25 April 2009

MSFT: Financial Analysis through March 2009

Microsoft Corp. (NASDAQ: MSFT) earned $0.33 per share in the three months that ended on 31 March 2009.  The company has already filed a 10-Q report for this period, which was the third quarter of the company's fiscal year.  This post provides the GCFR analysis of the results.

For the first time, Revenue was less than in the comparable quarter of the preceding year.

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.

Revenue from Microsoft Windows has recently been adversely affected by a substantial deceleration of personal computer sales growth and by the greater proportion of low-cost netbook PCs.  Microsoft responded to the new environment by taking several steps to cut costs, including the eventual elimination of up to 5000 jobs.  In the March 2009 quarter, the company recorded a charge of $290 million to cover employee severance costs.

Microsoft will soon make available a release candidate version of Windows 7, which will replace, perhaps later this year, the disappointing Windows Vista operating system.

The company's dominance in software has brought it considerable attention from antitrust authorities in the U.S. and around the world.  Judge Colleen Kollar-Kotelly, who sits on the U.S. District Court for the District of Columbia, recently extended federal oversight of Microsoft's 2002 antitrust settlement by another 18 months.  In Europe, Microsoft has been charged with unfairly bundling its Internet Explorer web browser with Windows.

Microsoft has been trying to increase its role in online advertising.  However, according to comScore, Google Inc. (NASDAQ: GOOG) performed 63.7 percent of U.S. online searches in March, to Microsoft's 8.3 percent.  Dow Jones reported that Microsoft is "still far from making good on its promise to challenge Google."  To improve its prospects in this area, Microsoft might try for a second time to acquire Yahoo! Inc. (NASDAQ: YHOO).  A $40+ billion bid in early 2008 was withdrawn when Yahoo's management resisted.  There have since been occasional reports that Microsoft remains interested in acquiring Yahoo's search business or partnering with it.  For example, Microsoft CEO Steve Ballmer made comments last March confirming his interest in Yahoo.

In September 2008, Microsoft joined the elite ranks of non-financial entities with AAA bond ratings, which is the highest S&P grade.  Microsoft also authorized its second $40 billion share repurchase program in September 2008.

Looking back to the December 2008 quarter, we are reminded that Microsoft's Net Income dropped 11.3 percent and Revenue disappointed.  This period also included a $400 million loss on derivatives and a $350 million loss on "foreign currency remeasurements."

December's results led to a significant drop in the Growth gauge.  However, a 45 percent plunge in Microsoft's share price in 2008 provided lift for our contrarian Value gauge.  The GCFR Overall gauge of Microsoft increased to 71 of the 100 possible points, which is an excellent score.

Now, with the available data from the March 2009 quarter, our gauges display the following scores:
  • Overall: 69 of 100 (down from 71)

Before we examine each gauge, we will compare the actual results to our Income Statement model, which was 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 was 5.6 percent less than in the year-earlier March 2008 quarter, and it was 18 percent less than the sequential December 2008 quarter.  Our estimate proved too optimistic by 1.5 percent.

Trailing four-quarters Revenue growth, at 5.6 percent, is the weakest Microsoft has ever experienced.

Microsoft blames "continued weakness in the global PC market" and the "recessionary economic environment" for the Revenue decline. The Windows operating system, Office application, and online advertising all brought in less Revenue.

The Cost of Goods Sold in the quarter was 20.6 percent of Revenue, which translates into a Gross Margin of 79.4 percent.  The company did a much better job controlling CGS than we had anticipated in the weaker sales environment, which explains why our 76 percent prediction for the Gross Margin was several points too low.

Research and Development and Sales, General, and Administrative expenses were also much lower than we had anticipated based on the company's guidance for the year.   R&D costs were up 8.7 percent, but we expected growth of 18 percent.  SG&A costs were down 30 percent, nearly twice as much as we expected.  Expenses were lower because of "decreased corporate marketing and advertising campaigns and decreased professional consulting fees."

There was a special charge of $290 million for employee severance costs.

Operating Income was 3.4 percent greater than in the March 2008 quarter, which isn't bad considering that Revenue fell and there was a large special charge.  Much lower-than-expected operating expenses pushed Operating Income 31.5 percent above our estimate. 

On the other hand, Microsoft's bottom-line results didn't beat our estimate by the same wide margin because of non-operating items.

Non-operating investment income and interest summed to a disappointing net expense of $388 million.  One reason this item was an expense instead of income was that Microsoft recorded a $452 million charge for loss on equity investments.

The Income Tax Rate of 26.5 percent was a little above the predicted 26 percent.  Net Income in the quarter was 32 percent below last year's value, but it beat our prediction by 9.5 percent.

Now, for the gauges:

Cash ManagementMarch 2009
3 months prior
12 months prior
Current Ratio1.7
 0.1 years
0.1 years
0.0 years
21 days
26 days39 days
Finished Goods/Inventory
Days of Sales Outstanding (DSO)56.8 days
66.5 days
57.7 days
Working Capital/Invested Capital124%
Cash Conversion Cycle Time-20 days
-13 days
-11 days
Gauge Score (0 to 25)

Microsoft has excellent liquidity and minuscule Debt.  The only Cash Management metric we would like to see improve, and this falls into the nitpicking category, is Days of Sales Outstanding.

GrowthMarch 20093 months prior
12 months prior
Revenue growth5.6%
Revenue/Assets 87.6%
CFO growth
Net Income growth -3.6%
Gauge Score (0 to 25)3
Growth rates are trailing four quarters compared to four previous quarters.

Revenue growth has slowed significantly.  Cash Flow and Net Income are falling.

The Growth score is not zero only because Revenue/Assets improved from March 2008.

ProfitabilityMarch 20093 months prior
12 months prior
Operating Expenses/Revenue 63.5%
ROIC 120%
Free Cash Flow/Invested Capital116%
Accrual Ratio
Gauge Score (0 to 25)13

Operating expenses came down substantially in the March quarter.  While ROIC and FCF/Capital are down substantially from last year, the current figures are still impressive and even some improvement relative to the December lows.  However, the increase in Accrual Ratio raises a concern about Earnings Quality.

ValueMarch 20093 months prior
12 months prior
P/E 10.3
P/E vs. S&P 500 P/E 59%
Price/Revenue 2.7
Enterprise Value/Cash Flow (EV/CFO)
Gauge Score (0 to 25)25

Microsoft's stock price dropped from $35.60 to $19.44 during 2008, and the shares lost another $1 in the March quarter. 

Given this price, the valuation ratios, which can be compared with other companies in the Application Software industry, have kept the Value gauge at its maximum value.

Our calculations indicate that the current P/E and Price/Sales ratios are about one-half of their five-year median values.

OverallMarch 20093 months prior
12 months prior
Gauge Score (0 to 100)69

While the initial response to Microsoft's results in the March 2009 quarter to note the unprecedented decline in Revenue, the cost-control measures announced at the beginning of the year have already gained traction.  The company remains extremely profitable, and its shares appear to be selling at a discounted price.

It's true that Growth has come to a halt, and the company faces challenges from drops in IT spending, more and more netbooks, competition from open source software, and even cloud computing.

We will conclude with one more ratio.  At the end of March, Microsoft's Market Value was about $164 billion.  During the first three quarters of fiscal 2009, Cash Flow from Operations was $15.2 billion.  We could say that this equates to a Price/Cash Flow ratio of about 164/[(4/3)*15.2] = 8.1.  The inverse of this number indicates that each dollar to purchase a share of Microsoft returns 12.4 cents in annual cash flow.  Yes, Cash Flow has fallen, and may continue to do so, but there is a wide margin between this return and the risk-free rates.

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