Microsoft, once the doyen of the tech sector, has had a rough old time since the sector blew up a dozen or so years ago. After its share price peaked at around $57 (adjusted) in December 1999, it quickly slumped to a range of $25-$30, where it has pretty much resided ever since.
A succession of new operating systems have failed to set the world on fire, the company has missed the boat on a range of new technologies and rivals such as Google and Apple have soared past it.
It’s common knowledge that the company has gone ‘ex-growth’, just churning out an annuity stream of revenue from its ubiquitous Windows and Office software. And like most common knowledge, there’s an element of truth to it, as well as some fiction.
PER falls from 80 to 14
In the 13 years since, earnings per share have in fact risen by an average of about 8% a year, which is not nothing, but the share price malaise is explained by the fact that this has taken the historical price-earnings ratio of about 80 in 1999 down to about 14 today.
Since 2005, when they started splitting it out, profits from the Windows division have indeed remained pretty flat ($11.9bn in 2012); but Office has grown at about 8% a year, to $15.7bn in 2012, and the ‘Server and Tools’ division has added about 18% a year to reach $7.5bn. The growing profit streams are taking over.
I don’t normally pay much attention to Microsoft. In fact I was about to write that as an unreconstructed Apple addict I won’t even have it in the house – but then I realised that I was in fact writing those words in Word. So pervasive is Microsoft’s software that we forget we’re even using it.
Prospective free cash flow yield of 10%
Anyway, it came to my attention because the Magellan Global Fund added the stock to its portfolio in the March quarter and it has shot up into its top ten holdings, with a weight of 5.7% at 31 March. The fund’s manager, Hamish Douglass, has built an impressive track record in a short period of time, using a Buffett-inspired value approach and is worth watching.
With most of Microsoft’s earnings coming through as free cash, that historical PER of 14 looks pretty cheap, especially alongside forecasts for earnings per share to rise from $2 to $2.79 in the current year and $3.11 in 2014 (compared to the current share price of $28.69).
I have no idea what’s expected to drive that growth (and I’d be interested in anyone’s comments), but if it comes through, in the same cash generative fashion as Microsoft’s current operations, it could land the stock on a prospective free cash flow yield of around 10% for this year or next. Magellan may be on to something.
Members can read our recent review of Magellan Financial Group, the manager of the Magellan Global Fund, over on the Intelligent Investor Share Advisor website. Non-members can take a 15-day free trial.
Disclosure: The author, James Carlisle, owns shares in Magellan Financial Group.