Microsoft (MSFT) may be large and very profitable, but it has been on a steady decline over the past decade. The company peaked at over $600 billion in market cap in 1999 and is now valued at $250 billion (a loss of over $350 billion in value). Microsoft’s loss in market capitalization is higher than the value of any company today, to put that into perspective.

During the dot com boom, many companies started to create cloud based applications to power everything from business applications to email, and for the most part they failed. Today, more and more applications are moving to the cloud, and users are getting comfortable doing just about everything via the web, enabling access from an ever growing number of devices.

Microsoft is in an interesting place right now. The company has a huge windows and office business that is being attacked from all sides by Google (GOOG), Apple (AAPL) and open source software vendors.  Microsoft is a company without a clear vision, even though they have products that most of us still use on a daily basis. We think Microsoft will figure it out, but it is likely to lead to lower margins and a continued drop in market cap.

Let’s look at how the company is performing financially.

Top Line Growth

Microsoft announced revenue of $19 billion for the second quarter ending 12/31/09. Microsoft’s revenue increased 14% YoY.

“Exceptional demand for Windows 7 led to the positive top-line growth for the company,” said Peter Klein, chief financial officer at Microsoft. “Our continuing commitment to managing costs allowed us to drive earnings performance ahead of the revenue growth.”

Windows and Windows live managed to grow at nearly 70% YoY based on the strength of Windows 7.  The Server and Tools division was up over 2% but all other divisions posted YoY losses in revenue.

Profit margins improved in all divisions except online, which continues to lose money, but the long-term trend is down.

Valuations

Microsoft’s PE has also trended down over the last decade with profit margins. Right now, MSFT trades at less than 13 times next year’s estimates.

Conclusion

So what happens now? MSFT is a company with declining margins and lots of new competitors vying to disrupt its dominance in operating systems and business productivity applications. The market isn’t very optimistic in Microsoft’s ability to turn things around, given the low multiple being put on the company. We would avoid the stock until the company clearly articulates a strategy to address macro trends to cloud computing and open source software that doesn’t cannibalize its existing business.

As you are aware from the barrage of TV commercials, AT&T (T) and Verizon (VZ) are both vying for the growing wireless market with new phones, claims of the best wireless coverage and now dropping prices.

The charts below show why the fight continues to get more aggressive in the telecom industry.  The CAGR is expected to grow at a respectable 6.6% between 2007 & 2012.  Wireless is the largest segment and expected to grow from 47% of total revenue to over 56% by 2012. The total opportunity for global wireline and wireless revenue is projected to expand from $1.65 trillion in 2007 to over $2.27 trillion in 2012.

In addition, new entrants like Apple (AAPL) and Google (GOOG) are adding pressure as they rip down the walled gardens that have existed for too long and focus on consumers.  Apple’s goal is to sell hardware and apps while Google focuses on ads.  Gartner just released a report that estimates that Apple was responsible for 99.4% of mobile app sales in 2009.  AT&T and Verizon should have owned this market.  In any event, consumers are winning with better phones, more services, options and ultimately lower prices but this isn’t necessarily good for AT&T & Verizon.

Industry Overview

Wireless Accounts

Wireless is the most important category with the largest long-term opportunity for the carriers.  Verizon grew retail customers to over 86 million in Q309 and added 1.2M accounts.  Average revenue per user (ARPU) was 52.78.  See Verizon full report here.  AT&T has ~82 million wireless subscribers and an ARPU of $61.23.  AT&T added 2 million subscribers in Q3.

Revenue Growth

AT&T’s growth in revenue is closely correlated with the introduction of the iPhone.

iPhone on Verizon

2010 should get even more interesting as Verizon is expected to carry the iPhone and many users that have been frustrated with AT&T’s coverage may be all to excited to switch. Verizon’s red map commercials have been pretty effective in convincing AT&T customers that Verizon will allow you to use the iPhone as a phone.

Long-Term Growth

The chart below shows Verizon’s growth over the last 10 years.  Revenue grew by over 228% in the last decade but net income only grew .17%.

AT&T performed better over the last decade with revenue up 297% and net income up by 150%.

Capital Expenditures & Profitability

Both are spending heavily on CAPEX with Verizon spending 126% of operating income and AT&T at 85%.

AT&T’s profit margin consistently more than doubles Verizon’s in the 10% range.

Stock Performance

If you have owned either company over the last decade, you have seen the stock price drop considerably but the dividend has provided some relief.

Conclusion

The established telecom players could go the way of newspapers if they aren’t careful. Mobile usage is expected to explode over the next decade with lots of companies keen on disrupting the market.

AT&T and Verizon should stop focusing on each other and turn their attention to the consumer. Otherwise, you might see Apple, Google or some other player radically disrupt the entire industry more than they have to date.

AT&T is currently valued at nearly $152 billion with Verizon near $85 billion.  Like the overall the telecom industry, AT&T and Verizon generate lower profit margins, on large debt, with declining wireline businesses and high SG&A expenses.  In general, these are not the characteristics that drive strong earnings growth or strong stock performance.

The macro theme for the wireless space is extremely positive and we expect lots of innovation and some great investment opportunities.  However, AT&T and Verizon have not proven that they can adapt at this point and we are avoiding the stocks as a result.

You can access full telecom industry metrics or setup your custom watchlist here.

The S&P 500 ended the year up over 26%.  Technology led the way posting a 60% return for the year with Google, Microsoft and Apple all adding ~$100 billion in market cap in 2009 or ~$274 million a day.

Apple (AAPL) was up ~150%, Google (GOOG) up over 100%, and Microsoft (MSFT) up over 60% for the year.  We analyze the key business metrics below to evaluate that attractiveness of the companies as we move into 2010.

Market Capitalization

Microsoft’s Market Cap is the largest at $276 billion up from ~$173 billion at the end of 2008.  Google’s Market Cap is approaching $200 billion up from ~$97 billion at the end of 2008.  Apple’s Market Cap is now $190 billion up from ~$76 billion at the end of 2008.

Growth and Profitability

Apple continues to have the strongest top line revenue growth at 25% YoY. Google’s revenue is up 7% YoY and Microsoft dropped 14%.   See revenue growth chart below.

Apple’s revenue is driven by innovative products including the iPhone, Mac and expectations are high for the iSlate tablet.   Google’s revenue growth has declined steadily as the search business matures and it has been unable to find a new revenue source beyond text ads.  Microsoft’s issues have been well documented but they do have the Windows 7 release that should improve revenues.

Gross Margins

Microsoft generates the highest gross margins at 78%, Google is consistently 63% and Apple is 37%.  See 10 year trends below.

Research & Development

Microsoft and Google both spend about 20% of their profits on research and development with Apple at just under 10%.

Profit Margins

Microsoft and Google have both consistently delivered profit margins in the 25 to 30% range.  Apple’s margins are lower at ~17% but have risen for the last 5 years with higher margin product launches like the iPhone.

Net Income

Microsoft more than doubles both Google and Apple in terms of net income but you can see that the difference is getting smaller as Google and Apple continue to grow at a faster pace.  Check the indexed chart to compare the growth rates.

EPS

The chart below shows the indexed EPS values beginning Q105.  You can see that Apple has grown EPS the fastest at 435% with Google at 298% and MSFT at 74%.  EPS has the highest correlation to price and explains why Apple has outperformed both Microsoft and Google during this timeframe.

Cash on Hand

All three companies have enormous cash positions.  Google has been the most opportunistic on the acquisition front but you would expect Microsoft and Apple to do more deals given their large cash piles and higher stock prices.

We see that all 3 companies have strong and consistent margins with Microsoft and Google having stronger margins but weaker on the top line than Apple.  Let’s move to valuation.

Valuation

Google’s TTM PE Ratio is over 40 with top line revenue weakening.  This includes Q408 which looks like an aberration.  Analyst estimates are for Google to earn $26.42 next year which gives you a 23.47 forward PE and YoY revenue growth of 17%.  Google is trying everything to grow top line revenue including acquisitions, Chrome browser, Chrome OS, mobile hardware and software.  Time will tell if they can enter these new markets successfully and diversify its revenue stream.  Google will continue to deliver strong profits but the growth story is concerning and the multiple looks a little rich right now.

Apple’s PE is over 33 but top line revenue growth is strong.  Analysts expect Apple to earn 7.81 this year ending Sept which gives you a forward PE of 27.  Revenues are expected to increase 23% YoY.  Apple is approaching our fairly valued price of $220 to $230 in the near term so we would not be adding to positions here.

Microsoft has the lowest PE Ratio at just under 20 with weak top line growth but it appears to be stabilizing and Windows 7 should improve things.  Analyst consensus is for 2.7% revenue growth in the year ending June 2010 and 8% in 2011.  The forward PE for the year ending June 2011 is ~15 based on 2.09 EPS estimates.  We see fair value in the $30 to $35 range.

Conclusion

Microsoft, Google and Apple have all had $100 billion plus increases in market cap during 2009 but continue to get into each others’ markets which should be good for consumers but may hurt margins over time. They are all trading near our fair value estimates so the upside may be limited in 2010 given the huge runs experienced last year. We would hold positions but not be adding at these levels.

Disclosure: Long GOOG, AAPL

You can access all fundamental, growth and valuation rankings here.

2009 has turned out to be a great year for equities especially after the financial meltdown we experienced.  The federal reserve continues to liquify the system and low yields are forcing investors into higher yielding equities.

The S&P 500 is up 21.3% YTD as of November 30.  The index leadership driven by consumer discretionary stocks is up 33%, materials up 43.21% and technology up 51.46%.  December is off to a strong start and analysts are now upgrading companies that led the ‘09 recovery.

Yields on 10 year treasuries are down to 3.21% and near historic lows.  Below is the long-term treasury yield curve. The red line represents current levels.

Let’s look at the earnings yield for the top 10 most valuable U.S. companies to gauge the attractiveness of equities vs risk free bonds.  The table below shows the top 10 U.S. stocks based on market capitalization with their net income for the TTM and theoretical risk free return.

8 of the 10 companies above are returning earnings in excess of the return you would generate from buying 10 year treasury bonds.  The risk free return is calculated by taking the companies market capitalization times the 10 year treasury yield.

For Exxon Mobil, you could buy the entire company for $360 billion dollars and generate $21.05 billion in earnings.  The other option would be to buy $360 billion in 10 year treasuries yielding 3.21% which would generate $11.55 billion a year.

You can also see this by looking at the XOM earnings yield below which is at 5.67% and above the 10 year yield.

Earnings yields for Microsoft (MSFT), Wal-Mart (WMT), Procter & Gamble (PG), British Petroleum (BP), Johnson & Johnson (JNJ), General Electric (GE) and International Business Machines (IBM) are all yielding above treasuries.  The two stocks that appear to be yielding below treasuries are Google (GOOG) and Apple (AAPL).   Both stocks have outperformed the markets by a wide margin and could be getting fairly valued in the near term.

With Google, you could buy the whole company for ~$184 billion which generated $4.93 billion in net income over the TTM but if you bought treasuries you would generate close to $6 billion.  So treasuries are a better investment right?

Keep in mind that Google took a $1.1 billion hit in Q408 for asset impairment charges related primarily to investments in AOL and Clearwire.  Google continues to make acquisitions and Eric Schmidt has indicated that they plan to be more aggressive moving forward.  Google acquired YouTube, DoubleClick, dMarc, AdMob, Feedburner and many other smaller companies with less than stellar results.  If you add back the Q408 impairment charge you get to company earnings which are above the equivalent risk free yield.

Time will tell if Google can invest its cash wisely.  This is one of the key questions for investors given the maturity of the search business and the fact that Google already dominates the market and generates the vast majority of it’s revenue from text ads.  The chart below shows Google’s unique visitor count for the last 12 months.

Apple is another high-flyer with a current earnings yield of 3.14%.  This looks like another case where treasuries provide a better yield.

However, if you are an investor in Apple you know that subscription accounting rules make this a little more challenging to figure out.  Reported GAAP figures widely understates Apple’s performance.  Therefore, investors should focus on the non-GAAP numbers.  Apple generated $8.3 billion in non-GAAP earnings over the TTM which is also above the risk free return for AAPL.

In general, earning yield provides a simple way to make comparisons but it is only a starting point.  Often, as is the case with GOOG and AAPL you have to dig deeper to get the real comparison.  Try evaluating your investments versus less risky assets like the 10 year.  Take note of where the companies are in the earnings valuation cycle. You can see from the AAPL and GOOG charts above that earnings yield has often provided good buy and sell signals.

Final note, if the yield on treasuries return to more historical norms these comparisons become harder.  Treasury yields would have to move up 100+ basis points to start becoming more attractive than the equities mentioned here.  You can access full fundamental stock rankings including earnings yield here.

Yahoo managed to surprise the street after the bell with better than expected earnings.  Yahoo! has $4.5 Billion in Cash and Marketable Debt Securities and sees the business stabilizing.  Yahoo! Inc. (NASDAQ: YHOO) reported revenues of $1,575 million for the quarter ended September 30, 2009, a decrease of 12 percent from the third quarter of 2008 and slightly above the second quarter of 2009. Net income per diluted share for the third quarter of 2009 was $0.13, compared to $0.04 for the third quarter of 2008

Free cash flow for the third quarter was up to 20 percent to $258 million compared to $215 million for same period of 2008.

“With revenue coming in above our guidance and flat sequentially, we had a solid third quarter that signals our major businesses have stabilized,” said Yahoo! chief executive officer Carol Bartz.

It looks like a good quarter but the revenue growth story for Yahoo! remains weak.

The most concerning story we see is the revenue growth trend and the traffic metrics.

Yahoo! needs to find a way to reverse the drop in traffic to start growing top-line revenue again.  Google continues to beat Yahoo on both fronts.

The stock is trading up after-hours.

Below are the Q309 Yahoo earnings details.

YQ3_Q309 YHOO Earnings Slides