Microsoft: More Room to Run

It's probably not too late to jump on board a rejuvenated Microsoft.

Shares of the software giant soared 9.5% on October 26, to a six-year high of $35.03, after it reported blow-out numbers for the quarter that ended September 30, the first of its 2008 fiscal year.

Spurred by unexpectedly strong sales of its Vista operating system and Xbox 360 video game console, the Redmond, Wash., company said it earned $4.3 billion, or 45 cents a share, an increase of 23% from the year-earlier period and well above the 39 cents that Wall Street analysts, on average, had been forecasting. Microsoft chalked up sales of $13.8 billion, up 27% from the previous year's quarter. "You need to rewind seven years back to find similar growth rates," Citibank analyst Brent Thill said in a note to clients.

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And there lies part of the explanation of why Microsoft shares have been so sluggish in recent years. As Microsoft has grown into a behemoth, its sales and earnings growth have, naturally, slowed. Over the past five years, according to Value Line, earnings have grown a mere 7% per year.

That's fine for stocks that trade at single-digit or low double-digit price-earnings ratios, but not so good for a stock, such as Microsoft's, that historically has fetched 30 or 40 or even 50 times earnings.

So, even as Microsoft has continued to generate steady though modest earnings growth, investors have become less willing to pay for those earnings, and the shares have stagnated. The stock (symbol MSFT) peaked at $60 in late 1999 and as recently as September 20 closed at $28.42.

Microsoft consists of five major divisions: Windows operating systems; Office applications; server software; entertainment systems, such as Xbox; and online services. The last category includes Web search and advertising, where Microsoft ranks a distant third behind Google and Yahoo and loses money. So does entertainment.

The rest of the company is a different story. Because Windows and Office are near-monopolies (more than 90% of new personal computers come with Windows installed), Microsoft collects a toll on most PC sales. Gartner Group estimates that 258 million PCs will be sold worldwide in 2007, and that figure is still expanding by 10% annually.

"Microsoft has an annuity stream," says analyst Keith Maher, of BB&T Asset Management. For the fiscal year that ended June 30, the Windows and Office divisions generated a combined $22.4 billion in operating profits (earnings before taxes and interest), representing a 72% profit margin. The fast-growing server division, which is gaining market share, produced a respectable 35% margin.

Now is a sweet time in the product cycle for all three money-making divisions. Microsoft launched its new Windows Vista operating system and Office 2007 earlier this year. Early next year it's scheduled to release Windows Server 2008. Many businesses will probably upgrade to all three simultaneously.

As FBR analysts David Hilal and Philip Dionisio said in a note to clients after the latest earnings report: "Microsoft is still in the early days of a massive product cycle across all of its business units, and this should drive sustainable double-digit revenue growth, improving operating margins, and accelerating earnings." The weak dollar also aids Microsoft, which booked 39% of sales abroad last year.

Under the leadership of chief executive Steve Ballmer and chairman Bill Gates, Microsoft will remain immensely profitable and continue to reward investors with growing dividends and extravagant share buybacks ($47 billion over the past two years). Each month Microsoft, which is debt free and holds nearly $22 billion of cash, generates more than $1 billion of free cash flow, most of which it can return to shareholders.

With the spectacular first quarter in the books, analysts fell over themselves raising earnings estimates and price targets. Microsoft itself forecast that it will earn between $1.78 per share and $1.81 per share for the fiscal year that ends next June.

For calendar 2008, analysts on average expect the company to earn $1.84 per share. At its current price, Microsoft sells for a tad less than 19 times that figure, which seems like a reasonable valuation for a powerful, debt-free company that just delivered 23% earnings growth.

Many analysts now see the shares reaching $40 over the next 12 months. That implies a potential gain of close to 15% from the October 26 close. That wouldn't be bad, but given all the momentum Microsoft has behind it, a target price of $40 may prove conservative.