Written by Louis Jamieson, Sanlam Private Investments – UK (Clime international partner)
Microsoft is going through, arguably, the largest restructuring in its history as it transitions towards becoming a cloud and ecosystem company for enterprise and consumer customers and, once again, becomes the king of technology software. We believe that this transition will build a more cohesive and innovative environment, making for an attractive long-term growth proposition. The strategy is underpinned by recurring, subscription-based revenues, which continue to show strength, translating into sustainable “quality” earnings growth.
Microsoft is a fundamentally attractive name with an exceptionally strong balance sheet and a growing free cash flow yield with 2015 and 2016 estimates being 7.4% and 7.8% respectively. This is especially attractive for a business with an increasing percentage of its revenues being subscription-based. The company currently has a net cash position of around $63.1 billion and has compounded free cash flow at mid-single digits growth rates over the past seven years. The company has an attractive estimated dividend yield based on our 2015 estimates of 3.0%, and the strong net cash position only goes to further highlight Microsoft’s financial flexibility going forward.
We are further encouraged by Microsoft’s recent announcement that all upgrades to Windows 10 from 7, 8.1 and Windows Phone will be free. This is positive news for the Microsoft ecosystem as the company begins to phase out Internet Explorer for certain applications. By making the software free, Microsoft can guarantee that the uptake of its new software will be excellent. This is especially the case as Microsoft controls the distribution of its software. This strategy is in part about making the software as consistent as possible across all devices. Having greater software consistency across PCs, tablets, phones, Xboxes and other hardware will give developers more devices to target.
The recent trend on normalised return of equity has undoubtedly been a disappointment for the stock with the 2011 level of 45% dropping to 30% in 2014. This downward trend is partially due to the ever increasing equity base as cash builds up on the balance sheet. With net profit after tax increasing in 2016 and 2017 to $23.7 billion and $25.5 billion respectively, we see scope for normalised ROE to stabilise at 28% and we have used this number in our assessment of intrinsic value. We expect management to become ever more shareholder friendly with a more progressive dividend policy which will stabilise ROE going forward.
Microsoft is currently valued at U$45.39, with a future valuation of U$46.48 (forecast FY). At current prices of U$43.87,  is trading at a 6% discount to its forward value.
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