ValueAct purchased close to $1.6 billion of Microsoft Corporation (NASDAQ:MSFT) shares according to a shareholder letter obtained by ValueWalk. This is a stake far larger than many other estimates, which placed the total closer to a billion. Additionally, with the increase in price the stake is now closer to $2 billion in value. Below is an excerpt from the letter on Microsoft followed by the entire letter in scribd.
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ValueAct Q1 letter
Some of our most successful investments over the years have been in situations where other investors can’t seem to shed their past perceptions of the company’s prospects. They bemoan the lack of “catalysts” or fear that a stock “just can’t work” and assume that multiple-compression will continue ad infinitum. While we admit there are always value-traps available in the market, we also believe that occasionally too much emphasis is placed on portions of a business that are challenged with too little credit given for successes.
A year and a half ago we outlined a case for Adobe Systems Incorporated (NASDAQ:ADBE) (“Adobe”), a company that had flatlined for eight years. Many investors believed it was just a stock to be traded in and out of around product cycles, with minimal growth in its user base and potentially existential threats like HTML-5. However, we saw a company completely embedded in its users’ workflow, with real and increasing innovation and the potential to monetize that innovation through subscription-based pricing. When Adobe took the bold step to accelerate subscription adoption, management proved that with a strong core value proposition, perception is malleable and investors have been rewarded with a stock up nearly 50% over that time period.
This quarter, we initiated a new core investment in Microsoft, Inc. (“Microsoft”), and at the time of this letter own 55,750,000 shares at an average cost of $28.29. We believe that Microsoft suffers a similar perception problem to the one that existed when we initially invested in Adobe. The company has long been regarded as a Windows / PC-cycle stock. In fact, just last week, dire predictions about near term PC deliveries spurred another round of terrible Microsoft headlines. “Microsoft Can’t Keep up in a Mobile World,” read the headline in the April 11th Wall-Street Journal. Sell-side analysts focus on Microsoft’s efforts to drive Windows client success in a changing computing world and have become increasingly
bearish after the lukewarm launch of Windows-8, which many hoped would revive PCs.
Heather Bellini of Goldman Sachs summed up the popular sentiment well in last week’s downgrade: “we think the most important consideration is whether Microsoft can regain share in the total computing market for PCs, tablets and smart phones.” It seems to us that many investors have simply tucked this stock away in the “open when PCs bottom” file and we believe the company is vastly under-owned by institutional investors.
We’ll save you the trouble and be the first to admit that we aren’t nearly smart enough to correctly call the bottom of the PC market, but we also think a singular focus on PCs completely misses the point at Microsoft. At its current valuation, we don’t even need an opinion on PCs. The current valuation at Microsoft exceeds our 10% cash-on-cash requirement giving no credit for Windows!
Instead of looking at Microsoft through the usual PC lens, we look at it through our “plumbing” lens and we like what we see. Nearly 70% of Microsoft’s earnings come from the enterprise-centric business divisions of Server & Tools and Microsoft Business Division (e.g. Office). These businesses derive 60% of revenue from multi-year annuity
agreements and have grown EBIT nearly 10% per year over the past five years.
Microsoft sells products that many enterprise customers spend their entire day consuming, such as a knowledge worker sitting in front of Outlook or an IT manager using Active Directory, at a cost that is often as low as $100 per user per year. These products are deeply embedded in the workflow and the enterprise platform agreement is a powerful means to distribute additional products and features that users value such as SharePoint and Lync for collaboration or System Center for IT management.
Microsoft has demonstrated an ability to drive new and premium products into the enterprise customer base and we believe there are plenty of opportunities for them to continue to drive growth. These businesses have already shown a de-coupling from the PC cycle and Microsoft is accelerating the trend with the subscription based pricing of Office 365. Similar to Adobe’s success with “Creative Cloud,” we see the potential for significant migration of Exchange / Office 365 to the cloud, with pricing upside and positive implications for the way investors perceive and value Microsoft.