Microsoft's Value Play

At one time the very question would have been absurd, since Microsoft (MSFT) embodied the notion of growth. For the past 10 years — a period when Microsoft was already a mature company — its sales have risen at an annualized rate of more than 20%, cash flow at 22.5%, and earnings at 24%, according to Value Line. That surely keeps it solidly in the growth camp, doesn't it?

After Microsoft stock's dizzying fall on May 1, when it plummeted 12% in its third-worst one-day decline ever, investors have to wonder. Even before that plunge, Microsoft shares had been stagnant for years. Nothing seems to have gone right for what was once the most illustrious of technology names. Giving away billions in a one-time dividend to shareholders did nothing except convince people Microsoft didn't know what to do with its cash. Its future has been clouded by the rise of Linux and the open-source software movement, which poses a long-term threat to the essence of Microsoft's business, the near-monopoly status of its proprietary Windows operating system. Windows' latest incarnation, the forthcoming Vista, has been delayed, which spooked investors hoping for a midyear revenue burst. Google (GOOG) has eaten Microsoft's lunch in the burgeoning web search and advertising business, in which Microsoft has fallen to a distant third, behind both Google and Yahoo (YHOO), and continues to lose market share. At the same time it remains plagued by allegations of unlawful monopolistic behavior, most notably from the European Union.

Compounding these woes, Microsoft simultaneously announced weaker-than-expected revenues and greatly increased capital spending estimated to rise to $2 billion a year. Investors bailed out, driving Microsoft shares last week to a multiyear low of $23.14.

So let's look at the usual criteria for value stocks: a relatively low price-to-earnings ratio; low price-to-earnings-growth ratio; a steady and predictable cash flow; low debt; and out-of-favor status with growth investors. For Microsoft, currently trading between $23 and $24 a share, its trailing P/E is 18.9; its forward P/E based on this year's expected earnings is 18.7, just above the S&P 500 trailing P/E of 17.5 but well below the software industry average of 23.6. Its price-to-earnings-growth ratio is 1.67, also well below the industry average of 2.24. Its price-to-sales ratio, at 5.81, remains a little high, albeit in line with industry norms.

If these numbers don't exactly scream value, they're still pretty low given Microsoft's earnings and sales growth. Lost in the recent dismay over Microsoft's soft revenue and capital-spending plans was the fact that earnings rose a healthy 16% from the previous year. Moreover, Microsoft retains an impeccable balance sheet, with mountains of cash, no debt, and a healthy and reliable cash flow. Even so, it's being shunned by many investors who have lost patience and thrown in the towel.

While I think the case can be made for putting Microsoft in the value camp, the real question is where the stock is going from here. My own view is that Microsoft is currently depressed by relatively short-term factors.

Concerns about capital spending strike me as overblown. This is exactly what Microsoft should be doing to compete with Google and other rivals. The Vista delays don't seem all that serious. Anticipation of the new operating system is no doubt one of the reasons revenue fell short this quarter, and it should merely be pushed back to later quarters. Worries about Linux and open software, meanwhile, are long-term concerns that aren't likely to affect Microsoft's dominance for years, if ever.

I wouldn't expect any sudden gains, but for patient investors, I think Microsoft is attractive at these recently depressed levels. You could simply buy the stock, or consider long-term call options. One measure of depressed investor sentiment on Microsoft is that the call options have hardly any premium built in. With Microsoft stock just under $24 this week, the January 2008 options with a strike price of $20 were just $5.50; the $15s were $9.50. I took advantage of the low premiums to add some of these calls to my holdings; I already own some Microsoft shares, which I've held for years.

Microsoft is still firmly planted in some major growth sectors, including Internet search, software applications, even videogames and entertainment. It's too big to ever recapture the heady days of its youth, but my own view is that it deserves to regain its status as a growth stock.

At the moment it just happens to be priced for value.