he High Cost of Microsoft's Success
28 Apr 2006
The downturn for Microsoft shares looks overdone.
Paul DeMartino
Reuters.com
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On April 28, Microsoft Corp.'s (MSFT) earnings release revealed margin compression that was caused by rising costs associated with new businesses. But while the market has punished the shares, the pullback looks like an overreaction.
Our valuation approach suggests that MSFT, priced at $24.26 (a sample price during the day on April 28), would be appropriately priced if one were to believe the company's annualized five-year earnings growth rate can come in at or above eight percent.
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Putting this in context, the mean analyst long-term earnings growth projection for Microsoft is 12.47% post-announcement, with the most bullish projection at 15% and the most bearish at 10%. That's a relatively tight spread. And when we compare the mean with our required earnings growth rate, it seems that the shares are undervalued.
There is definitely a bearish viewpoint now, though. Some fear that Microsoft is overspending and that the level of sales need to justify these expenditures won't materialize.
Software, though, generally follows the pattern of high initial outlay followed by high backend sales. In this context, then, one should expect high costs right before a major new release; it was simply the magnitude that threw the analysts. We could make a similar observation about Xbox 360. Even though Xbox is out there, gaming hardware is still a relatively new business for Microsoft. But given that Microsoft seems to have produced a hit franchise, the failure to get expenditures in line at the outset, although disappointing, is not necessarily the end of the world.
Furthermore, an eight percent growth rate would not by any means be pie in the sky. In fact, year-over-year, Microsoft's consolidated net income rose 16.8 percent in the most recent quarter, so eight percent would represent a significant slowing of sales or narrowing of margins, or both.
Given that Microsoft is on the cusp of both the introduction of Vista and widespread availability of the Xbox 360, this seems an odd time to go bearish.
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