MSFT’s Sept. ’09 earnings (I): is MSFT a stock for 2010?

MSFT reported September-period earnings (the first quarter of its fiscal 2010) last Thursday, the day after the official introduction of Windows 7.

Earnings were surprisingly good, for two reasons.

X-Box continues to be the major force in this generation of console video game machines.  X-Box Live was up 50% year over year, and the latest installation of MSFT’s Halo has been a very big seller.   Yes, MSFT has been helped to some degree by Sony’s missteps, but the operational improvement at MSFT during this generation is still impressive.

Also, the consumer PC business is picking up again for MSFT, everywhere in the world ex Europe.  Netbooks are a big reason.  They’ve come from zero to 12% of the PC market in a couple of years.  Virtually all netbooks now sport a Windows operating system, although not many users opt for an Office suite.

The case for MSFT as a stock

Two points:

1.  better management The company has known intellectually for a long time that it is no longer a fast-growing company.  I recall vividly at a MSFT analysts’ meeting in Seattle early in this decade a questioner asking Bill Gates and Steve Ballmer when 20% eps growth would resume for MSFT.  The MSFT top managers were stunned.  Their somewhat scornful reply was that it was an heroic achievement just to get a company as big as MSFT to grow at 10%!

It seems to me, however, that MSFT hasn’t until recently accepted this fact emotionally.  That is to say, management continued to act as if MSFT were still a secular growth company and not a cyclical manufacturer of semi-commodity products.  The company hired a veteran of the forest products industry (the ultimate non-grower) as CFO in mid-2005.  Over the past year or so it has begun to tighten its belt.  It is paying increasing attention to costs and has even reduced its workforce by 4%.  It has also backed away from plans to acquire Yahoo, opting for a search joint venture instead.

Bears worry that MSFT will go back to its old free spending ways as recession abates.  For the sake of argument, thought, let’s assume MSFT understands that as a value company it is called to a different standard of management competence than it could get away with when the business was growing rapidly.

2.  strong cyclical recovery MSFT, like most other firms, believes the low point for world economies came (and went) in the June quarter.  The consumer is slowly reviving now.  Businesses, however, are simply adhering to the spartan budgets they developed last December at the height of economic uncertainty.

Large firms are already signally that they will boost their capital spending significantly next year if the recovery, weak though it may be, stays on course.   Their spending on new desktops and laptops may be unusually strong and they are wedded to MSFT products.   How so?

The PCs businesses are now using are on average about five years old.  Maintenance costs are too high.  According to Intel at least, firms are unhappy with the level of support available for the XP operating systems they’re using.  They would have upgraded long ago, except for two things:  recession; and Vista, the operating system no one wants.  But cash flows should be substantially stronger next year.  And Vista has been replaced by Windows 7, which reviewers have reported to be far superior to Vista.

Unlike netbooks owners, business PC buyers will doubtless also buy large amounts of the new Windows 2010 Office products.

So the second half of the current fiscal year, and all of fiscal 2011, could be unusually profitable.

By the way, MSFT has almost no debt and around $2.60 a share in working capital.  The stock yields 1.9%.  It has performed about in line with the market since the lows in March.

My conclusion:

I’m not sure this is an overwhelmingly convincing positive case.  On the other hand, the company’s strong cash generation and its near-monopoly with businesses seem to me to limit the stock’s downside.  If the market becomes convinced that the company has two years of 15%+ annual growth ahead of it, I think the stock will go significantly higher.  It may also benefit from the facts that:  as a multinational, it gains from dollar weakness; and, although consumers may not spend on luxury goods, they clearly have not lost their appetite for technology gizmos.  And, having followed MSFT since the late Eighties, this is the most positive I’ve been for almost a decade.

Tomorrow:  MSFT and netbooks

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