Featured Call: Long Microsoft (Nasdaq: MSFT) Shares

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: John Beall
Firm: Private Hedge Fund. San Francisco, CA.

Recommendation: Long Shares of Microsoft (Nasdaq: MSFT)
Timeframe: 1 to 2 Years
Recent Price: $30.00
Target Price: $40.00

Quick Thesis
MSFT trades at 8.8x 2012 earnings ex-cash vs. 12.9x for the S&P despite far better EPS growth, margin stability, shareholder payouts, and a AAA balance sheet. 70% of profits are from corporate end markets, where MSFT’s firmly entrenched software will benefit from the corporate PC refresh cycle and forced upgrade of the 50% of users still on the decade-old XP platform, with pull-through to MS Office and Windows Server.

Gartner projects CAGR growth over the next 5 years of 6% in enterprise software and 7% in PC’s. Over the next year, MSFT will launch new versions of all major products. It is a highly liquid stock with very strong brands, IP and corporate / OEM relationships. It has been “dead money” over the last decade as multiple contraction offset a four-fold growth in EPS, but that seems likely to change.

MSFT has grown EPS over the past decade at a 15% CAGR vs. 8% for the S&P, and over the past 5 years at 18% vs. 2% for the S&P. Yet the stock price has been stuck in the $25-30 range for most of the last 10 years, as multiple contraction offset the fourfold EPS growth.

MSFT currently pays a 2.6% dividend yield ($0.20/quarter vs. $31 price) and is repurchasing stock at a 1.5% annual rate ($1bn/quarter vs. $258bn equity cap). The combined 4.1% shareholder cash return is only 45% of the projected 2012 earnings yield of 8.9%. The dividend is likely to increase in QE 9/2012 as it has in prior years (+18% in 2009, +23% in 2010, +25% in 2011). Much larger share buybacks are possible given the cash balance, leverage capacity and ability to use low-cost cash / debt to repurchase high-yielding stock.

Multiple product launches within the next year including Windows 8, Office 15, Windows Server 8, Windows Phone 8 and possibly Xbox 720. Recent alliances with Nokia and Yahoo may fuel further gains.

Risks
*PC Dependence: MSFT has thus far failed in the rapid growth of smartphones and tablets.

*Management: Critics blame MSFT’s growth area failures on a bureaucratic and innovation-stifling culture that fails to hire and retain the best employees.

*Cloud Threat: Longer-term, analysts believe an “industrial revolution” type sea change will drive a massive shift of corporate computing to managed data centers, driven by huge savings from centralized computing power, storage and tech support.

*Piracy: Worldwide, an estimated 50% of MS Office software is pirated.

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