Microsoft: a hated stock with a low downside, high upside?

• Microsoft is currently “uncool” and its stock is underpriced
• New Surface tablet may be a hit, take market share from iPad and Android
• Wave of new non-MSFT tablets will run MSFT’s Windows 8
• Bond-like Windows revenue continues; Server, Business divisions growing

Microsoft, which is reporting its Q1 results today, is shrouded in pessimism and has been since the iPad came out. 

Actually it has probably been shrouded in negativity since 2000 when the tech bubble popped. Microsoft has never regained the ridiculous valuation of around 40 P/E that it reached in 1999.  Since many people look at price charts to make investment decision, looking at Microsoft’s 10 year price chart makes the company look like a dud.

But if you look at something more important like EPS growth, a quick look at the chart above shows that Microsoft’s EPS is 300% more than it was in 1999. The current Microsoft P/E is 10.  If the company had been priced at a P/E of 10 in 1999 like it is currently, the stock would have returned 300%  in 12 years given a similar valuation!

So how is Microsoft going to break out of its ‘dead’ stock slump?

Two things have a potential to shake up the world’s view of Microsoft.  One is its new Surface tablet, and the other is the wide palette of Windows 8 tablets, which have the potential to open up a new revenue source for the company.

Firstly, if the Microsoft Surface is proclaimed a success, it might help to redefine the company in the eyes of investors (as we speak the base model of the Surface RT has actually sold out in less than 24 hours!). Although many analysts see the Surface as just another revenue source, if the Surface is done correctly and considered to be a strong rival to the iPad, perception of Microsoft might slowly change. I currently believe that Microsoft is being undervalued due to a perception that the company is a clunky, slow moving giant, ill-equipped to compete with the likes of Google and Apple. Therefore a simple change in perception might easily boost the stock simply by a revaluation of the company’s prospects.

Windows 8 will open huge market

Second and most importantly, Windows 8 will open a huge market for Microsoft. Currently Microsoft has for all intents and purposes a 0% market share in the tablet sector. Current forecasts for tablet shipments of Windows 8 seem very pessimistic, with a 6% market share by the end of 2013 according to IDC. And even worse is the expectation that Windows will only have approximately a 15% market share in tablets by 2016. An increasing market share in an increasing segment is always good but these numbers seem excessively negative and this is why:

Goldman Sachs analysts believe that Microsoft will produce and sell around 15-20 million Surfaces from now until the end of 2013, or 10-15 million in 2013 alone. These 10 million of unit sales would equal to about 6% of total expected tablet sales for 2013 (160mn). 

But as I said above, IDC believes that Windows will only have a 6% market share of tablet sales in 2013  including the army of OEMs who are about to unleash a plethora of Windows 8 tablets/hybrids/convertibles unto the market place.

If Goldman did its homework and the Surface numbers are accurate, the IDC numbers will be completely wrong since the Surface itself will account for the entirety of its projected Windows market share in tablets.

There is an argument that Windows 8 tablets could cannibalize regular laptop sales, but the argument can also go the other way, as such touch laptop (hybrids and convertibles) sales could take a chunk of the non-Microsoft tablet market. Either way, Microsoft’s Windows division starts growing again and earnings go up, and Microsoft wins. The chart below, provided by ComponentArt, highlights how much Windows could potentially impact this ever growing pie. (For a good article why the IDC number are possibly wrong go to ComponentArt).

So for any contrarian, this is the perfect stock. An underpriced company, which is at the least not very well liked, which is about to enter a brand new market with a huge potential. Now, I am not so bold to assume that I know if Windows 8 will be a success and a force in the tablet sector, but at least I can understand the huge potential that Windows 8 could bring to the PC industry.

What if I am wrong?

If I am wrong and Windows 8 tablets and the Surface massively disappoints, Microsoft might break even on the Surface. Meanwhile, the Windows division will keeps trotting along and continues to generate 12 billion in operating profit per year with zero growth in PCs and laptops . If you add the bond-like revenue of Windows and add the Server and the Business divisions growing at around 15% and 7% respectively, with stock trading at a FY1 P/E of 10, you still get a decently priced investment.

So basically if Windows 8 tablets just fail to catch on, the company has very little downside, since expectations are already so low. But if I am correct and Windows 8 and the Surface are relatively successful, you will see Microsoft grabbing a significant portion of the high-growth tablet market. A market that up until October 26^th was generating no earnings for the company, the stock might will jump to reflect more truly the intrinsic value of the company.

In times of uncertainty, a stock with low downside risk with a high upside is always a good trade in my book.