24 January 2009

MSFT: Financial Analysis through December 2008

Microsoft Corp. (NASDAQ: MSFT) has announced earnings and filed a 10-Q report for the quarter that ended on 31 December 2008.  This post provides the initial GCFR analysis of the period, which was the second quarter of the company's fiscal 2009.

The earnings data was accompanied by a widely anticipated statement indicating that Microsoft will "eliminate up to 5,000 jobs ... over the next 18 months, including 1,400 jobs today."

A high-tech Goliath, Microsoft is best known for operating system and application software, but the company also sells video game consoles, music players, and computer peripherals

In recent years, Microsoft has increased its role in the online advertising business, in direct competition with Google Inc. (NASDAQ: GOOG).  Interest in this business resulted in Microsoft offering $40+ billion to acquire Yahoo! Inc. (NASDAQ: YHOO).  However, the bid was withdrawn when Yahoo's management resisted.  Since that decision, Carol Bartz replaced co-founder Jerry Yang as Yahoo CEO, and this has led to frequent speculation that talks between the two firms might heat up again.  A three-way deal involving the AOL subsidiary of Time Warner Inc. (NYSE: TWX) is also possible, although less likely.

Last September, Microsoft joined the elite ranks of non-financial entities with AAA bond ratings, which is the highest S&P grade.  After Microsoft's board authorized as much as $6 billion worth of debt, the company established a program allowing issuance of $2 billion of short-term commercial paper.  Microsoft also opened a $2 billion revolving credit facility.

Microsoft also initiated a new $40 billion share repurchase program, and the company increased its quarterly dividend by 18 percent.

MSFT common shares were not immune to the market meltdown in 2008.  The price per share dropped 46 percent during the calendar year.

Three months ago, the GCFR Overall gauge of Microsoft registered 57 of the 100 possible points -- down just 4 points.  Our full evaluation of the September 2008 quarter was explained in this analysis report.  The Growth and Profitability gauges weakened in this period, but the Value gauge remained a robust 18 of 25 possible points.  Net Income was 2.0 percent more than in the year-earlier quarter.

Now, with the available data from the December 2008 quarter, our gauges display the following scores:

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

Please note that the tabular format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.


Revenue in the December quarter was much less than the $17.3 to $17.8 billion guidance provided by the company when it reported September's results.  Revenue fell below the midpoint of the range, $17.55 billion, by 5.2 percent.  When compared to the year-earlier quarter, Revenue grew by a mere 1.6 percent.

Changes in currency exchange rates added $200 million to fourth quarter Revenue. 

A substantial deceleration of personal computer sales growth, coupled with a greater proportion of low-cost netbook PCs, led to decreased sales of Microsoft Windows. 

We expected Microsoft to attain a Gross Margin of 81 percent of Revenue in the quarter, and they fell far short of this target.  The actual value was 76.5 percent since the Cost of Goods Sold was 23.5 percent of Revenue.  In the year-earlier quarter, the margin was 78.4 percent of Revenue. 

While there are many components of CGS, Microsoft made a point of mentioning that costs for online "traffic acquisition" were higher.

Research and Development expenses were 13.8 percent of Revenue in the quarter, surprisingly less than our 14.5 percent estimate.

Sales, General, and Administrative expenses were 27 percent of Revenue, nicely less than our 30 percent estimate.  The increase in these expenses relative to the previous year was "primarily as a result of increased corporate marketing and advertising campaigns, headcount-related expenses, and bad debt expenses."

The lower than expected R&D and SG&A expenses were not enough to compensate for the disappointing Revenue and Gross Margin.  As a result, Operating Income was 7.3 percent less than the value we forecast.  Operating Income was below the bottom of the $6.1 billion to $6.4 billion range indicated in the company's guidance.

Investment and interest income, which had been reliable source of income for cash-laden Microsoft, flipped to a substantial expense in the fourth quarter.  The explanation is that the fourth quarter included a $400 million loss on derivatives and a $350 million loss on "foreign currency remeasurements."

Pre-Tax Income was below our $6.66 billion projection by 15.3 percent.

The Income Tax Rate of 26 percent was below the predicted 29 percent because a greater percentage of earnings were in lower-tax jurisdictions.  Net Income in the quarter missed our prediction by 11.7 percent, and it was also 11.3 percent less than last year's value.

Cash ManagementDecember
3 mos.
12 mos.
Current Ratio1.6
 0.1 yrs
0.1 yrs
0.0 yrs
25.9 days
43.7 days39.0 days
Finished Goods/Inventory
Days of Sales Outstanding (DSO)66.5 days
54.8 days
67.8 days
Working Capital/Market Capitalization  8.0%
Cash Conversion Cycle Time-13.2 days
0.6 days
-5.8 days
Gauge Score (0 to 25)

The last two measures above are the most noteworthy.  The increasing ratio of Working Capital to Market Capitalization hints of Microsoft's transformation from a growth stock to a value play.  Although the relevance of the CCCT when assessing Microsoft can be called into question because it depends, in part, on Inventory data -- the big downward jump (a good thing) shows that Microsoft's ability to manage its cash flow remains powerful.

3 mos.
12 mos.
Revenue growth7.1%
Revenue/Assets 93.1%
CFO growth
Net Income growth 1.6%
Gauge Score (0 to 25)10
Growth rates are trailing four quarters compared to four previous quarters.

Revenue, Cash Flow, and Net Income growth have all either slowed significantly or been eliminated.

Revenue/Assets, a metric to which we give substantial weight, remains much above historic levels.

The drop in Cash Flow for Operations would concern us greatly, except that the decrease was due to a $3.1 billion payment to the settle a tax audit from 2000-2003.

3 mos.
12 mos.
Operating Expenses/Revenue 64.5%
ROIC 108%
Accrual Ratio
Gauge Score (0 to 25)10

While the rise in operating expenses shows that Microsoft is less profitable than it once was, the company's profitability is still significant when assessed by traditional return-on-investment metrics.

3 mos.
12 mos.
P/E 10.1
P/E to S&P 500 average P/E 75%
Price/Revenue 2.8
Enterprise Value/Cash Flow (EV/CFO)
Gauge Score (0 to 25)24

Microsoft's stock price dropped all the way from $35.60 to $19.44 during 2008,  and the plunge has continued in January.  The Value gauge, based on the year-end price, is within one point of it maximum value.

Microsoft's valuation ratios can be compared with other companies in the Application Software industry.

Who would have ever imagined that these ratios for Microsoft would be as low as they are now.

3 mos.
12 mos.
Gauge Score (0 to 100)68

The rises in the double-weighted Value gauge and the Cash Management gauge pushed up the Overall score to a level that is normally very attractive.

Towards the end of 2008, sales of IT systems decelerated suddenly.  Fourth quarter Revenue and earnings projections made in October and November by hardware and software vendors alike proved, in most cases, to be wildly optimistic.  The earlier declines in equity prices, which were triggered by the financial industry's catastrophic missteps, and which might have seem unjustified for big, rich technology companies, now seem prescient.

After the steep drop in the price of Microsoft shares, the company's Market Value is about $153 billion.  During the last six troubling months, Microsoft's Cash Flow from Operations was $9.15 billion.  If this performance were to matched in the next six months, we could say that the present Price to Cash Flow ratio is about 8.4.  This is equivalent to a cash yield of about 12 percent.  Even if Cash Flow drops by, say, $1 billion to cover severance costs, the cash yield would still be an enticing 11 percent.

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