21 August 2010

MSFT: Financial Gauge Analysis for the June 2010 Quarter

Microsoft (NASDAQ: MSFT) earned $0.51 per diluted share in fiscal 2010's fourth quarter, which ended on 30 June 2010.  Earnings per share increased a robust 50 percent when compared to the $0.34 Microsoft made in the same quarter of 2009.

A previous article examined Microsoft's Income Statement for the June quarter.  Reported earnings were $0.04 per share more than the $0.47 we had forecast for the quarter.

We have now updated the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.  This post reports on the metrics for Microsoft and the associated financial gauge scores.  The metrics were calculated using data from Microsoft's current and historical financial statements, including the 10-K for fiscal 2010.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

Microsoft develops and sells the operating system software that runs on more than 90 percent of personal computers, and it also has dominant application software and server software franchises.  In addition, the company provides various online services, such as the Bing search engine and online advertising.  Microsoft also sells video game consoles, entertainment devices, and computer peripherals

Additional background information about Microsoft and the business environment in which it is currently operating can be found in the look-ahead.

In summary, Microsoft's latest quarterly results produced the following changes to the gauge scores:

The current and historical values for the financial metrics that determine the gauge scores are listed below, with some brief commentary.  Readers are encouraged to verify these figures and calculate others as they see fit using the filings available at the SEC's web site and elsewhere.

Cash Management30 Jun 201031 Mar 201030 Jun 20095-Yr Avg
Current Ratio2.
LTD to Equity10.7%8.2%9.5%2.0%
Debt/CFO (years)
Inventory/CGS (days)21.822.329.838.2
Finished Goods/Inventory0.
Days of Sales Outstanding (days)62.160.468.062.3
Working Capital/Revenue41.6%39.5%27.2%42.5%
Cash Conversion Cycle Time (days)-16.6-17.9-8.1-2.3
Gauge Score (0 to 25)20191818

The strength of Microsoft's Balance Sheet was formally recognized in 2008 when it joined the elite ranks of non-financial entities with a AAA rating bond rating.

The company's debt $5.5 billion cash hoard is almost enough to repay its entire debt  -- $1 billion in short-term obligation and $4.9 billion in long-term debt -- and Microsoft has another $31 billion in Short-term Investments.

The debt is roughly equivalent to the Cash Flow from Operations in a typical quarter.  Debt/Equity of 11 percent is also considered minimal.

Since Microsoft didn't, strictly speaking, need the proceeds from its first sale, in May 2009, of long-term bonds, the purpose of the debt offering might simply have been to exercise the mechanisms through which the company could raise larger amounts of cash in the future.  This could become important should Microsoft decide to pursue a large acquisition.

The metrics related to cash efficiency have improved over the last year.

Growth30 Jun 201031 Mar 201030 Jun 20095-Yr Avg
Revenue Growth6.9%-2.7%-3.3%9.7%
Operating Profit Growth17.4%13.6%13.7%15.0%
CFO Growth26.5%15.7%-11.9%21.0%
Net Income Growth28.8%9.3%-17.6%15.1%
Gauge Score (0 to 25)149115
Revenue, CFO, and Net Income growth rates compare the last four quarters to the four previous quarters.
The Operating Profit rate is the annualized rate of growth in Operating Profit after Taxes over the last 16 quarters.

The growth rates for Cash Flow from Operations and Net Income have surged, and are now over 25 percent year-over year.  The current growth rates dramatically improve on the negative rates experienced last year.  Both of these growth rates are now above their five-year averages.

Three consecutive quarters of Revenue growth (22 percent in the June quarter) pushed the trailing-year growth rate into positive territory.   Fiscal 2009 was the first year in which Microsoft's Revenue was less than the year before.

It's somewhat surprising that the Revenue/Assets ratio hasn't yet started to trend up, which would boost the Growth gauge score.

Profitability30 Jun 201031 Mar 201030 Jun 20095-Yr Avg
Operating Expense/Revenue61.3%62.6%64.6%63.1%
Free Cash Flow/Invested Capital151.4%157.7%120.2%167.7%
Accrual Ratio7.0%11.8%14.5%-1.5%
Gauge Score (0 to 25)19141216

Microsoft has made its already enviable operating margin even more lucrative, which is reflected in the lower expense ratio.  Cost-cutting proven to be an effective response to competitive threats to profitability.

The ROIC and FCF percentages are impressive even if they've given up a few percentage points in the recent quarter.

Last year, we viewed the upward spike in the Accrual Ratio to be a sign with potentially negative connotations.  However, the drop over the last four quarters suggests improving earnings quality, allaying our concerns.  The ideal case would be for the Accrual Ratio go below zero again.

Value30 Jun 201031 Mar 201030 Jun 20095-Yr Avg
P/E vs. S&P 500 P/E
Enterprise Value/Cash Flow (EV/CFO)
Gauge Score (0 to 25)1791815
Share Price ($)$23.01$29.29$23.77-

The Value gauge's latest upward move is the result of two factors: (1) Revenue, Cash Flow, Operating Income, and Net Income all growing strongly during the June quarter; and (2) the share price falling 21 percent during this same three-month period.

This combination has resulted in Price/Earnings, Price/Sales, and other valuation multiples much less than has historically been the case for Microsoft.  MSFT shares have become a Value stock.

The share price is back of $24 since the quarter ended, but this relatively small rebound doesn't change the fundamentals.

Overall30 Jun 201031 Mar 201030 Jun 20095-Yr Avg
Gauge Score (0 to 100)72505963

The Overall gauge rose sharply, and the score is now in a very attractive range.  Scores over 70 points are rather rare.

The Growth gauge had been the laggard, but it has risen from 1 point to 14 points in the last year.  It needed more robust Revenue growth to reach the upper tier of its range, and we're now seeing that performance.

Full disclosure: Long MSFT at time of writing.

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