19 August 2007

MSFT: Financial Analysis through June 2007

We have analyzed Microsoft's (MSFT) financial results for the fiscal year and quarter that ended on 30 June 2007, as reported in a Form 10-K filed with the SEC. The more complete data in the 10-K did not change the results of the analysis performed on the preliminary financial results reported in a press release.

Microsoft sells operating systems, server applications, business solutions, video game consoles, music players, and computer peripherals. The company also provides online information services.

On 30 January 2007, after several delays, Microsoft launched the consumer version of the Vista operating system. First quarter revenues surged 32 percent over sales in the period ending March 2006. Quarterly net income increased an impressive 65 percent, although the increase was a tepid 3 percent when assessed on a year-over-year basis.

Microsoft shares, after years of stagnant performance, moved up nicely in anticipation of the Vista release and in response to a massive stock buyback. The shares retreated somewhat after Steve Ballmer threw cold water on the most optimistic expectations, and the company was ordered to pay $1.5 billion to Alcatel-Lucent (later overturned) for infringing on digital music technology. However, the shares were subsequently carried back up toward their January highs when the overall market rallied. Use of Vista will expand if for no other reason that manufacturers will install it on new computers; however, consumers have reported reasons to wait for changes.

More recently, when the company announced that the second-quarter results would include a $1 billion charge to repair faulty Xbox games, the shares fell a minuscule $0.02.

When we analyzed Microsoft after the first quarter, the Overall score was a very good 51 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 18 points. Cash Management and Value were weakest at 11 points each. [Note that recent algorithm tweaks led to minor changes in the previously reported scores.]

Now, with the available data from the June 2007 quarter, our gauges display the following scores:

Before we examine each gauge, let's compare the latest Income Statement to our expectations.

13371 13300 11804
Op expenses

CGS (2180) (2394) (2130)

R&D (1948) (1862) (1861)

SG&A (4197) (3990) (3932)

Other 0 0 0
Operating Income
5046 5054 3881
Other income

Investments 0 0 0

Interest, etc. 295 400 377
Pretax income
5341 5454 4258
Income tax
(1557) (1691) (1430)
Net Income
3784 3763 2828

0.39/sh 0.38/sh 0.28/sh

* To make the 2Q-2007 actual results comparable with our prediction, we backed out the charges for Xbox repairs. This decreases CGS by $1057 million and increases Income tax by $308 million. It's possible that the charges should be distributed differently.

Revenue was near the upper end of the range predicted by the company. We thought the Cost of Goods Sold (CGS) would be 18 percent of Revenue, and the actual value was 16.3 percent (if we backed out the Xbox charges correctly). Research and Development (R&D) expenses were 14.6 percent of Revenue, a shade more than our 14 percent estimate. Sales, General, and Administrative (SG&A) expenses were 31.4 percent of Revenue percent, 1.4 percent greater than our forecast.

The higher R&D and SG&A expenses were canceled out by the lower CGS, which resulted in Operating Income almost exactly at the forecast value.

Non-operating income was $105 million less than expected. However, the Income Tax Rate was only 29 percent instead of the predicted 31 percent. By coincidence, these differences also canceled each other out. This led to a Net Income that just slightly exceeded our prediction.

Cash Management. This gauge decreased from 11 points in March to 7 points.

The measures that helped the gauge were:
  • Debt/CFO = 0
  • LTD/Equity = 0%
  • Current Ratio =1.7 (down from 2.2 last year, and much high levels before that, since large amounts of cash -- $27 billion in FY2006 -- have been spent repurchasing common stock)
The measures that hurt the gauge were:

Growth. This gauge increased from 18 points in March to 22 points.

All relevant measures helped the gauge:

Profitability. This gauge increased from 14 points in March to 15 points.

The measures that helped the gauge were:
  • ROIC = 52 percent (!), up from 34 percent
  • FCF/Equity = 50 percent, up from 32 percent
  • Accrual Ratio = -2.3 percent, down from -0.3 percent
The decreasing Accrual Ratio tells us that more of the company's Net Income is due to Cash Flow from Operations (CFO), and, therefore, less is due to changes in non-operational Balance Sheet accruals.

The measures that hurt the gauge were:
The increase in operating expenses was basically the result of a decrease (as a result of the Xbox charge) in Gross Margin. Other expenses were lower.

Value. Microsoft's stock price rose over the course of the quarter from $27.87 to $29.47. The Value gauge, based on the latter price, dropped to 9 points, compared to 11 points three months ago (and 18 points twelve months ago).
The average P/E for the Software and Programming industry is a more expensive 28. The average Price/Revenue for the industry is 5.9.

Now at a 46 out of 100 possible points, the Overall gauge is down a little from March. The score is good, not great.

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