Edmond Jackson's Stockwatch: Microsoft's risk/reward tied to tapering outcome

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Despite last week's plunge on Wall Street, Microsoft rose to $36.81 (£22.21) after declaring strong final-quarter 2013 sales of software/services for businesses also its Xbox game consoles and Surface tablet.

This period represented Microsoft's second quarter in a financial year ending June. Furthermore, group revenue looks to be trending better after 2012 weakness and the last two quarters have beaten expectations; which is also interesting in terms of the US economy gaining traction given loose monetary policy.

It affirms a contrarian investment theme of "the big unpopular company" on which I drew attention to Microsoft at $24.75 in May 2011.

An attractive risk/reward profile is offered when the share price is modest relative to strong market positions and the company has medium-term catalysts. A 12-month forward price/earnings (P/E) multiple under 9 times looked cheap considering "at some point in the next year or two, the IT corporate spending cycle is liable to kick in - with Microsoft still the preferred supplier."

Decline of the PC market

Although the PC market is declining, it has been disregarded how important the company remains to business users, implying demand for the Windows operating system and Microsoft Office software, also "cloud" based online services.

Care is needed as the group evolves towards devices and services: devices are fast-moving and competitive hence involve lower margins (at least initially) than Microsoft's glory days of selling pricey software on discs.

But since the P/E multiple was modest it has only needed a re-rating to just over 12 times and the earnings outlook also to improve, for the stock to rise about 50% including dividends.

It defies a prejudice against big company shares - "elephants don't gallop" - showing how you can exploit this.

Last October at $35.7 I noted strong first-quarter (to end-September) numbers with a 16% increase in like-for-like revenues, operating income up 19% and earnings per share up 17%. From October to December, like for like revenue then rose 14% to $24.5 billion beating expectations for $23.7 billion.

Mind that while profit was well ahead of expectations, the table shows gross profit rising only 2.9% to $16.2 billion reflecting the shift to lower-margin products, and a similar rate applies across the profit levels.

Looking more closely at devices and consumer hardware, revenue grew by 68.4% to $4.7 billion but where gross profit has plunged 46.1% to $411 million. An explication is needed considering the hopes pinned on this segment.

Firstly a much lower margin is involved with the Xbox One whereas sales of the old Xbox 360 has a better margin but won't run future new games. The hope is that in due course the new console will expand the audience and generate sales of higher-margin games and online services.

Secondly, Surface, a laptop-tablet hybrid is not yet in profit. Launched a year ago it aims to compete with Apple's iPad combining the portability and ease of use of a tablet with the productivity of a traditional PC. Microsoft contends it is "one device for everything in life."

Jump in sales

Sales jumped to $893 million in this latest quarter, more than the whole of the last financial year although $932 million manufacturing and selling costs mean Surface needs to make more progress.

By comparison, Apple sold 14.1 million iPads worth $6.2 billion.

To an extent the de-rating in Microsoft I drew attention to was logical in representing this uncertain period for the group as it tries to re-position itself towards devices and services - turf which Apple dominates.

Yet its downturn appeared to run too far considering Microsoft's commercial licensing which remains a superb cash cow (see table) and is starting to enjoy upturn with the corporate IT cycle.

Profits are also benefiting from a tighter rein on costs and earnings per share via buybacks: Microsoft repurchased $2.1 billion worth of shares during the latest quarter, maintaining its pace.

So there is strength and hope in these figures although the market may be liable to fret whether Microsoft can genuinely go the distance in devices.

This likely explains why it trades firmly despite the stockmarket downturn, albeit up only 3% in about 3 months. Can it now "climb a wall of worry" as the bull adage goes, with progress continuing to beat cautious expectations?

The next step for market confidence will be a new chief executive to replace Steven Ballmer after the announcement last August he would be stepping down.

The shares initially surged 7% in anticipation, for although Ballmer introduced Xbox, rival firms have been more adept at harnessing growth from smartphones and tablets. Mind the appointment is still likely to be in the "professional manager" mould given the industry lacks such a creative genius as Gates and Jobs in their go-go years.

A near 3% yield is not really a prop for Microsoft but if the US economy can remain firm such that businesses continue to upgrade IT then the substantial cash flow implied, should be.

So the risk/reward profile is rather tied to the outcome of the Fed's QE tapering; whether the economy is now self-sustaining. With the stockmarket entering an overdue correction it looks possible to await another buying opportunity; but watch for who the new CEO appointment brings.

For more information see microsoft.com/investor