In the beginning of June I announced a contest. The topic was Question: Is Microsoft a value stock or value trap? Why? (Disclosure: Long MSFT calls).
The winner was decided by whoever got the most “likes” on their comment.
The winner was to receive-Two new print books: Accounting for Value by Stephen Penman. Stephen Penman is George O. May Professor of Accounting at the Columbia Business School. He is the author of “Financial Statement Analysis and Security Valuation“, for which he received a Wildman Medal Award, and an editor of the Review of Accounting Studies. Stephen recently wrote a (very popular) guess column on Value Walk, titled Benjamin Graham’s Accountant, and The Big Secret for the Small Investor: A New Route to Long-Term Investment Success byJoel Greenblatt.
Below are the entries which were submitted:
1. I think of this as somewhat simple. The company I currently work at has over 300k employees. Every one of those employees runs a computer that has Windows XP and Microsoft Office 2003 on it. It is getting to the point where they think this is a bit outdated and are looking to upgrade. What will they be considering? Not anything revolutionary, not Google Chrome, not MacOS. They will, without almost any other thought, go and upgrade to the new Windows OS/Microsoft Office suite. Large companies all across the world make the same quick decision, because that is path of least resistance. The fact that this is how large companies think about their computing needs allows MSFT to have averaged 40% ROE over the last 5 years, through one of the worst global recessions ever seen. There are many more reasons why I think MSFT at a p/e-ex cash of 7 is a great value, but the reason mentioned above is the foundation to all the others and therefore the most important.
2. I believe at this point that MSFT is a value trap. Sure they have a huge pile of cash but they are fighting competition from the likes of Google in search and their OS business. Their moat simply isn’t what it used to be and will likely continue to narrow. What I can see MSFT doing is using that pile of cash to make acquisitions for the sake of testing things out to see what sticks. This may prove costly to shareholders as M&A isn’t necessarily the best way to grow a company (i.e companies tend to overpay for those acquisition).
3. Value Stock if and only if management changes. Too many missed opportunities for a one time industry leader and a formidablecompetitor.
And the winner is…Andrew:
Andrew does not want to reveal his identity, but you would never guess where he is located! Congratulations to all contestants.
I have already contacted him and will be sending him the books.
Read his great answer below:
Personally I think currently MSFT has a nice value
proposition for investors, but the situation is very dynamic and you have to
keep an eye on it. Since it’s a value investing site, there probably would be
no need to list MSFT’s fundamentals (ROE, ROIC, CashFlow Margin, Net Margin,
nice & growing Div Yield etc). They are all solid and very nice-looking and
are exactly the reason why we want to make sure they will remain that way.
However, driving while looking in a rear-view mirror is a sure way to get into
trouble. So we need to look into the future and try to make an educated guess
whether things will remain fundamentally solid for Mr. Softy in the future. At
this point I am not concerned at all about MSFT’s stagnant price. Price follows
value eventually. The key profit drivers for MSFT are its Windows and Office
franchises. The major buyers of these products have been corporations and
individual PC users in developed countries (in third world countries they just
hack the program and use it for free – which is a subject for another
discussion). Now the Wall Street seems to be very scared that PC sales slump
will hurtl MSFT major profit drivers. I agree that tablets will eventually
become the new PCs for individual users (mostly for personal use like reading books
or surfing the web or playing games). Here’s what Bill Gates, none other, has
to say about the future of PCs:
“The PC is the tablet….You’ll see devices and say ‘is that a PC, is that
a phone?’ The words will change because innovation is happening so fast.”
However, personally, I don’t think that tablets will be of great significance
for traditional corporate desk-top users (which are plenty world-wide). It’s
just not comfortable to use a tablet for doing a spreadsheet or working on a
presentation. And many corporations will keep on updating their PCs with
Windows and Office systems installed. Trying something new will result in high
switching costs for these guys. They’d have to re-train their staff and in some
cases change other software systems that are only compatible with Windows. So
the chances of that happening are slim to none.
Secondly smart-phones are basically the same tablets
so once you have a PC in the office and a mobile smart-phone with a nice big
screen, you don’t really need to carry around a tablet. A lot of people in my
office wouldn’t buy a tablet for anything else than entertainment. So tablets
are definitely not a fad, they are here to stay as a useful tool for personal
use and students and maybe some specific types of jobs, but they are not a sophisticated
replacement for office desk-tops. Nor even for laptops, especially when we
start seeing improved battery life in new ultra-books.
Secondly, MSFT is trying to catch up in the tablet and
smart phone market and unlike their partner Nokia, their future does not depend
solely on the success of a single partnership project.
Thirdly MSFT is moving nicely in another fashionable
trend, which is cloud computing and services. Again I don’t think that
cloud-based services will be a major thing for big corporations with sensitive
data due to security issues. Think recent Citi-bank hacking problems. You will
always want a copy on your hard-drive, safe and secure behind a solid
fire-wall. Think about it this way, would you personally want to store all your
private data on a remote server as a single storage place? I wouldn’t. Now for
a small start-up it’s a nice value proposition to save on servers etc, but for
a big company keeping all your trade information in someone’s yard is a crazy
idea. So again cloud is here to stay, but will find it’s niche and will be most
likely used selectively. Surely cloud is unlikely to destroy PCs.
Fourth thing is MSFT’s entertainment division is
booming. It’s a small part of the profit pie now, but just wait and see.
All said MSFT is not without its problems. Among which
the biggest I see is being too arrogant, which leads being slow to innovate, diluting
shareholder value through overpriced acquisition and basically sitting on a
pile of idle cash (the last one is ok as long the share buy backs are
increasing as the stock price remains cheap.
In conclusion, I am willing to wait and see whether
MSFT will eventually play things right in the smart phone/tablet market and
whether it’s entertainment segment will grow to be a much bigger part of MSFT’s
overall business. And I will keep my eye on returns of capital, debt