DRIP Portfolio Candidate: Microsoft

This week, Fool analysts Todd Wenning and Bryan Hinmon are presenting two stock ideas for inclusion in the Fool DRIP Portfolio. Technology stocks are on the docket today, with Todd presenting Microsoft, and Bryan making a case for IBM (NYSE: IBM  ) .

I love buying temporarily unloved companies, especially when they happen to be in superior financial health.

But that's only one reason why Microsoft (Nasdaq: MSFT  ) should be included in the DRIP Portfolio.

No player haters
Yes, relative to Apple (Nasdaq: AAPL  ) , Microsoft's recent achievements pale in comparison. But Microsoft has actually had a very solid run, primarily driven by the legacy Windows and Office platforms.

Company

5-Year Revenue Growth

5-Year EPS Growth

Microsoft

9.4%

13.3%

Apple

35.3%

62.2%

So while Microsoft may not be the high-growth machine it was during the dot-com era, it's smartly accepted its position as a mature growth company. As such, it pays a 2% dividend that scores an "A-" on my dividend report card, and it has repurchased around $70 billion of its shares (net) since June 2005. Now that's what I call returning shareholder value.

All this was accomplished while maintaining a sterling, AAA-rated balance sheet. In fact, Microsoft is only one of four non-financial companies with a AAA-rating, alongside Johnson & Johnson, ExxonMobil (NYSE: XOM  ) , and Automatic Data Processing (NYSE: ADP  ) . One of the benefits of this AAA-rating? If Microsoft chooses to tap the debt markets to raise a little capital -- which it's recently done -- it will come at little cost to them, leaving more profits left over for shareholders.

From a financial perspective, Microsoft is built on a strong foundation. Let's see what's keeping the share price down.

PC load letter?
There's no doubt that Microsoft has been a great company -- the real question on investors' minds is, "Will it continue to be a great company?"

There are a ton of innovations under way in the technology world, most notably mobile computing and cloud computing. Microsoft's future in these new arenas is a tad uncertain, and that uncertainty is a prime factor in keeping shares down.

In the mobile space, Microsoft has had several product duds like the Zune music player and the Kin, a social media-inspired phone. Apple has simply wiped the floor with Microsoft in these fields, first with the iPod, then the iPhone, and now the iPad. Even Google (Nasdaq: GOOG  ) surged past Microsoft in mobile technology with its Android platform. Unless it makes a large acquisition of Research In Motion (Nasdaq: RIMM  ) , Microsoft appears to be on the outside looking in at the mobile computing market.

Microsoft has many reasons to want to hang onto its highly profitable legacy Windows and Office platforms for as long as possible. But if the company spends too much time looking backward, they could miss future opportunities. The largest opportunity is in cloud computing, which in simple terms takes your data and programs off the hard-drive on your computer and stores them on Internet servers, aka "the cloud."

The movement to the cloud is bad news for Microsoft's traditional Windows and Office platforms, because they're kept on your hard drive, and the cloud will allow users to access various programs from various software providers. (Click here to read about Microsoft's moves into the productivity cloud).

Microsoft's cloud computing future lies in its Windows Azure platform. In fact, one of Microsoft's unheralded assets is the legion of third-party programmers who've used Windows programs over the past twenty years or more. If Microsoft can get them on board to create applications for Azure, the company could take a strong lead in cloud computing and have solid success in coming years.  

Valuation
Frankly, Microsoft's rather embarrassing missteps over the past few years give bears plenty of reasons to be skeptical, but I also think most of these concerns are already priced-into the stock.

Consider the consensus analyst estimates for the next few years:

Metric

2010

2011

2012

2013

2014

Sales

61,542.65

67,161.89

71,881.84

75,277.56

80,120.70

EBITDA

26,014.88

28,495.27

31,249.63

33,549.32

35,704.18

*Data provided by Capital IQ, a division of Standard and Poor's, as of July 22, 2010. All figures in millions of U.S. dollars.

Over the past five years, Microsoft has traded at an average enterprise value-to-EBITDA ratio of 10.8; today, the ratio is just 7.5. Applying that five-year average to 2010 consensus EBITDA (while factoring in cash and debt) would put Microsoft shares near $34.50 today. Using the consensus data, running my own discounted cash flow analysis, and assuming a 9% weighted average cost of capital and zero terminal growth thereafter, I put shares near $31. By my calculations, then, at $26 per share, it seems the market is pricing in declining growth for Microsoft past year five.

Foolish bottom line
If you think, as I do, that Microsoft will successfully shift its business from the Windows and Office legacies to cloud computing, then buying near today's prices is a good entry-point into the stock. With what seems to be limited downside risk in this highly profitable, financially strong technology titan, Microsoft makes for a great first stock in the DRIP portfolio.

So what do you think? IBM or Microsoft? Please post your vote in the comments box below.

Previous DRIP Portfolio Articles:

Fool analyst Todd Wenning owns shares of Johnson & Johnson, but of no other company mentioned. Microsoft is a Motley Fool Inside Value pick. Johnson & Johnson and Automatic Data Processing are Income Investor choices. Apple is a Stock Advisor pick. Google is a Rule Breakers selection. The Fool intends to buy shares of Google and has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 26, 2010, at 6:39 PM, rdtuck02 wrote:

    Haven't checked out IBMs Drip, but MSFT plan seems expensive with $2.50 cash purchase fees and 5% div re-investment fees for over 100 shares. These fees kill the return for folks only putting in the min $25 a month. I have DRIPS for both WTR and XOM currently. XOM essentially pays everything, while WTR gives a 5% discount on re-invested divs. Also like PG, PEP, SO, and HNZ as all are direct purchase plans with minimal to no fees. If you plan on investing large amounts of money each time, I guess the fees are trivial, but add up quickly for small time investors making monthly min contributions. I love the idea of the series though guys, and will be following closely.

  • Report this Comment On July 26, 2010, at 9:34 PM, FutureMonkey wrote:

    Inspite of Todd's excellent use of reference to Michael Bolton's fight with the fax machine in the movie Office Space (P.C. Load Letter), I'm going to have to back IBM as the dream tech DRIP for the coming decade. While I believe MSFT is also a good investment, if I could have only one stock and disappear to a desert island for 25 years, I'd go with IBM over Microsoft.

  • Report this Comment On July 26, 2010, at 9:38 PM, xetn wrote:

    It sees there are moves afoot at MSFT to get rid of Ballmer because he "let" AAPL become larger that MSFT. If this were to happen, what do you suppose would be the impact on MSFT's stock price? Who would be in line to replace him?

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