Microsoft Corp. (NASDAQ: MSFT), best known for operating system and application software, 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). This interest led Microsoft to make a $40+ billion proposal to acquire Yahoo! Inc. (NASDAQ: YHOO), but the offer was ultimately withdrawn.
Last month, 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 $40 billion share repurchase program, and the company increased its quarterly dividend by 18 percent.
Earlier, the GCFR Overall Gauge of Microsoft increased to 61 out of 100 possible points -- a very good score -- when we analyzed of the company's results for the June 2008 quarter. The Growth and Value gauges were particularly strong. Revenue in the June quarter exceeded that in the year-earlier quarter by 18.4 percent. Research and Development expenses were, however, unusually high, which Microsoft attributed to increased personnel ("head-count") expenses and rising product development costs. The higher costs, somewhat offset by a lower Income Tax Rate, resulted in Net Income below our prediction by 3.7 percent; however, it was 42 percent above earnings in the June 2007 quarter.
Now, with the available data from the September 2008 quarter, our gauges display the following scores:
- Cash Management: 11 of 25 (up from 10 in June)
- Growth: 17 of 25 (down from 22)
- Profitability: 10 of 25 (down from 13)
- Value: 18 of 25 (unchanged)
- Overall: 57 of 100 (down from 61)
Before we examine each gauge, we will compare the latest Income Statement to our expectations, which were based on company guidance and our trend analysis.
Please note that the tabular format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($M) | | September 2008 (actual) | September 2008 (predicted) | September 2007 (actual) |
| Revenue | | 15,061 | 14,800 | 13,762 |
| Op expenses | | | | |
| | CGS | (2,848) | (2,664) | (2,675) |
| | R&D | (2,283) | (2,072) | (1,837) |
| | SG&A | (3,931) | (4,144) | (3,332) |
| | Other | 0 | 0 | 0 |
| Operating Income | | 5,999 | 5,920 | 5,918 |
| Other income | | | | |
| | Investments | 0 | 0 | 0 |
| | Interest, etc. | (8) | 350 | 298 |
| Pretax income | | 5,991 | 6,270 | 6,216 |
| Income tax | | (1,618) | (1,881) | (1,927) |
| Net Income | | 4,373 | 4,389 | 4,289 |
| | | $0.48/sh | $0.47/sh | $0.45/sh |
| Shares outstanding | | 9,183 | 9,400 | 9,513 |
Revenue in the recent quarter surpassed the $14.7 and $14.9 billion announced as guidance by the company when it reported the results of the June quarter. Revenue exceeded the midpoint of the range, which was our target, by 1.8 percent. When compared to the year-earlier quarter, Revenue grew by 9.4 percent. One third of the gain was due to foreign currency exchange rates.
We expected Microsoft to attain a Gross Margin of 82 percent of Revenue in the quarter, and they fell a little short. The actual value was 81.1 percent since the Cost of Goods Sold was 18.9 percent of Revenue. In the year-earlier quarter, the margin was 80.6 percent of Revenue.
Research and Development expenses were 15.2 percent of Revenue in the quarter, much higher than our 14.0 percent estimate. According to the 10-Q, "The increase in [R&D] expenses was primarily driven by a 24% increase in headcount-related expenses."
Sales, General, and Administrative expenses were 26.1 percent of Revenue, nicely less than our 28 percent estimate. This line item no longer includes gains and losses resulting from foreign currency "remeasurements."
The deviations in the individual operating items, relative to our projections, canceled each other out. Operating Income was only 1 percent more than the value we forecast. Operating Income was 2.6 percent greater than in the September 2007 quarter.
Non-operating investment income would have been $336 million, very close to our estimate, but it was wiped out by losses on derivatives and the aforementioned foreign currency "remeasurements."
The Income Tax Rate of 27 percent was below the predicted 30 percent because a greater percentage of earnings were in lower-tax jurisdictions.
Again, the loss on investment income was canceled out by the lower tax rate. As a result, Net Income in the quarter almost exactly matched our prediction, and it was 2.0 percent more than last year's value. Earnings per share were $0.01 more than we expected because Microsoft repurchased more its shares than we anticipated.
Cash Management. This gauge increased from 10 points in June to 11 points now.
| September 2008 | 3 mos. ago | 12 mos. ago | |
| Current Ratio | 1.5 | 1.4 | 1.6 |
| LTD/Equity | 0% | 0% | 0% |
| Debt/CFO | 0.1 yrs | 0.0 yrs | 0.0 yrs |
| Inventory/CGS | 43.7 days | 33.2 days | 57.8 days |
| Finished Goods/Inventory | 72.0% | 54.5% | 54.0% |
| Days of Sales Outstanding (DSO) | 54.8 days | 75.3 days | 53.5 days |
| Working Capital/Market Capitalization | 5.2% | 5.2% | 4.7% |
| Cash Conversion Cycle Time | 0.6 days | -7.5 days | 12.2 days |
Despite the new debt program, which led to $2 billion in short-term notes payable, and the $6.5 billion spent on common stock repurchases in the last quarter, the debt amount is clearly negligible. Microsoft still has more than $20.7 billion in cash and short-term investments.
We don't scrutinize Inventory at Microsoft because they are more of a Services business than a Manufacturing business.
Growth. This gauge decreased from 22 points in June to 17 points now.
| September 2008 | 3 mos. ago | 12 mos. ago | |
| Revenue growth | 14.1% | 18.2% | 19.2% |
| Revenue/Assets | 94.4% | 88.9% | 82.6% |
| CFO growth | -2.6% | 21.4% | 38.7% |
| Net Income growth | 19.4% | 25.7% | 15.0% |
Revenue growth has slowed, but is still rather impressive for such a big company. We have to temper our plaudits because changes in currency conversion rates accounted for $439 million of the quarter's Revenue. Revenue/Assets, a metric to which we give substantial weight, continues to rise strongly.
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.
Profitability. This gauge decreased from 13 points in June to 10 points now.
| September 2008 | 3 mos. ago | 12 mos. ago | |
| Operating Expenses/Revenue | 63.4% | 62.9% | 63.2% |
| ROIC | 115% | 132% | 132% |
| FCF/Equity | 47.6% | 54.7% | 50.6% |
| Accrual Ratio | +0.6% | +0.9% | -3.2% |
The values for the ROIC and FCF/Equity ratios both demonstrate Microsoft's incredible profitability. On the other hand, the increasing Accrual Ratio tells us that less of the company's Net Income is due to Cash Flow from Operations (CFO), and, therefore, more is due to changes in non-operational Balance Sheet accruals. (See above for how a tax matter distorted cash flow.)
Value. Microsoft's stock price slipped from $27.51 to $26.69 over the quarter, before the October market slump brought the price down to $22. The Value gauge, based on the quarter-end price, maintained the 18 points it achieved three months ago.
| September 2008 | 3 mos. ago | 12 mos. ago | |
| P/E | 13.8 | 14.6 | 18.8 |
| P/E to S&P 500 average P/E | 82% | 80% | 110% |
| Price/Revenue | 4.0 | 4.3 | 5.2 |
| Enterprise Value/Cash Flow (EV/CFO) | 11.8 | 10.8 | 13.2 |
Microsoft's shares are trading at much less than a market multiple, even though the company is much more profitable than the average company.
While the Growth and Profitability gauges gave up a few points each, the double-weighted Value gauge remains a strong 18 of 25 possible points. (it would be even higher if we used the current share price.) The Overall gauge score slipped to 57 of the 100 possible points, which is a very good result.
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