MSFT: Financial Gauge Analysis for the March 2010 Quarter

Microsoft (NASDAQ: MSFT) earned $0.45 per diluted share in fiscal 2010's third quarter.  Microsoft made $0.12 more per share, 36 percent, than the $0.33 it earned in the March 2009 quarter.

In our earlier review of Microsoft's Income Statement, we compared the actual results to our "look-ahead" estimates.

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 latest 10-Q report.

Microsoft is best known for operating system and application software, but the company also sells video game consoles, music players, and computer peripherals.  Additional background information about Microsoft and the business environment in which it is now operating can be found in the look-ahead.

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

• Cash Management: 19 of 25 (unchanged from December)
• Growth: 9 of 25 (up from 2)
• Profitability: 14 of 25 (down from 15)
• Value: 9 of 25 (unchanged)

• Overall: 51 of 100 (up from 48)

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 Management	31 Mar 2010	31 Dec 2009	31 Mar 2009	5-Yr Avg
Current Ratio	2.1	2.0	1.7	2.0
LTD/Equity	8.2%	8.5%	0.0%	1.4%
Debt/CFO (years)	0.3	0.3	0.1	0.1
Inventory/CGS (days)	22.3	25.1	29.5	38.4
Finished Goods/Inventory	0.8	0.8	0.6	0.7
Days of Sales Outstanding (days)	60.4	63.6	63.4	62.0
Working Capital/Revenue	39.5%	35.2%	23.4%	45.2%
Cash Conversion Cycle Time (days)	-17.9	-15.1	-11.0	-2.3
Gauge Score (0 to 25)	19	19	18	18

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 $2.25 billion in short-term debt and $3.75 billion in long-term debt, combined, is less than its $8 billion cash hoard.  The debt is only a little more than the amount of Cash generated from Operations during a typical quarter.  Debt/Equity of 8 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.

In a sign of improved efficiency, the number of Days of Sales Outstanding was reduced by about 5 percent during the latest quarter.  After previous quarters, we had noted a surge in the Allowance for Doubtful Receivables, which surpassed $500 million during December 2009 quarter.  We even wondered if a big customer was having trouble making payments.  However, the allowance for doubtful receivable accounts was pared back in the latest quarter to $381 million.

Growth	31 Mar 2010	31 Dec 2009	31 Mar 2009	5-Yr Avg
Revenue growth	-2.7%	-5.3%	5.6%	9.4%
Revenue/Assets	77.4%	79.4%	87.6%	78.2%
Operating Profit growth	13.6%	17.2%	18.0%	13.2%
CFO growth	15.7%	3.2%	-12.1%	17.1%
Net Income growth	9.3%	-5.7%	-3.6%	10.6%
Gauge Score (0 to 25)	9	2	5	15

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.
Microsoft's Revenue in both of the last two quarters was greater than in the year-earlier periods.  However, the recent uptick was not enough to outweigh earlier weakness and get 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.

The Growth gauge is also not going to respond favorably when Revenue as a percentage of Assets is falling.

However, and this might be more important, the situation is much rosier with respect to Cash Flow and Net Income growth.  The latter surged back above zero, getting to 9 percent, in the latest quarter.  This, and robust Cash Flow, led to the improvement in the Growth gauge score.

Profitability	31 Mar 2010	31 Dec 2009	31 Mar 2009	5-Yr Avg
Operating Expenses/Revenue	62.6%	62.8%	63.5%	63.4%
ROIC	129.7%	108.4%	131.6%	150.4%
Free Cash Flow/Invested Capital	157.7%	124.6%	127.4%	174.2%
Accrual Ratio	11.8%	12.7%	7.2%	-2.5%
Gauge Score (0 to 25)	14	15	13	16

Although the operating margin could have weakened when inexpensive netbooks started to gain market share, Microsoft's cost-cutting proved to be an effective response.  Operating expenses as a percentage of Revenue have remained steady, at a very profitable level.  Our figures for this metric are on a trailing-year basis, which does help smooth the results.

The ROIC and FCF percentages rebounded nicely in the last quarter.  They don't quite match their long-term averages, but they are impressive nonetheless.

The rising accrual ratio bears watching as potential cautionary sign.  Quality of earnings is considered better when the ratio is negative and getting lower.

Value	31 Mar 2010	31 Dec 2009	31 Mar 2009	5-Yr Avg
P/E	15.0	16.8	10.3	17.9
P/E vs. S&P 500 P/E	0.8	0.9	0.6	1.0
PEG	1.1	1.0	0.6	0.6
Price/Sales	4.4	4.6	2.7	5.1
Enterprise Value/Cash Flow (EV/CFO)	10.1	11.6	7.3	11.9
Gauge Score (0 to 25)	9	9	25	15
Share Price ($)	$29.29	$30.48	$18.37	-

At the end of March, Microsoft's share price was 3.9 percent lower than on 31 December 2009.  However, it was 59 percent higher that it was one year earlier.  The Value gauge responded to last year's bargain share price with a perfect 25-point score, but the gauge has sagged over the last year as the share price surged higher while sales and earnings grew unevenly.

Nevertheless, the Value metrics do not appear unreasonable on an absolute basis or when compared to Microsoft's longer-term averages.

Overall	31 Mar 2010	31 Dec 2009	31 Mar 2009	5-Yr Avg
Gauge Score (0 to 100)	51	48	71	63

The Overall gauge rose modestly, mostly because the Growth gauge woke from a yearlong slumber.  Cash Management strength and Profitability remain splendid (although below peak levels).  Better Revenue growth would help the gauges move up to the next tier.



Full disclosure: Long MSFT at time of writing.