Carnevale: Microsoft Too Cheap to Ignore

By Chuck Carnevale

NEW YORK ( F.A.S.T. Graphs) -- With the major stock market indices approaching record levels, finding good value is becoming more difficult every day. However, there are major sectors that the markets are currently leaving behind. One glaring example is the blue-chip, dividend paying technology sector.

It was not very long ago when adjectives such as, blue-chip or dividend paying, simply did not apply to high-profile technology companies. But that is changing, and I believe the way we look at high-profile technology stocks must change with it. Enter Microsoft ( MSFT).

This stalwart is a classic example of a once high-flying and hyper-growing technology company that now appears to be morphing into a blue-chip, high-yielding dividend growth stock. Therefore, I believe investors should consider adjusting their views about Microsoft the business, and Microsoft the stock. Let's evaluate the stock and the business, through the lens of F.A.S.T. Graphs, a fundamentals analyzer.

Since 1999, Microsoft has been a losing investment based on capital appreciation. Only the initiation of its first dividend in 2003, and its rapid growth, plus a special dividend of $3 per share in calendar year 2005, have enabled shareholders to just barely break even. Regardless, Microsoft the stock can only be described as a lousy investment since 1999. Consequently, attitudes about Microsoft the business are mostly and understandably poor and/or negative.

Microsoft's poor stock-price performance has masked its exceptional business performance over the same time period. Moreover, I believe Microsoft's operating record demonstrates that CEO Steve Ballmer has been unfairly criticized as a result of Microsoft's poor stock performance. It's important to recognize that the CEO of a publicly traded company should be held responsible for the operating results of the business. However, it should also be understood that they do not control Mr. Market. Consequently, they cannot control the price action of their stock in an auction market.

Microsoft's Ugly Performance Record

Look at Microsoft's price and dividend performance since the end of calendar year 1998. From the performance table below, we discover that a $1,000 investment in Microsoft on Dec. 31, 1998 would have fallen to $817.61 by March 5, 2013, generating a compound loss of 1.4% per annum.

Thanks to the cumulative dividend totaling $224.09, shareholders were able to break even. The combined total capital loss plus dividends amount to a total ending value of $1,041.70 on the original $1,000 investment. This computes to a .03% total annualized rate of return vs. a 2.8% annualized total rate of return from an equal investment in the S&P 500. Clearly Microsoft's stock has been dead money for the better part of a decade and a half.

Microsoft's Beautiful Business Record

Next let's move on to examining Microsoft's business by looking at its earnings per share growth since 1999. The orange line on the following graph plots Microsoft's earnings per share and represents a fair value PE ratio of 15.

The green shaded area represents total earnings. Looking to the green shaded rectangle in the Fast Facts to the right of the graph, we discover that Microsoft's earnings growth averaged 12.5% per annum, which incidentally is almost exactly two times the growth rate of the S&P 500.

Clearly, Microsoft's business performed exceptionally well since calendar year 1999, producing a superior and impressive long-term record of consistent above-average growth.

At this point, we should be asking the questions: How and why is the stock of such a great business has performed so badly?

My next graph adds dividends, which are represented by the light blue-shaded area. Although dividends are paid out of earnings, they are stacked on top of the orange line for visual perspective, and because they represent cash payments to shareholders. Now we have a visual depiction of the $3.00 special dividend paid in 2005. As you can see, Microsoft's regular dividends have grown steadily, and the 25% payout ratio is low.

This next graph overlays monthly closing stock prices in order to reveal the relationship between earnings and stock price over time. The orange line on the graph represents Microsoft's calculated True Worth, based on a widely accepted formula utilizing a DCF methodology.

Therefore, I contend that this graph reveals why Microsoft's stock has been such a poor performer. The reader should note that calendar years 1999 and 2000 were a time referred to as the infamous technology bubble, also known as the irrational exuberant period.

Consequently, Microsoft's stock price, along with many other high-profile technology names, represented massive overvaluation. In other words, even Microsoft's exceptional earnings power prior to and subsequent to 1999 and 2000 could not justify its absurdly lofty valuation. At its peak valuation, Microsoft was trading at PE ratios exceeding 80, while earnings only justified a fair value PE of 15.

Therefore, Microsoft's stock price had nowhere to go but down until price eventually aligned with earnings, by Feb. 2008.

This was just in time for the Great Recession to sink most all stock prices to below fair value (the orange earnings justified valuation line). Moreover, I believe that earnings growth for 2012 and 2013 has been temporarily reduced due to the launch of Windows 8 (see each year's growth rate calculation at the bottom of the graph).

Currently, 35 analysts reporting to Capital IQ forecast five-year forward earnings growth of 10% per annum.

My final earnings and price correlated graph on Microsoft paints a clear picture of a fiscally fit blue-chip technology bellwether. The massive overvaluation that the company had suffered with for so long is now gone. Today I believe that Microsoft offers investors growth and an above market (with potential annual increases), dividend yield of 3.2%. Microsoft's balance sheet is strong, and cash flow generation high. But most importantly, with a blended PE ratio of only 10, Microsoft appears to be bargain priced based on fundamentals. Perhaps there's a lot of fight yet left in this dog.

Summary and Conclusions

At current levels, I believe that Microsoft offers long-term investors three proverbial kicks at the profit cat. I expect future price gains to be generated based on above-average earnings growth (10% per annum), a potential expansion in the PE ratio from its current below-market PE of 10 to a market average PE of 15, and finally the opportunity for above-average and growing dividend yield. Add it all up, and I believe Microsoft offers the prudent long-term fundamental investor above-average growth and income, plus a margin of safety based on its low valuation.

At the time of publication, Carnevale was long MSFT, although positions may change at any time.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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