Is Microsoft still a good investment?  Or is it the beginning of the end for the software company?

Are they about to go the way of the Dodo bird?  Or Eastman Kodak?  Or Wang Labs – one of the biggest office computer makers of the eighties – long since sunk without a trace.

These are great questions to ask because the news about Microsoft of late hasn’t been that great.  Consider this…

·         Microsoft’s profits at $0.59 were lower than the lowest estimate ANY analyst had for it at $0.61 a share.

·         Their share price recently took a whopping 10% dive – all in one day.

·         The Surface Tablet version 1 was a failure that cost nearly $1 billion to write off.

·         Windows 8 is considered a dud, and market research firm Gartner says that 90% of companies globally have no plans to deploy it in a big way.

·         Even university adoption rates of Windows 8 have been dismal, with International Data Corp’s PC Tracker showing the highest adoption rate at an anemic 5.9% at Rice University.

But all those facts considered, I don’t believe it’s the beginning of the end for Microsoft. And even if it is, they will continue to be around for a long time.

The Financials Still Look Great

Because despite the flurry of bad news, Microsoft’s quarterly sales, at $19.8 billion, were up 10% over the same quarter last year.  And their annual sales for the fiscal 2013 year just ended, were up 6% over last year, at $77.8 billion.  And on the profit side, Microsoft’s reported earnings are up against last year as well.

Equally on the plus side, Microsoft’s Tools & Server business grew sales by 9% and operating profits by 14%.  And its cash monster Microsoft Office, the suite of desktop applications software, saw sales grow by 14% and operating income by 18%.  All of this leading to an increase in cash on their balance sheet of $14 billion, from $63 billion to $77 billion.  Which means nearly $10 of the $31 dollar stock price is represented by cash.

Future Challenges

But there are challenges to Microsoft’s thriving PC business which it has benefitted from for many years.  A recent CNBC Financial segment reported that personal computer sales plunged 14 percent in the first three months of the year.

And International Data Corp, a leading tech tracking firm, indicates this is the steepest sales decline in the two decades since they started publishing numbers in 1994.  As buyers move away from PC’s to mobile devices like tablets, they appear to be avoiding Microsoft’s new Windows 8 operating system, which comes preinstalled on many new PC’s.

So Microsoft will have to adapt in the future as consumers move away from PC’s to the newer, mobile tablet touchscreen devices.

The Tablet IS Important

Microsoft, and other industry leaders such as Intel, are struggling to transform themselves to tablets and whatever else comes after PC’s.  Which means figuring out the tablet business is going to be key to them growing in the future. 

That’s why, even though their first steps caused a major write-down, Microsoft has entered the market in the past year with two tablet devices, the Surface RT and the Surface Pro.  Sales for both tablets combined accounted for 900,000 units sold for $863 million in revenue during the last quarter.  But Microsoft had to take a $900 million write-down due to unsold inventory and higher than expected related expenses.  And they have a lot of catching up to do when compared to the leader, Apple, who sold 22.9 million units of iPads, their competing products, in the same quarter.

But Microsoft’s failure with the Tablet seems to be more with marketing and sales execution than with their actual tablet products.  For example, marketing missteps like no price mentioned for months after the initial announcement, and initially only offering the tablets for sale in Microsoft stores, of which there were 20 in total at the time.  That’s not great execution for a product rollout, and so their tablet business was deemed a failure.

However, concerning the actual product itself, initial interest in their announcement and marketing videos on YouTube was so high that potential customers were literally emailing the Microsoft web site and telling them to “shut up and just take our money.”  So Microsoft has renewed their efforts with a recently announced a $100 price reduction on both tablet versions, and it looks like they’re serious about another go around.  And with $77 billion in cash on the balance sheet, you could say that they can afford a few strikes to get it right.

But Windows 8 Is Not As Important As Servers and Office Software Business

The low consumer enthusiasm for Windows 8 in the IDC study is related to the tablet too.  Past Windows operating systems have used drop down menus and mouse clicks for navigation around the screens.  But tablet and iPad users are used to navigating by touching and swiping icons on a screen. 

So Microsoft tried to combine both navigation methods into Windows 8 with their Metro user interface.  The main problem stems from power users, who are not using a touch screen, and are still relying on menus and mouse clicks for navigation.  They find themselves bedeviled at times after landing on screens with no apparent way to navigate to another screen. 

So there has been disappointment.  But Microsoft has promised a future release to address some of these issues.  And still, with all the complaints, projections are that they will sell 100 million copies of Windows 8.

Even so, the Windows 8 story is not nearly as important as it seems.  Because over 72% of their operating income stems from the Microsoft Business Division and the Server and Tools Division. 

The Microsoft Business Division has the cash-gushing Office suite of products, like Word (word processing), Excel (electronic spreadsheet), Outlook (email), and other application software.

These products are used by one billion people around the world.  Indeed, this report you are reading was written using Microsoft Word, the calculations were made in Excel, and collaboration with the Chapel Hill Letter team done through Outlook emails.  So these products are pervasive.

Consider also that distribution costs of software products like these are low, so once the initial development cost is recovered, every unit sale after that is virtually pure profit.  Meaning that it’s not hard to generate cash when what you are selling for $149 to $399 costs almost nothing.

There’s A Solid Business For The Server Division As Well

And there’s a solid business for the Server Division’s products as well, which are used by businesses large and small.  Interestingly, you and I use server software products every day, although we are mostly unaware of it because it is “behind the scenes” software.  But every time you go to a company’s web site, the information it displays back to you had to use this kind of server software to retrieve the information.

And companies have had to invest literally thousands of man-years into development in their server and database programming code.  So those using Microsoft server products will not make a change away from Microsoft on a whim.  Indeed, this captured market aspect is the epiphany Warren Buffett, one of the world’s greatest investors, had when he finally quit avoiding investing in technology stocks.

So What’s The Bottom Line?

It’s true that Microsoft has some challenges with tablets and the Windows 8 operating system.  But Microsoft is a cash rich company with at least two solid, growth businesses.  And at a share price of around $32, they are selling for 9 times earnings.  And if you take out the cash on the balance sheet, the valuation story gets even better.

But accounting assessments aside, just compare their price / earnings to the current S&P 500 mean PE of 15.5.  Were the market to value this cash gushing company at that average ratio, their stock would be trading for over $53 a share, which indicates just how undervalued they are.  Add to that a growing dividend of 2.9%, which has increased eight out of nine years, and it sounds to me like Microsoft is going to be around for a long time.

So if you are looking for a good long term investment, consider buying them at the current price, around $32 a share.  And if you currently own them, I would hold the shares.

Action to take: Buy Microsoft (NASDAQ: MSFT) for about $32 a share.