Can Microsoft’s R&D Efforts Save It?

Jack is back with further commentary on Microsoft. For background, read the most recent two articles under the MSFT label. Here’s Jack on the free cash flow margin of safety:

From Reuters, we find that Microsoft has produced:

12.50% 5-year avg revenue growth
24.16% 5-year avg earnings growth
20.26% 5-year avg ROE

The interesting thing is that growth has accelerated in the last two years. How come? Perhaps because of the $6 billion for research and development spent in 2006 and $7 billion in 2007. These items compromise earnings in the short run but are a mechanism for this relentless growth. At this rate (24%), earnings currently double every three years, and in 13 years the company will earn as much as its current market capitalization in a single year. If the P/E were to remain the same, this means the share price will go up 17 times in 13 years. If Steve Ballmer keeps doing what he is currently doing, I have no doubts about MSFT reaching that level of earnings.

When Bruce Berkowitz invests in a stock he likes to think “of the worst things that could happen. What if a natural disaster, an attack, a dirty bomb, what if financing dries up, etc.”. So what happens if Microsoft is incapable of growing forever? Thus Microsoft is essentially producing free cash flow (FCF) at the rate it earns at the present time, to eternity. Its current FCF yield is approximately 7%. But hold on, what is the point of R+D and growth CAPEX when there is no more future growth?
So adding back the R+D into FCF, we add the after tax R+D (7Bn * 0.7) = 4.9Bn back into earnings. What is the picture now? FCF yield doubles to a little more than 14%. That’s a neat package to have every year.

Of course Microsoft faces intense competition in the market it is in. However the lack of erosion in its incumbent business (for 25 years!) means that its core earnings are very unlikely to change. Growth may be compromised in certain areas (such as search marketing, etc.) however, Ballmer has shown that he is still capable of increasing earnings at an increasingly rapid rate.

The only problem in my mind is MSFT generates too much cash and management does not know how to allocate it. (This is why ROE has fallen from historical averages of 50+% to 20+%.) I gave a great sigh of relief when MSFT cancelled its bid for Yahoo.

This looks like a pro-Microsoft day here, so I’ll pass along comments from Justin, prefaced with his caveat that he thinks “Microsoft is a dinosaur” and that they “may have made a fatal mistake in not doing enough with the internet.” Nonetheless:

But there are a few business segments in which Microsoft is still innovating. They are beginning to introduce a surface computing device that is simply awesome:


And in the long Microsoft tradition of stealing ideas from Apple, they are beginning to introduce multi-touch technology into other consumer devices. I think multi-touch — along with voice recognition — will be the next major revolution in user interfaces, the same way the graphics user interface replaced text-based inputs. Look at this:


And as you pointed out, the X-box is doing really well. There are actually a lot of young kids who think of Microsoft as a really cool company that makes games like Halo.

If all this planning for a better future has a good chance of delivering a better future to Microsoft shareholders, why then hasn’t the share price risen to reflect the strengthening business? Jack is right that earnings have been growing. Because the P/E has been shrinking, however, the share price hasn’t budged.

Is everybody just wrong about the glorious days ahead for Microsoft, or are they onto something? If the future is Apple stealing Microsoft Windows share with its computers and Microsoft Exchange share with MobileMe, and Google stealing Microsoft Office share with Google Docs and preventing Microsoft from ever gaining any meaningful hold in internet search, then investors are onto something. If Microsoft can innovate into new markets or keep its existing market dominance relevant and growing as Jack contends, then investors are missing a great bargain.

Which do you think is the case?

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