Why Microsoft's Cash Makes It A Bargain

Is it safe to buy Microsoft (MSFT) yet? It's certainly an odd thing to ask about a stock that's up 34,186% since its 1986 debut. And if it says more about my aversion to risk than it does about Microsoft, so be it. Cash is as easy to lose on Wall Street as it is rare to find on a sidewalk: Buyers of the stock four years ago have 50 cents on the dollar now.

Still, with Microsoft near $25, its shares are getting hard to resist. In a minute, I'll explain my reasons why, but it's not because I have some special clue about Microsoft's fiscal third-quarter profit report, set for Apr. 22. Nor is it because the next version of Windows is sure to reignite the glory of 1996-2000, when net income quintupled. I'm simply betting that even amid such clear business risks as Linux, the stock offers a rich potential reward precisely because of where those wildly profitable years have put Microsoft today.

IN OTHER WORDS, it's all about the cash -- specifically, the 53 billion greenbacks, give or take a few hundred million, in Microsoft's coffers, plus the billion or more that its operations mint each month. This financial muscle gives Microsoft unprecedented leeway to treat shareholders handsomely, even in an expected era of slower growth in sales and profits.

To see what I mean, let's walk through some numbers. In this fiscal year, ending June 30, Microsoft sees sales growing 11%, to nearly $36 billion. Operating income, it estimates, will climb 10%, to perhaps $10.5 billion, which should be good for earnings per share of up to $1.18. (Note: This excludes the 35 cents a share that Microsoft, famously conservative in its accounting, is deducting for the cost of options and other stock-based pay. Few companies do this yet, so to compare Microsoft, an adjustment is necessary.)

Now assume Microsoft's growth slows. A lot. Suppose in each of the next three fiscal years, net income grows not 40%, as it did last year, or 20% as it might this year, but 7%. How could investors stand for that? Because of Microsoft's hoard of cash. A comfort when it was besieged by rivals and regulators, the cash can now power the stock. As the fearsome monopolist makes nice, settling lawsuit after lawsuit, look for it also to convert the cash that's left over after legal settlements from a low-earning security blanket into higher returns for investors.

One obvious way is via dividends. Microsoft paid its first in March, 2003, and doubled it in November, to 16 cents a share, when it noted that it will review its dividend policy each year. It could easily triple the payout, giving the stock a middling yield of 1.9%, and at current operating rates still have up to $10 billion in annual cash flow even after spending on research, product development, and capital projects.

A more potent move would be reducing public shares. After rising steadily, the tide already has turned, with the number of fully diluted shares outstanding falling 2.5%, to 10.9 billion, in 2 1/2 years. Suppose Microsoft devoted just half of its $53 billion in cash to repurchases. It could buy back a billion shares over, say, three years, lowering the total by over 9%. The effect: Even if net income rose just 7% a year, earnings per share could grow an average of 10.5% annually. With an average dividend yield of 1.7%, a buyer of Microsoft at $25 could reasonably expect a 12% annual return at low risk.

Will Microsoft precisely adopt my shareholder-rewards program? Doubtful. But the point is, Microsoft holds the easily realizable potential to please investors. Another way to view this value is by adjusting Microsoft's stock price for the strength of its balance sheet. If Microsoft were to pay off all of its liabilities -- every last penny -- it still would have $3.32 a share left over in cash. Subtract that from its recent $25 stock price, and the cost of Microsoft's underlying businesses is closer to $21.68 a share. That's 18 times fiscal 2004 earnings, when the Standard & Poor's 500-stock index sells for 21 times. Mighty Microsoft is selling at a discount. By Robert Barker

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