Microsoft: Sleeping, but No Beauty

 | Dec 06, 2011 | 6:45 AM EST  | Comments
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From what I understand, there are three films inspired by the Sleeping Beauty fairy tale coming out in the next few weeks. That reminds me of Microsoft (MSFT), the Sleeping Beauty of the tech world. Will Prince Charming ever come along and wake up this slumbering giant? Or will the wicked witch of underperformance cast her evil spell and win out?

Lots of professional investors love the Microsoft story. It's a pretty simple story. Undervalued shares driven by low-single-digit growth give investors a calm port in a storm of market volatility. Investors are hoping the company's predictable, steady growth gently walks the shares into the mid $30s over the next year or so. A tiny 3% yield and a gigantic amount of free cash flow make it a must-buy value name.

In fiscal 2011, Microsoft managed to grow revenue about 12% because users began to upgrade to the latest version of Windows. But now, in fiscal 2012 and 2013, it looks like just 6-7% annualized revenue growth, driven by sluggish PC sales, decent enterprise demand and double-digit growth in the entertainment portion of the business. The server and tools business is expected to grow 6% to 7%, while the Enterprise unit drifts along between 5% and 6%. The Entertainment business, which is on fire because of the success of Xbox and the Kinect gaming console, is expected to grow about 18%. Margins have been under pressure as lower-margin businesses grow faster.

The Windows franchise continues to chug along. The company has sold more than 400 million Windows 7 licenses and only a quarter of enterprise desktops have deployed it, implying years of growth for Windows. It's a similar story for the Office business as well.

While there are a lot of reasons to recommend Microsoft, investors buy growth, not value. Just because the stock is cheap really doesn't matter. Lots of stocks are cheap. Growth companies earn higher multiples. Microsoft needs a catalyst to drive its shares higher. Investors are buying the stock and wishing for a higher multiple. Wishing doesn't sound like an investment strategy.

While cloud computing and Xbox adds excitement, those businesses aren't large enough to move the needle. For example, Windows and Office accounted for 97% of the company's operating income. Everything else, like tablet computing and cell phones, are still in the infancy stage. Meanwhile, margins are being dragged down because of an unfavorable product mix towards emerging markets. Lower average selling prices in faster-growing emerging markets have kept the pressure on. Gross margins have narrowed from 82% in fiscal 2002 to 78% in 2011.

Personally, I don't think Prince Charming will be able to part the thorn bushes and kiss the princess. Investors in Microsoft should slumber for another 100 years.

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