Microsoft (MSFT) currently trades at a P/E of 10 based on this year’s earnings (they have a June year end) or 9 times next year’s consensus EPS of $2.76. Their cash hoard net of long term debt is $31.6 BN or $3.69 per share, so the business excluding cash trades at only 7.9 times 2012 estimated earnings. Revenues will grow at 11% this year and probably 10% next year.
The familiar criticism of MSFT is that they generate monopoly-like profits from their dominance of the PC business through Windows and Office only to sink it all into gaming and online services with precious little profit to show for it. Nonetheless they’ll still generate around $4.12 per share of Free Cash Flow to Equity this year and revenues in their Entertainment and Devices division are growing at twice the company’s overall rate.
Eventually, and maybe sooner rather than later, gaming and online will stop using cash and start generating it. In fact JPMorgan produced some research earlier this year illustrating that even with fairly stagnant growth in cashflow the NPV of flows suggested there was still substantial upside in the stock. At current levels we think MSFT provides exposure to global GDP at a reasonable price with attractive potential.
Today’s announced rebalancing of the Nasdaq 100 Index (NDX) provides additional support for MSFT. While precise figures are hard to find, all the money that’s benchmarked against the NDX will need to rebalance by May 2nd or incur tracking error against its benchmark. Gary Kaminsky noted on CNBC this morning that $300 BN is benchmarked in this way; the QQQ ETF alone has a market cap of $24.4 BN. While we don’t know the precise figure, MSFT’s weighting will increase from 3.4% to 8.3% on May 2nd. If Gary’s $300BN figure is correct that suggests $14.7BN of additional buyers of MSFT between then and now, or around 9X average daily volume.
The long interval between the announcement date and effective date is quite unusual. No doubt many benchmark-driven managers are considering the best strategy to acquire the additional MSFT shares. For managers already underweight MSFT, buying as late as possible minimizes tracking error, but runs the risk of underperforming the index towards the rebalancing date. Meanwhile, overweight managers would seem to have little reason to reduce positions. MSFT has been such a weak performer of late that it’s unlikely to be held by many “momentum” driven investors (since it has none), and its current holders more likely include value-driven investors who assess its value to be substantially higher.
It’s also likely that the net rebalancing effect on the NDX will press the index lower, as generally the higher weighted stocks (such as AAPL) are being reduced and so will be under pressure, while the lower weighted stocks are being increased.
We are long MSFT in our Deep Value Strategy, and also own it in our Discount Arbitrage strategy where it’s hedged with short QQQ.