I suspect that many investors buy shares of Microsoft (NASDAQ:MSFT) because it's the largest tech company in an industry that includes such giants as IBM (NYSE:IBM), Google (NASDAQ:GOOG), and Hewlett-Packard (NYSE:HPQ). These investors should remember, however, that the only reasons to own a stock are for capital appreciation and/or dividend income. Company size should be of little consequence.
Indeed, absolute size does not equal growth, and Microsoft, which now provides a dividend yield of 1.25%, is not currently a long-term capital gains story. The company's growth leveled off five years ago, and there's no significant fundamental catalyst to propel this stock meaningfully higher.
Unfortunately, this is reflected in Microsoft's stock price, which has fallen by more than 40% since 1999. Long-term investors who bought that year and held wouldn't have made money. Its shares have risen by about 30% from its $19.23 (split adjusted) low on Oct. 4, 2002, however. But the S&P 500 Index is up 52% during this same period.
Largest doesn't equal growth
Microsoft CFO John Connors hit the nail on the head when he said during the company's Jan. 16, 2003, earnings call: "To grow a $32 billion company, first you have to do $32 billion in business."
Although Microsoft continues to make money on its monopoly products -- operating systems and applications -- these lines of business aren't growing particularly quickly. Future growth is limited, for now. Microsoft already owns large chunks of the IT market, and there's limited ability to grow revenues from Office, since doing so would risk annoying end users and driving more people off license. Growth in new PC sales with the resulting operating system sales will likely be limited to three- or four-year upgrades for laptops and four- to six-year cycles for desktops. Creation of new markets for other sorts of operating systems may be constrained by many partners' reluctance to enter into partnerships with Microsoft.
Microsoft does have areas where it can grow. Databases, analytical services, and small-business end users are all segments with growth potential. But everything else seems to be losing money for Microsoft -- at least for now.
Its relatively sluggish projected revenue growth rates aren't enough to justify owning Microsoft for the next three to five years -- not, at least, as a capital gains story.
Whither its cache of cash
Microsoft's dividend is getting more appealing, but that's for investors wanting quarterly income payments. It won't propel long-term stock price appreciation. Microsoft currently provides a dividend yield of 1.25%, but it could do more. If Microsoft declared, say, a 60% payout rate of operating cash flow minus capital expenditures, it would result in $9 billion in annual dividends, or a 3.2% dividend yield. So as the cash piles up again, as it inevitably will, management could boost the dividend again. And if it does, it would be yet another admission that Microsoft's not a growth company. It would appear less attractive to the capital appreciation crowd, but more enticing to the dividend hounds.
But there's more. A big dividend payout would underline the shift from a growth-oriented stock to an income-oriented one. On this matter, I'm a true theoretical finance analyst: Microsoft's shares should fall by the amount of the one-time dividend, and there will be no future benefit (or damage) from paying the cash out.
Operating cash flow growth needed
Many investment opinions continue to emphasize Microsoft's balance-sheet cash. Yes, Microsoft generates a ton of cash. I won't deny its cash-generation ability -- $38 billion is a ton of money! But I prefer to look at operating cash flow (OCF) growth, and that has slowed dramatically since 1999.
Microsoft generated $13.1 billion OCF in fiscal 1999 (ended June 1999) and $14.5 billion in fiscal 2002. In fiscal 2003, it peaked at $15.8 billion, after which it fell to $14.6 billion in fiscal 2004.
The peak in OCF in fiscal 2003, unfortunately, was a one-off event; the switch to the licensing model required an advance payment largely booked into revenues. In addition, it represented some "pulling forward" of revenues from future periods, essentially draining away from future quarters. While the amount of "pulling forward" was unknown at the time, even Microsoft tried to manage investor expectations during its October 2002 conference call, when it stated that that quarter's strength was a one-time event and that growth going forward "will be muted."
Microsoft's stock started to fall around six months after its OCF growth rate started to slow in mid-1999, and the stock price hasn't yet recovered. Pull up a five-year chart of the stock relative to the market: It's a real point of inflection in the company's price history.
Focus on cash flow valuation, not earnings growth
The focus on valuing Microsoft should shift to cash flow generation rather than EPS growth, although this caps the valuation multiple that the company should be awarded in the future.
The stock has traded in a $24 to $28 range since 2001. There's no catalyst to propel it beyond this range, not for the next two years or so. In 12 months' time, Microsoft will probably be lower than it is today, even if the market is higher. If I were to weigh Microsoft's growth prospects with its potential loss of business to Linux (a high probability there), then there seems little chance of much growth. On this basis, the stock, trading at around an eight times its price-to-sales ratio, is priced too high.
It's a rough period for any stock when it shifts from a growth- to income-oriented class. In the absence of a fundamental catalyst to propel this company higher, I'd expect its valuation to continue to deflate, as share ownership continues to shift.
For related Foolishness:
Mathew Emmert of Motley Fool Income Investor has been keeping an eye on Microsoft as of late. To see some of his most recent selections, click here.
Fool contributor Melanie Hollands does not own shares in any company mentioned.
