Is Going Long Microsoft Another Bad Ira Sohn Conference Idea?
The Ira Sohn has been a source of interesting ideas that have not always panned out. In 2010, another hedge fund honcho, Steve Eisman, recommended that investors bet on a decline in stocks in the for-profit education industry. As I posted in June 2010, the case he made regarding the shoddy business practices in the industry was compelling.
Eisman's key allegation was that for-profit education companies used aggressive tactics to enroll people in programs they could not afford while borrowing money from a government program. The for-profit education companies, however, did not suffer when the newly enrolled students -- most of whom did not pay back their loans -- defaulted.
Eisman believed that the Department of Education was going to crack down on these business practices and make it much harder to get those government loans. While stocks of companies in the industry did decline, they are pretty much back to where they were a year ago -- based on the reality that things did not turn out as badly as Eisman had thought. For example Bridgepoint Education (BPI) fell from $23 in May 2010 to about $13 in August and now stands at about $23.
This suggests that Eisman mis-calculated -- shockingly enough, Bridgepoint stock rose 15% on Wednesday after it was named the best investment idea at the Ira Sohn conference Wednesday. A year ago Bridgepoint was touted as a short -- yesterday, as a long. I guess some people have short memories.
So you should take with a grain of salt Einhorn's comments on Microsoft (although his 9.1 million shares show that he is putting some money where his mouth is). On Microsoft, he made funny comments that its CEO, Steve Ballmer, is like Charlie Brown, a perpetual loser.
But that's not really news. As I posted in June 2006, when Bill Gates retired as CEO, the stock had been dead money for the preceding five years -- falling from about $57 at the end of 1999 to $22. Since then its stock has stayed dead -- having risen to an unimpressive $24 -- a five year annual growth rate of 1.75%.
In the past five years under Ballmer the market has lost interest in the stock -- even though some measures of its financial performance have improved. For example, its return on equity has risen from 25.5% to 40.6% from 2006 to 2010 while its net margin declined just slightly from 30.8% to 30%. Meanwhile, Microsoft's Price/Earnings ratio tumbled from about 22 to 13 (it was 46 10 years ago).
My interpretation is that Microsoft sales growth is too slow to interest investors. In the last five years, Microsoft sales have risen at a 9.5% annual rate -- far below the applications software industry growth of 14.1%. And that industry average is way below the far more interesting comparable growth rate for Apple (AAPL) -- 36.2% that has contributed to Apple's 41.2% 10-year average annual stock price appreciation.
Microsoft generates plenty of cash thanks to its dominance of PC operating systems and office applications. Alas, the world is moving away from PCs and onto wireless devices and social networks. And as Einhorn told the Sohn conference, Ballmer's “allowed competitors to beat Microsoft in huge areas, including search, mobile-communications software [its market share there has tumbled from 6.8% to 3.6% in the last year], tablet computing and social networking. Even worse, his response to these failures has been to pour tremendous resources into efforts to develop his way out of these holes.”
Yet Microsoft's recent profit performance has not been all that bad. In its third quarter ending April, revenue was up 13% to $16.43 billion -- 1.4% above estimates -- while operating income climbed 10% to $5.71 billion as net income spiked 31% to $5.2 billion. And its earnings per share of $0.61 were five cents ahead of estimates.
This overall performance masked variations among the divisions. Microsoft's online service lost money and its Windows unit suffered a 7% sales decline on weak PC demand. But its gaming division enjoyed a 60% revenue pop on the sale of 2.4 million Kinect game controllers. Its office software division enjoyed a 21% sales increase; and its server and tools division saw an 11% sales boost.
To Ballmer's credit, the gaming division is one area where Microsoft's investment in new businesses has paid off. I'd advise Microsoft's board to spin that off because the rest of Microsoft's moribund businesses are masking its exciting growth prospects.
But for the time being, investors don't have that choice. So should you go with Einhorn on Microsoft? To think about that, we can look at its price-to-earnings-to-growth (PEG) ratio — a way to determine whether the value that the market assigns a stock is justified by the rate at which it expects the company’s earnings to grow. I think a PEG of 1.0 is a fair price, and anything below that is a bargain.
Microsoft trades at a low PEG of 1.35. Its P/E is 9.6 on earnings forecast to grow 7.1% to $1.76 in 2012. This stock is not over-valued but at that PEG ratio, it does not offer anything to get excited about -- unless a 2.65% dividend yield makes your day.
If Microsoft's board could spin off its gaming division and put Ballmer in charge -- then let Steve Jobs run the rest of Microsoft, this stock would look exciting. But that will never happen so for all the media attention that Einhorn's Ira Sohn plug received, Microsoft is likely to remain dead money.