Buy, Sell or Hold: With $44 Billion in Cash and a Focus on Shareholder Value, It's Time to Buy Microsoft Corp. (Nasdaq: MSFT)

The last time I recommended Microsoft Corp. (Nasdaq: MSFT), Bill Clinton was in the White House. But it's time to take another look at the "cash-flow-engine" that Bill Gates built - and to explain why Microsoft is a "Buy" in today's stock market.

Microsoft is one of the safest investments in the world, but the software giant's stock price has done essentially nothing for the last 10 years. But the company is still a monopoly, has no debt, and continues to generate a torrent of cash.

In fact, Microsoft now has one of the largest cash hordes in the history of capitalism - more than $44 billion, and growing.

So what's different? What's the catalyst that promises to break this giant out of its somnambular state, to make its shares a "Buy?"

The answer is very simple: For the first time in a long time, Microsoft is making a clear, and concerted commitment to boosting shareholder value. In fact, it's doing so in three areas. To boost shareholder value, Microsoft is:

  • Looking at such shareholder standbys as share buybacks and dividend increases.
  • Combining unique business strategies with new business opportunities to defend its core strengths.
  • Looking to capitalize on the historic low-interest-rate environment to add leverage, a strategic way of further enhancing shareholder returns.

Let's take a look at each of these.

The "New" Microsoft

With a cash hoard that's at $44 billion - and growing quickly - Microsoft already pays out a steady diet of dividends to its long-term investors. But company executives want to see those payouts increase. And a strong, ongoing financial performance will make this possible.

In its most recent quarterly earnings report - in the face of one of the toughest economic backdrops in the company's history - Microsoft said its fiscal-first-quarter earnings soared 52%, easily outstripping Wall Street estimates. Even revenue advanced a staggering 25%, exceeding $16 billion for the first quarter.

The results were driven by a broad adoption of the newest version of its Windows operating system - Windows 7 - and by strong sales of its Office software suite.

I mentioned that Microsoft is employing "creative" strategies to defend - and build upon - its key strengths in its core businesses. Well, the company has also tossed its hat into the ring in the "smart-phone" market that's dominated by iPhone-maker Apple Inc. (Nasdaq: AAPL). In the view of many observers, this was just another example of Microsoft attempting to reach beyond its core software business by grabbing a handhold in a new business - just as its done in the past with Internet search, computer gaming, cable TV and some of its other ventures.

Investors who believe that, however, are overlooking a very important distinction that makes this an entirely different initiative. You see, these onlookers have failed to understand that the "smart phone" has become the "mobile desktop" of choice for businesspeople. Microsoft's core competency isn't software - it's the desktop. By rolling out its Windows Phone 7, Microsoft is actually employing a unique and creative business strategy to defend its desktop business.

In my mind, that shift into smart phones is a stroke of creative genius.

While all of the above is great, here's the real key: I believe the fact that Microsoft is considering ways to unlock extra yield for its investors via increased stock buybacks and steady escalations in the company's dividend payout.

There is an additional way to unlock even more yield during this process that I want to share with you.

Balance Sheet Maneuvering

It's the dividend that caused me to return to Microsoft and give it a new look. The company has made it clear to Wall Street that it is interested in leveraging up its massive balance sheet with new debt. The company can use its "AAA" credit rating to borrow money that can be used to unlock shareholder value.

But the key to this plan is Microsoft's hefty and predictable cash flow. It took a hit product to make that a reality.

The company released Window 7 - the answer to its much-panned "Vista" operating system - in mid-2009. A significantly friendlier operating system, Windows 7 has enjoyed brisk sales, given that Corporate America was finally willing to abandon its aging Windows XP desktops.

In fact, the acceptance has been so strong that the shift to Windows 7 has actually turned into a "product-event cycle," with companies starting to upgrade their entire computer systems. This has made it clear that Microsoft will have the predictable, long-term cash flow it needs for many years to come.

In fact, it is this diet of cash that makes Microsoft so interesting in today's economy. The company can borrow money via the debt markets almost for free. When it comes to enhancing shareholder value, this predictability gives Microsoft a lot of options that other companies don't have - including steady dividend increases and a larger share-buyback rate, both of which are under consideration.

Moves to Make Now

These two events will help increase the yield on shares held by an investor. However, there is another way to increase the yield on holding Microsoft shares. I'm talking about "covered calls."

If you own shares of a company like Microsoft, you can write short term slightly out-of-the-money covered calls on your current position. Each call is for a block of 100 shares. You can generate a little extra income from these options if they expire out of the money. If the stock rises above your strike price on the options expiration, your shares will be placed with the holder of the covered calls you wrote.

When you look at a chart of a stock like Microsoft, you are looking at one of the best covered-call stocks available. Over the past 10 years, the stock price has been very stable. Microsoft is so huge that its share price is not going to advance at a fast pace from here. So we don't have to worry about a major stock move happening when our position is covered.

That allows us to focus on generating extra income without fearing that we are going miss a major share-price move.

And if our shares are called away, we can just go back into the market and replace them and start over.

Let's do a quick review why Microsoft is a "Buy" for our long-term portfolio:

  • It had a great quarter, with earnings up 52%.
  • It has a stable dividend, which is expected to grow from here.
  • Microsoft has more than $44 billion in cash on its balance sheet, and can leverage up its AAA-rated balance sheet with cheap debt.
  • The company has a newfound commitment to increasing shareholder value.
  • And Microsoft's share price is stable, permitting us to employ a "covered-call" strategy.

In an economy where companies are worried about merely maintaining their dividends, Microsoft is actually worried that it's not paying enough attention to its shareholders. Let's have Microsoft worry about us, and pay us for being a patient and loyal investor of theirs.

Microsoft shares closed at $26.85 each on Friday, down 1.07%. They are trading right in the middle of their 52-week range of $22.73 to $31.58. The dividend yield is a respectable 2.38%, while the Price/Earnings (P/E) ratio is 11.5.

Action to Take: "Buy" Microsoft Corp. (Nasdaq: MSFT) at the market, and add it to our long-term portfolio of dividend-producing stocks (**).
It's going to be increasing its current 2.38% dividend yield, and buying back shares, which will have the effect of boosting its per-share earnings (EPS) over time.

For a slightly improved yield, once we have our shares, let's look to sell some "covered calls" for strike prices around $30.00 that expire in December.

(**) Special Note of Disclosure: Jack Barnes holds no interest in Microsoft.

[Editor's Note: If there's one thing top global investors understand, it's that you have to "follow the money" to reap the benefits of the best profit opportunities that are available at any one time. Money flows point out the next profit opportunities. Sometimes that means "following the money" from one sector to the next. Other times that means moving from one geographic market to another.

To make those moves successfully, investors need a compass or, better yet, a guide. And successful investors will tell you, one of the best guides out there is The Money Map Report.

This monthly advisory service - an affiliate of Money Morning - employs many of the same experts whose columns you read here each day. The difference is that The Money Map Report's straight investment analysis. Our writers use proprietary money-flow indicators to identify and isolate the most timely profit opportunities you'll find anywhere. For more information about The Money Map Report, please click here.]

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