MSFT

**dahhuilaudavid** Sat Apr 29, 2006 3:28 am

MSFT
Microsoft suffered from the biggest single day decline since December 2000 as its share slided more than 11% yesterday. This is equivalent of a loss of $32B in a single day! The hot issue now is whether this company is a buy or not.

Prof. B. Greenwald, from Columbia Business School, has said in his lecture before that big company like Microsoft has hundreds of analysts following it. Therefore, it is crucial to know why you think you are right in comparison to the army of analysts.

Let me do some simple analysis on Microsoft:

Step 1: FCF/EV yield vs. Treasury yield

Enterprise Value (EV) = $232B

Free Cash Flow (FCF) = $14.5B

FCF/EV yield = 6.25%

Treasury yield (30 years) = 5.17%

Microsoft looks like a better deal than treasury yield.

Step 2: Insider holdings

I have mentioned about superior return by investing in founder-CEO companies. Investing in companies that have significant insiders holding is one of the great ways to achieve superior return.

Steve Ballmer and Bill Gates have holdings over 10% of the Microsoft, and they have significant passion for this company. Without doubt, they will work extremely hard to expand Microsoft Empire.

To read my previous comment on insiders holding, please visit: http://dahhuilaudavid.blogspot.com/2006/04/superior-stock-return-by-having.html

Step 3: Is Microsoft a Good Company?

Profit Margin (ttm): 31.57%
Operating Margin (ttm): 40.92%

Return on Assets (ttm): 16.09%
Return on Equity (ttm): 28.56%

By looking at these simple indicators, Microsoft is not only a good company, but a superior one.

Step 4: Does Microsoft management shareholders-orientated?

Microsoft has been buying its own shares aggressively; purchasing up to $13.88B, which is more than its income of $13B. On top of that, Microsoft has paid up to $3.44B of dividend. I view this move as a very favorable management of Microsoft. Buying back shares and paying dividend are important steps to enrich shareholders, as long as it doesn’t restrict its financial ability to expand and improve its service.

Step 5: Do you understand its Business?

Almost everyone uses Microsoft products, and it is a simple company to understand. Microsoft Corporation engages in the development, manufacture, license, and support of software products for various computing devices worldwide. As Microsoft is famously known, I’m not going to elaborate further on its business.

Step 6: Does Microsoft have a Moat?

Warren Buffett emphasizes “moat” seriously. He would only invest in companies with “castle-like moat with alligators swimming around it”. At the moment, Microsoft does have significant moat with its dominance in PCs operating systems (over 90% of operating systems use Microsoft products). However, it is hard to tell what will happen in 10 years time. That is why Warren Buffett has not invested in a significant way in Microsoft despite Bill Gates is his good buddy.

Step 7: Does any superinvestor invest in Microsoft?

There are some superinvestors interested in Microsoft, e.g. Charles de Vaulx (2.79% of assets), George Soros (2.52% of assets), Brian Rogers (1.33% of assets) and others. However, I have not found any superinvestors invest in a significant way in Microsoft.

Step 8: What are the potential risks in buying Microsoft?

As I discussed above, I am not sure how will Microsoft’s moat evolves in 10 years time. In this fast changing world, many things could happen, and technology and software may become obsolete really fast. If Microsoft failed to maintain its superior software, its moat will evaporate.

As importantly, size matters in determining superior stock return. Microsoft has one of the largest capitalizations in the world. The bigger the company, the lower the return. However, John Chew, an independent analyst wrote……

“Intel, MSFT, Coke, CISCO are all behmouths--they became huge through their dominance, so their size will limit returns vs. a smaller cap company.

However, what you give up in returns you may pick up in safety through their consistent slower growth IF the management knows they are over capitalized and return cash to shareholders through buybacks and dividends.

MSFT is essentially a utility company--they control 95% of the operating systems market and they earn 100%+ returns on tangible capital, the problem is what do they do with the cash? Let it sit on the balance sheet, deworseify, or give it back to shareholders. If mgt. returns cash to shareholders then buying at a 30% discount to IV with IV growing through 4% to 6% organic growth and 4% to 6% share buybacks or dividend yield is not bad given that it probably will be hard for the market to average much above 6% over the next few years.”

Conclusion:

Microsoft is a buy for me at current price of $24.15. I’m going to end my discussion here by quoting Warren Buffett….

“Buy companies with strong histories of profitability and with a dominant business franchise.”

Happy investing,
Dah Hui Lau (David)
dahhuilaudavid@gmail.com

**springsnailt** Sun Apr 30, 2006 3:03 pm

IMHO, most of the analysis applies when MSFT was $27.

**DonQuixote** Sun Apr 30, 2006 7:42 pm

I think MSTF's moat could get pretty eaten away over time. Look at Google's OpenOffice.org and it's challenge to Word. I think Google will have a big role in taking MSFT down to size. I don't think this fall would have happened if Google didn't exist. It's days of being a monopoly are over although it still dominates in the Operating System realm.

I don't like it's delays with Vista. Personally, I have an ancient computer (over 6 years old) and I'm holding off buying another one until Vista comes out because I don't want to have to pay extra and upgrade when it comes out some time in 2007. Maybe other consumers are thinking the same way.

I think Buffett doesn't invest in MSFT is because it is technology and he is not able to understand technology absolutely so he stays safe and avoids it. Although he is good friends with Gates, he's not going to compromise his investment strategy over friendship, which is why he's the world's most successful investor.

**RT Wolf** Mon May 01, 2006 2:20 pm

Google doesn't own or run OpenOffice.org. OpenOffice is a split of Sun Microsystem's productivity suite. OpenOffice is also open source. Google has thrown money and programmers at it, though.

I think, you're overestimating the strength of Google, as well as their abilities.

Microsoft is a conglomerate of sorts with seven segments:

"Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment." From their 2005 10-K.

To determine Microsoft's moat, you are going to have to go through each one of those categories, determine which products/businesses are operating at peak and which ones can be boosted in the future. Then you're going to have to survey the competitive landscape for each one of those products/services and make sure that the competition is weaker or somehow blocked out. Perhaps most of all barriers to entry and competitive advantages need to be understood.

I'm afraid I don't have to time to do all of that (nor, really, the inclination). But I would like to add some notes about the moat.

The biggest thing that Microsoft has going for it is that people don't like change. People don't want to have to learn a new operating system or new way of doing things. Technologically savvy people often forget that other people don't want to spend time learning how to use a tool like a computer and would rather use it. If companies were to initiate changes to mac or linux, they would have to spend considerable time, effort and money retraining everyone. It's cheaper just to go with what works well enough. This is definitely a strength for Microsoft and is, ironically, the reason for Firefox's quick expansion. It works almost the same as Internet Explorer and adds a number of useful features. In the operating system and office productivity suites arena, it is almost the same thing. However, here, I don't think MS will hesitate from pulling out legal action to curtail copying of their programs.

That, IMO, is the biggest component of MS's moat: very high switching costs. The incompatibility and closed-source nature of Office formats is also a switching cost.

MS also has a strong distributor network. All the large computer companies have Windows pre-bundled with competitive prices. I remember some people complaining about how a computer that came without Windows or pre-loaded with Linux was more expensive from one of the big companies (might've been Dell). This contributes to their moat as well.

Without crunching the numbers, I'd say Microsoft has a very strong moat and a ruthless management understanding it and willing to protect it. Their moves to create "basic" versions of their products to try to move into developing countries and curb piracy show that Microsoft is still a company very much on its toes.

If you'll notice, I haven't given an opinion on the moat, I've just decided to elaborate parts that compose it. I haven't even started to talk about the different attackers trying to storm the castle and I prolly won't unless someone specifically wants it.

As a computer geek, I soak up most of what's happening in the tech world almost through osmosis, so I hope to be able to use that as a sort of edge in the tech field in the future.

Personally, I think the best case scenerio is that MS will continue to dominate its core markets of operating systems and productivity suites in both the home and corporate spaces, for the next ten years. The worst case scenerio, IMO, is that MS's dominance is squeezed but it will continue to hold very large market and mindshares in a number of the industries it competes in, as well as diversify into related industries. I can't give you numbers that far into the future, but I can see them dominating more of the gaming market as well as the home theatre market. If you think it's cheap, buy it and just revalue it again in a few years. It's still going to have its unnatural dominance in five years, IMO.

HTH. :)

**goodness0001** Wed May 03, 2006 10:02 am

Wide Moat
Another factor to consider about whether MSFT has a wide moat or not is the high switching costs. Things to consider:

1. Microsoft makes the only product like Microsoft Access which businesses use day in and day out. There is no other product like it.

2. Businesses are not going to switch to online productivity suites. The reason is what happens if a business's internet connectivity went out. They would be brought down to it's knees. You need to also consider the privacy issues.

3. The amount of applications that are built around Microsofts .Net framework. If a company wanted to move to another platform, their code would need to be completely rewritten. That would be a very expensive task.

You may or may not like microsoft and their products, but it is going to be a very long time before somone/company will be able to take them down. I believe companies will chisel away at its moats, but Microsoft still holds the trump card. It has 95% of the OS market. This means if people are going to go to google.com they are going to be using some browser that is running on a MS product.

**RT Wolf** Wed May 03, 2006 10:29 am

MSFT opened to an even lower price today, setting a new 52 week record. I am suddenly a lot more interested but don't have enough money to buy it, but I am interested in the growth estimates. Yahoo tells me that even the beariest analyst expects a growth of 12% in EPS over the next year. The fact that MSFT has averaged about 6% in the preceding five years is interesting but I don't have access to analyst reports to understand how they arrived at those figures.

A great company like MSFT is today, it does deserve a premium over the average company. With an S&P P/E of 17, MSFT is a lot more attractive to me at 19. It is certainly lower than it has traded in forever.

Dell is also at a VERY attractive price. VERY VERY attractive. Southeastern bought Dell when it was over 30 and it's about 25 now. Definitely an outperform over the next few years. Perhaps I sohuld do a writeup of it.

**goodness0001** Wed May 03, 2006 11:41 am

I bought more of MSFT today, I already had some shares. I also opened a new position in dell today. According to my fair value estimate based on discounted free cashflow, dell is about 50% below fair value. Even if I am wrong about my fair value, I am not so wrong that a 50% margin of safety will vanish.

**goodness0001** Wed May 03, 2006 12:04 pm

DELL VS HPQ
In regards to DELL, look at this chart. What does HPQ do that Dell doesn't do? They operate in the same competetive market.

**RT Wolf** Wed May 03, 2006 12:32 pm

Well, "HPQ's efforts to reduce operating expenses in the PC segment have been successful." - Value Investor's Club

"Less 4 dollars a share, the price is 21 dollars for the earnings. So you're paying 14.4 times earnings for an EXCELLENT company that is expected to grow about 12-15% a year for at least the next few years. It is the lowest cost distributor of computers with a strong brand identity. management is awesome, commited and aligned with shareholders because they're major shareholders. strong founder/CEO. About $1.40 Free cash flow per share, so you're paying 15 times free cash flow." - Me, elsewhere.

We really should start a new thread to talk about DELL specifically instead of hijacking MSFT's thread.

The Value Investor's Club thingy also had more info about possible reasons the stock has languished. Which is better because Dell should keep buying back stock.

**goodness0001** Wed May 17, 2006 1:59 pm

MSFT continues to decline. I think it is a compelling stock right now.

**forestforever** Thu Jun 15, 2006 7:53 pm

"Does Microsoft have a Moat? "

It seems that web based softwares are getting popular. Google still get a chance to succeed in this area.

**goodness0001** Sat Jun 17, 2006 6:25 pm

Just remember, that to get to google, you are most likely booting up a windows computer...