Monday, August 13, 2012

Why I Own MSFT

In this time of global economic uncertainty, we instinctively flee to safety. I feel one of the safest investments is Microsoft. It is one of my top 4 holdings.

MSFT is truly a global franchise. It dominants operating system portion of the PC market. It leverages that to create its biggest money maker: the Office Suite. Its balance sheet is straightforward and thus makes the company easy for us non-professionals to analyize. MSFT has $50 bil in tangible book value, which is $5.80 / shr. Earnings are also simple and extremely attractive. The following shows the last 10 years of earnings and free cash slow per share.

The earnings are wonderfully consistent with the exception of the last 12 months because of a $6.2 bil writeoff for the 2007 purchase of aQauntive. The cash flow picture is even better.

So, at the current price of $30/shr, we pay $24/shr for about $3.50/shr of free cash flow.  Warren Buffett has said that the value of a company is the present value of all future cash flows.  So, if we can assume that the next 10 years will be at least this rate of cash flow, and management returns this money to its shareholders in the form of generous dividends and stock buyback, then this stock would pay for itself in that time.

So far my argument is easy to straightforward because I stayed away from the technological merits. I feel this is the Warren Buffett way. I doubt Buffet gave much thought to technological details of IBM when he took his $10 billion position.

But I will make some basic comments about technology. In the above analysis, I have assumed MSFT will lose market share in operating systems (as is the conventional thinking).  But I feel it is primarily because our computing devices are more varied, we use desktops, ultrabooks, tablets, smart phones to name a few. So the market will have more operating systems, but with it also comes a larger market of devices.  I also feel the market is under-estimating the switching costs for companies and home PC market.  But despite all this, I will conservatively say that a worse case is MSFT will only maintain its revenue for the next 10 years.  After 10 years other paradigms like cloud-computing could erode MSFT windows dominance, and then I cannot say where MSFT will stand. But, by then the cash flow would have paid off my current investment.

On the optimistic side, Microsoft also appears to be trying its hands at many different initiatives to stay dominant in computing and entertainment; i.e.  Office, Outlook, Bing, XBOX, Skype to name a few.  Don't be surprised if MSFT can lead in some of those areas. MSFT has demonstrated time and again that even if it loses the initial round in a technological battle, it can catch up and later dominate.

So one way or another, I think investing in MSFT will pay off.

Disclosure: Despite my bullishness of MSFT stock, I like Linux much more than Windows, and I primarily use Linux at home and work.

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