MSFT: Analysis through Dec 2006

Microsoft has just reported its financial results for the quarter that ended on 31 December 2006. This was the second quarter of the company's fiscal 2007. We used the new results to update the analysis we performed after the quarter that ended in September 2006.

• Cash Management: 9/25
  
• Growth: 11/25
  
• Profitability: 10/25
  
• Value: 8/25
  

• Overall: 37/100
  

Cash Management. This gauge held steady from September to December. It isn't particularly meaningful for Microsoft because Inventory doesn't have the same significance for a software company that it has for a manufacturer. Long-Term Debt is negligible. The Current Ratio is an ideal 2.0; it has come down from previous unnecessarily high levels. The only interesting ratio in this category is Accounts Receivable/Revenue, which increased to a record high 78 days. We suspect that this is because new products began to ship at the end of the quarter.

Growth. This gauge slipped a notch from September. Revenue growth was 11 percent year over year; it has been holding steady at this level for the last four quarters. Net Income, on the other hand, decreased by 9 percent; this was the first time in four years that Net Income showed a year-over-year drop. Cash Flow from Operations (CFO) also declined by 10 percent on a year-over-year basis. Revenue/Assets held at a historically high 69 percent. It had been increasing when stock buybacks were reducing assets.

Profitability. This gauge also dropped a notch from September. The Return on Invested Capital (ROIC) slipped to 36 percent, but it was still 8 percentage points above last year's value. Free Cash Flow (FCF) to Equity held at 33 percent, which is about where it has been for the last seven quarters. Operating Expenses as a proportion of Revenue moved up from 63 percent to 66 percent, which is due to a decline in Gross Margin. The Accrual Ratio held at zero percent, which tells us that the company is no longer brings in more CFO than Net Income.

Value. This gauge dropped sharply from a healthy 15 points in September. Due to the reduction in Net Income, the Price/Earnings ratio moved up to 25. The P/E ratio is now an expensive 53 percent above the S&P 500 market multiple. The PEG ratio became meaningless because earnings didn't grow, they contracted. The Price/Revenues ratio was a seemingly scary 6.5, but this is actually a tad lower than historic values.

Now at 37 out of 100 possible points, the Overall gauge registered its sixth consecutive decline. The score was a fabulous 70 in mid 2005, which might have foretold subsequent gains in the stock price. If we believe in the gauge's predictive powers, consistency would suggest that we now accept that the recent score decline is telling us that the price gains have run their course.


We had decided ahead of time to give special attention to certain facets of the December results:

Revenue growth: We wanted to see if revenue growth would maintain a double-digit pace, and it did. Revenue for the quarter exceeded all estimates.

Operating Expenses: We wanted to see if the company would hold spending in check enough to keep the ratio of Operating Expenses to Revenues below 63 percent. Instead, these expenses increased to 66 percent of Revenue.

Net Income, which dropped to $0.26 per share, still exceeded the market estimate of 23 cents per share for the quarter. It fell below our estimate of a more robust 33 cents.

CFO: We said we wanted to see CFO start growing again. It didn't come close.