27 April 2007

MSFT: Analysis through March 2007

Microsoft (MSFT), the developer of operating system and application software, recently submitted a 10-Q for the quarter ending on 31 March 2007. This post reports on our analysis of those results.

The quarter included the long-delayed release in late January of the Vista operating system to consumers. Microsoft stock, after years of stagnant performance, rallied in anticipation of the release. Share repurchases also added lift. However, the gains, at least in part, proved to be ephemeral. The shares reversed course after Steve Ballmer threw cold water on the most optimistic expectations. An order to pay $1.5 billion to Alcatel-Lucent for infringing on digital music technology probably didn't help.

When we analyzed Microsoft after the results from December 2006 became available, the Overall score was a modest 37 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 11 points. Value was weakest at 8 points.

With the available data from the most recent quarter, our gauges now display the following scores:

Cash Management. This gauge has been stuck at 9 points for the last 10 quarters. The Current Ratio is now a solid 2.0. It has come down from previous unnecessarily high levels. Long-Term Debt/Equity is, as always, negligible. Inventory/Cost of Goods Sold rose to 67 days from 66 days at the end of December. The percentage of Inventory that is product ready for sale (i.e., Finished Goods) is 76 percent, compared to 83 percent in December. If the Finished Goods ratio is meaningful, and we're not sure it is for a software firm, it suggests that product demand was a little higher than expected. Maybe it says something about X-box sales. Accounts Receivable/Revenues equal 62 days. This is higher than the 58-day average for the company. We suspect this change is more related to the revamped product line, rather than the company's ability to get customers to pay their bills.

Growth. This gauge increased 7 points from December's 11 points. Revenue growth is now 16 percent year over year, with revenues accelerating in the last quarter, up from 10 percent a year ago. Net Income growth is a surprisingly weak 3 percent, down from 20 percent a year ago. The increase was slowed by a change in the income tax rate from 25 to 31 percent. CFO growth is a tepid 10 percent, up from 6 percent a year ago. Revenue/Assets surged to 78 percent. The increase indicates that the company is becoming more efficient at generating sales. The asset reduction caused by massive share repurchases, $13 billion in the last six months of 2006, might be a non-operational explanation for the increase.

Profitability. This gauge increased 2 points from 10 points in December. ROIC grew to an impressive 46 percent from 31 percent a year ago. It reached its highest level since 2001. FCF/Equity jumped up to 41 percent, its highest value since 1999, from 34 percent. Operating Expenses/Revenue stayed at 63 percent, which is the same percentage it was a year ago. Lower SG&A expenses offset a decline of a few percent in Gross Margin. The Accrual Ratio, which we like to be both negative and declining, didn't change from the -1 percent value of March 2006. This tells us that the contributions of cash flow and balance sheet accruals to Net Income remained the same.

Value. Microsoft's stock price fell over the course of the quarter from $29.86 to $27.87. The Value gauge, based on the latter price, increased to a 11 points, compared to 8 points three months ago, but down from 17 points twelve months ago, respectively. The P/E at the end of the quarter was 20, down a little from recent quarters (and down a lot from the historical average over 30). The average P/E for the Software and Programming industry is a more expensive 32. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is at a 24 percent premium to the average P/E, using core-operating earnings, for stocks in the S&P 500. In the last couple of years, the premium has compressed from much higher levels. Companies tend to trade at a premium when their growth rates are greater than average, particularly when the growth rates seem more likely to be sustained. The PEG ratio of 7 is indicative of a very expensive stock, but will come down once earnings growth is realized. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has declined to about 5.5. The average Price/Sales for the Software and Programming industry is 6.

Now at a solid, but unspectacular, 48 out of 100 possible points, the Overall gauge bounced back from December's 37-point low. There were great signs of growth in the most recent quarter, and we will be waiting to see how much it reaches the bottom line.

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