Hold Your Nose and Dive Into Microsoft

 | Jul 30, 2013 | 11:00 AM EDT
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While we were very disappointed with Microsoft's (MSFT) recent quarter, outlook and conference call, we believe that the stock price is now far too cheap. In spite of CEO Steve Ballmer's apparent disregard for shareholders, we also think that better things are in store for Microsoft's investors. 

Microsoft does face a significant headwind in its core markets. However, it has powerful software franchises in Windows, Office and Server and Tools, and it is making some of the right moves to position itself for the future. Microsoft has shifted to cloud computing, with enhanced features and higher subscription fees, and that's one particular area the market seems to be overlooking

Our biggest frustration is that, while management is doing a good job of running the company, they have done a miserable job at optimizing earnings and improving shareholder value. 

For the fiscal fourth quarter, revenue totaled $19.9 billion, falling short of expectations by $800 million. A big part of the shortfall was the lackluster acceptance of the recent Surface Tablet rollout, for which the company had to take a $900 million inventory writedown. Additionally, all of the units -- from Server and Tools, to Windows, to the Microsoft Business Division (MBD) -- issued subpar results, weighed down by declining personal-computer sales. PC-unit shipments declined more than 10% in the quarter as more consumers abandoned the PC for smartphones and tablets. 

Thanks to the weaker-than-expected sales, earnings fell short at $0.66 per share, excluding the inventory writedown. Analysts had expected $0.75. In order to offset the recent pressure, the company said it would engage in another management reorganization and further increased capital spending in the upcoming fiscal year (ending June 2014). This notwithstanding, analysts are reducing their 2014 earnings targets on the company to incorporate the recent disappointing results -- and the average estimate now stands at $2.83 per share vs. the previous $3.08.

Since the quarterly update, Microsoft's share price has declined more than $4, or 12%.

The silver lining here is that these poor results should eventually lead to shareholder activism. Value Act, a leading investor, has taken a significant stake in Microsoft over the past year and is pushing for a board seat and broad corporate change -- which should transpire if only a few other meaningful and openly unhappy shareholders surface. We would expect that activists will advocate for more cash to be returned to the stockholders, and a more careful and judicious investment policy.

The company has many resources at its disposal to boost shareholder value, including industry-leading product lines, $22 billion per year in annual earnings and $60 billion in net cash, or more than $7 per share.

Our hope is that such activism will push Microsoft to adopt an IBM (IBM)-type model for shareholder value and capital allocation that includes aggressive cost cuts and a bigger and more consistent stock-buyback policy. In addition, any meaningful increase in the company's already-healthy 2.9% dividend yield could attract a larger universe of potential investors. So we do think shareholder activism will help the board focus on improving matters for shareholders. However, we do not expect a change in business plan, divestiture of businesses or a change in the CEO.

Still, shareholder activism could have a very meaningful and positive impact on the stock, potentially enhancing Microsoft's position as an attractive income generator and as a gilt-edged franchise.

So, while it is not our usual posture to embrace stocks after substantial earnings misses, the very magnitude of this particular miss might set into motion the changes that could propel the stock higher. If that turns out to be the case, this quarter will have proven to be a blessing in disguise -- and an opportune time to have bought the stock.

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