Last November, fellow Fool Michael Olsen made software and technology titan Microsoft (Nasdaq: MSFT ) his pick for best blue-chip company for 2007. The advice looked impressively prescient as the stock continued a run into the New Year that had started back in July. But more recently, a downbeat Mr. Market and concerns over Vista have dragged the shares back down to a recent $27.75. According to Olsen, that's an even better risk/reward trade-off, and I tend to agree.
My thesis for my bullish stance on Microsoft is as follows: The company is a market leader and has an extremely profitable software business, which allows it to generate prodigious amounts of free cash flow. It then uses that free cash flow to benefit shareholders and develop future growth avenues as the core business matures.
Sure, the primary Windows operating system and Office software businesses aren't growing nearly as rapidly as they used to, but the collective client and business divisions generated an astounding 72% operating margin for fiscal 2006. These businesses make up nearly 63% of total sales and account for all of Microsoft's cash-flow generation as it invests in other divisions to diversify its business. You'll be hard pressed to find a more dominant franchise out there.
Critics argue that competitors are eating away at Microsoft's software clout. This is true to an extent. Firms such as Google (Nasdaq: GOOG ) , IBM (NYSE: IBM ) , and Red Hat (NYSE: RHT ) have been able to move users to Internet-based Office alternatives and competing server and business application systems such as open-source Linux. But after decades of effort, none has seriously dented Microsoft's installed base of business and individual users who, whether they like it or not, continue to rely on its product offerings.
What's more, the latest operating system, Windows Vista, was recently released. At best, the system will inject a needed boost to sales and cash flow growth, and at worst, it will serve to solidify Microsoft's existing Windows and Office franchise. In either scenario, management will continue to buy back stock, increase the dividend, and put money in the bank, adding to the billions in cash already on hand.
At some point in the future, Microsoft's operating system and software dominance will probably fade. As such, it has been working to develop a number of new revenue streams, including its MSN online network, Xbox gaming devices, and Zune portable music players. And while none is currently profitable, they have become solid alternatives to leading firms such as Google and Yahoo! (Nasdaq: YHOO ) online, Sony (NYSE: SNE ) and Nintendo in gaming devices, and Apple's (Nasdaq: AAPL ) iPod in portable music. Plus, profitability is close on the horizon, especially in the gaming realm.
Add it all up, and you have one of the most diversified ways to combine exposure to burgeoning technology platforms with a cash-cow business that has at least a fight or two left in it.
The shares aren't as much of a steal at the low $20s they reached last fall, but as long as Microsoft can continue growing in the double digits for another decade, it could be worth somewhere between $30 and $35, just as Olsen surmised last November. Based on current levels, that's no home-run return, but it is a respectable single or double, and that sure beats a strikeout.
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Fool contributor Ryan Fuhrmann is long shares of Microsoft but has no financial interest in any other company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.