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.)