Imagine a low netbook with qcom cpu and google o.s. that run as good as the windows notebook but with better battery life.

    I sold some Jan10 $20 puts for a nice premium. That way you are protected if the shares falls 10-20%, which can happen if this rally stalls.

  • ryanpatrik on 25 July 2009

    Jim, I have to agree with Algalli that MSFT does not stand out as a great buy amongst all the others out there at the moment. At $20 or less, perhaps, but not now. They will have difficulty maintaining sales levels, let alone increasing them because the way people use software is passing them by. MSFT mobile apps are not preferred, APPL is encroaching on the PC market share, GOOG and the rise of netbooks are cannibalizing their margins on Office and Windows and they still have losses greater than even revenue from online business. MSFT will be a nice cash engine for a few more years if they cut costs but I see no real catalysts for any real growth. With limited resources, there seem to be a lot of better choices don’t you think?

  • ryanpatrik on 25 July 2009

    slee12dent…..great idea selling the puts. I went out even further and sold the jan11 20s before the recent runup and cashed them out for a nice profit. After MSFT drops a bit closer to 20 I just may do it again. MSFT has a lot of downside protection because of it’s cash position and it’s solid reliable cashflow, so selling puts is not overly risky and as I said above you don’t have a lot of upside that you may miss by not just buying the stock.

  • slee12dent on 26 July 2009

    I’ve been selling puts when a stock gets slammed hard. Its a great way to establish position but also getting paid while you wait through time decay. As for microsoft, I do think we are going to wait a bit before the stock takes off. Ryanpatrik…I am using interactive broker and I strongly recommend it for put writing due to its ultra low commssion.

  • topdog53711 on 27 July 2009

    I been in the IT business for over 50 years and in the market for 55 years and I say don’t buy now. Sales of xp will continue to drop until they bottom out when 7 is released. I would wait at least until after next quarter’s earnings are released. I thin another drop is possible. Then about the 1st of the year a buy will be in order.

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