MSFT…

When I was writing about AAPL yesterday and wanted to make the point that the stock is cheap, I looked around at other, much weaker, tech-related firms to see their valuations.  I wanted to illustrate that AAPL shares are not only cheap in an absolute sense but are also inexpensive relative to other tech firms with weaker managements and/or inferior business models.  I settled on CSCO as a good example of both latter characteristics.  There were lots of others, too.

…is a very cheap stock

While I was searching, I took a quick look at MSFT.  I knew it has been the darling of value investors for some time.  But I was stunned by how cheap it is–much cheaper than AAPL.

I do have some history with MSFT.  I’ve been a user of its products beginning with the 30 lb+ Compaq “portables” of the early 1980s.  I bought the stock in my portfolios for the first time in late 1990.  I held it continuously for almost a decade, before selling it in late 1999 at around double the current quote.  Yes, I have subsequently held the stock for short periods after that, at the urging of a former CIO, but without much conviction–and without much success.

details

But this is what I saw yesterday:

1.  As of June 30, 2012, MSFT had cash of $63 billion.  Against that, the company had $11 billion in debt.  So net cash is $52 billion.  8.4 billion shares are outstanding, meaning net cash amounts to $6.20 per share.

2.  During the June 2012 fiscal year, MSFT generated $31.6 billion in cash flow, or $3.75 a share.  It spent $2.3 billion of that on capital equipment and about $10 billion more on dividends and stock buybacks.

3.  Consensus Wall Street estimates are for about a 10% increase in cash generation over the coming year.

some arithmetic

The share price of MSFT as I’m writing this is about $29.  Subtract out $6.25 in cash, leaving $22.75.  Dividing by $3.75 indicates that MSFT is trading at about 6x cash flow in fiscal 2012 and 5.5x expected cash flow for the coming 12 months.  That’s an extremely low number, especially for a firm like MSFT which has negligible capital spending needs.

Why so cheap?

What is this valuation saying about the company?

Three possibilities:

–much of MSFT’s cash pile, and a good portion of its profits, are accumulating overseas, free of US corporate tax.  Returning that money to the US, where it could be used for dividends, would require that MSFT pay Uncle Sam.  To some degree, that lessens the value of MSFT’s cash flow.  But any global company is in the same boat.  And, although I think it’s an issue, Wall Street doesn’t seem to mind at all.

–top management has been, well, bad, for at least a decade.  These are the same folks who wanted to pay $40 billion+ for YHOO a few years ago (they probably thank Jerry Yang every day for refusing to sell).  They just took a $6 billion+ charge for impairment of goodwill–acknowledging that the company overpaid substantially when it bought aQuantive five years ago.

On the other hand, MSFT has the dominant PC operating system.  And neither AAPL nor GOOG, nor Linux have been able to make much headway against the Office productivity suite.  So they have arguably been adequate stewards of the MSFT legacy of the last century.

In addition, poor management is often a plus for value investors eyeing a stock.  They imagine how much better things could be if competent hands were at the tiller.

–Is change of control possible?  It’s hard to say.  My impression is that MSFT has always been run for by long-time friends of Mr. Gates, whom he knows personally and trusts.  He seems extremely loyal to managers he has appointed, without much regard to their objective performance.  As the past decade+ has shown, change from within doesn’t appear to be a good bet.

Forced change from the outside?  Together, the founder and Steve Ballmer, the CEO, own 10% of MSFT.  The Bill and Melissa Gates Foundation may own more.

History shows that individual shareholders are immensely supportive of incumbent management, no matter how bad its performance may have been.  A proxy fight involving a company this large would be expensive. Its outcome would be hard to predict.  Are individual investors going to  support a movement that will effectively unseat Mr. Gates?  I’m not sure.

I think the belief that corporate change is unlikely is the main barrier to a better valuation for MSFT.  Wall Street believes–with ample justification, I think–that a dollar of cash flow in the hands of MSFT management is worth substantially less than one hundred cents.  And the market believes there’s no easy way to change the situation.  That’s certainly what I hear the stock price saying.