Microsoft struggles to regain former growth

Reporting from Seattle —  A quarter-century into its career as a publicly traded company, Microsoft Corp. finds itself a prisoner of its own past success.

The company continues to grow top-line revenue, but at a slower pace than in the glory days of the late-1980s and 1990s. Its profitability would be the envy of most other companies, but operating margins have gradually declined for most of the last decade.

Investors worry that Microsoft’s missed opportunities in smartphones and its late entry to the tablet market threaten its core Windows and Office businesses — the sources of most of the company’s value. And any new business lines, no matter how successful, almost inevitably would be less profitable than Windows and Office.

The result is a stock that has been so persistently undervalued for the last decade that it looks more like a bond — no longer a stock young people buy to get rich but one retirees buy to stay afloat.

“It’s certainly not valued as a growth company,” said Sid Parakh, an analyst who follows Microsoft for Seattle’s McAdams Wright Ragen brokerage. “Could they become a growth company at some point in the future? The potential is there, but for them to deliver on it they really need to execute.”

The company has high hopes for its smartphone partnership with Nokia, tablets running the future Windows 8 operating system and the hosted software and services business that goes by the moniker “cloud computing.”

In the wake of several recent high-profile announcements of corporate split-ups (Abbott Laboratories, McGraw-Hill Cos., Sara Lee Corp., Tyco International Ltd.), some investors may renew calls for Microsoft to spin off one or more business lines or split itself up entirely.

But even though a split-up might unlock some value — in the server-software and tools segment, for instance, or the Microsoft Dynamics business-software operation — company management insists that its various product lines support one another.

Nor would a breakup address the fundamental force holding back Microsoft’s share price: doubts that Windows and Office will be able to continue generating cash at their historical rates, or that the company will find any similarly big, high-margin successor.

“What some investors are saying is, ‘Hey, you’re so reliant on two businesses to drive your operating profitability, and in one of those businesses you’re falling behind,’ ” Parakh said.

With a few brief exceptions, Microsoft’s shares have traded in the mid-$20s for most of the last decade — a price that almost certainly undervalues the company.

Using standard valuation metrics to put a price tag on the company and estimate how much each of Microsoft’s five operating segments contributes to its overall value, the company has an overall enterprise value of $399.3 billion, which implies a fair-value share price of about $47 — well above what Microsoft stock has been trading at. The shares closed Friday at $25.30.

Microsoft’s Business Division, which includes Office and Dynamics, accounts for more than half the company’s total enterprise value. The Windows unit accounts for more than a quarter, while the Server and Tools segment adds 14%. Everything else — the Xbox gaming platform, the Bing search engine, MSN, Windows Phone — contributes negligibly to Microsoft’s value.

This analysis probably overstates Microsoft’s value because it is based on revenue and operating income for the last four quarters, while professional analysts and investors use projected future financial results. Still, most outside analyses peg the stock’s fair value in the low $30s.

And there’s no doubt that most of the earning power, and hence the value, of Microsoft remains with the Windows and Business divisions. In the last 12 months, for example, the Business Division generated $14.4 billion in operating income and Windows kicked in an additional $12.2 billion. Together, they accounted for nearly all the company’s operating earnings, as smaller profits in the Server and Tools and Xbox units were mostly offset by losses in online services and general corporate expenses.

Still, with two such powerful cash engines strapped to its wings, why is Microsoft valued by shareholders at so much less than comparable firms? The main reason seems to be skepticism that those two engines will continue to pump out cash at the rates they have been — combined with dismay at management’s apparent slowness in responding to new competitive threats.

Take smartphones, which more people are using to surf the Web, check email, play games and do other things they once needed a PC to do. Early on, Microsoft was one of the leading vendors of smartphone operating systems, but it has lost much of that ground to Apple’s iPhone and Google’s Android system. Research firm Gartner Inc. estimates that Microsoft captured less than 2% of global smartphone sales in the second quarter.

But the company, and some analysts, have high hopes that the situation can be turned around, especially with the release of Windows Phone 7.5 (code name: Mango) and Nokia’s decision to base all its new smartphones on Microsoft’s system. Research firm IDC predicts Windows Phone will capture 20% of the smartphone market by 2015.

“They’re late, but there’s still time for them to get back in the game,” Parakh said. “There’s still a lot of growth potential in smartphone.”

DeSilver writes for the Seattle Times/McClatchy.