25 October 2007

MSFT: Financial Analysis through September 2007

We have analyzed Microsoft's (MSFT) financial results, as reported to the SEC on Form 10-Q, for the quarter that ended on 30 September 2007. This post reports on our evaluation.

We really appreciate it when a company submits a 10-Q on the same day that they announce their results to the public.

Not satisfied by selling operating systems, server applications, business solutions, video game consoles, music players, and computer peripherals, Microsoft is determined to be a major player in the online advertising business. This puts the company in direct competition with Google and Yahoo. Earlier this year, Microsoft paid $6 billion for the aQuantive advertising network. The $240 million spent to acquire an 1.6 percent stake in Facebook, a company with minimal revenues, was a strategic investment. Of course, for Microsoft, $240 million is walking-around money; earlier this year they set aside $1 billion to repair faulty Xbox games

In January of this year, Microsoft finally launched the consumer version of the Vista operating system. Not surprisingly, first quarter revenues surged. Microsoft shares, after years of stagnant performance, moved up nicely in anticipation of the Vista release and in response to massive stock repurchases. But, the rally faltered, and the January highs merely established the top of new trading range for the company shares. (A new, higher trading range will probably be established tomorrow.

When we analyzed Microsoft after the June quarter, the Overall score was a solid 46 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 22 points. Cash Management was weakest at 7 points.

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

Before we examine each gauge, let's compare the latest Income Statement to our expectations, which were based on company guidance and trend analysis.

Sept 2007 (actual)Sept 2007
Sept 2006
1376212500 10811
Op expenses

CGS (2675)(2125) (1696)

R&D (1837)(1750) (1786)

SG&A (3332)(3750) (2855)

Other 00 0
Operating Income
59184875 4474
Other income

Investments 00 0

Interest, etc. 298350 567
Pretax income
62165225 5041
Income tax
(1927)(1568) (1563)
Net Income
42893658 3478

$0.45/sh0.38/sh 0.35/sh

Microsoft's Revenue in the September 2007 quarter was an amazing 27.3 percent greater than in the year-earlier quarter, on brisk sales of the new "Halo 3" video game, Windows and Office. The company had forecast Revenue growth between 14.7 percent and 16.6 percent. We expected Cost of Goods Sold (CGS) to equal 17 percent of Revenue, and the actual value was 19.4 percent. Research and Development (R&D) expenses were 13.3 percent of Revenue, a shade less than our 14 percent estimate. Sales, General, and Administrative (SG&A) expenses were 24.2 percent of Revenue percent, much less than the typical value of 30 percent.

The win-win combination of higher revenue and lower costs resulted in Operating Income more than 21 percent above the forecast value.

Non-operating income was $52 million less than expected. The Income Tax Rate matched the predicted 31 percent. Net Income exceeded our prediction by 17 percent.

Cash Management. This gauge increased from 7 points in June to 10 points now.

The measures that helped the gauge were:
The measures that hurt the gauge were:

Growth. This gauge increased from 22 points in June to 23 points now.

To get that score, all relevant measures helped the gauge:

Profitability. This gauge increased from 15 points in June to 18 points.

The measures that helped the gauge were:
  • ROIC = 55 percent (!), up from 43 percent in Sept 2006
  • FCF/Equity = 54 percent, up from 34 percent in a year
  • Accrual Ratio = -3.6 percent, down from +0.9 percent one year ago.
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:
Since operating expenses include a huge repair charge related to the Xbox, other expenses must have come done by an equal amount.

Value. Microsoft's stock price lost a penny over the course of the quarter, changing from $29.47 to $29.46. The Value gauge, based on the latter price, increased to 10 points, compared to 8 points three months ago (and 13 points twelve months ago).

The measures that helped the gauge were:
  • Enterprise Value/CFO = 13.2, down from 17.1 in September 2006
  • P/E = 18.8, down from 21.2 a year ago
  • P/E to S&P 500 average P/E = 17 percent premium, down from a five-year median over 40 percent
  • Price/Revenue ratio = 5.2, down from a five-year median of 6.8.
The average P/E for the Software and Programming industry is a more expensive 29. The average Price/Revenue for the industry is 7.5.

Now a very good 55 out of 100 possible points, the Overall gauge is up 9 points from June. The September quarter was excellent by any measure, and Microsoft shares appear to hold significant value.

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