25 January 2008

MSFT: Financial Analysis though December 2007

We have analyzed Microsoft's (MSFT) financial results, as reported to the SEC on Form 10-Q, for the quarter that ended on 31 December 2007. We really appreciate it when a company submits a 10-Q on the same day they announce their results to the public. This gives us the earliest possible access to a full set of financial statements, and there is unlikely to be a discrepancy between the press release and the 10-Q.

It's been one year since Microsoft launched the consumer version of the Vista operating system. Revenues surged immediately, and profit growth followed with a bit of lag. Microsoft shares, which had moved up nicely in anticipation of the Vista release, traded in a narrow range for most of the year. Good third quarter results led to a late rally, which stalled when the overall market tumbled after the start of the new year.

Not satisfied by selling operating systems, server applications, business solutions, video game consoles, music players, and computer peripherals, Microsoft is determined to be a major player in the online advertising business. This puts the company in direct competition with Google and Yahoo. Earlier this year, Microsoft paid $6 billion for the aQuantive advertising network. The $240 million spent to acquire a 1.6 percent stake in Facebook, a company with minimal revenues, was a strategic investment. Of course, for Microsoft, $240 million is walking-around money; earlier this year they set aside $1 billion to repair faulty Xbox games

When we analyzed Microsoft after the September quarter, the Overall score was a solid 55 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 23 points. Cash Management was weakest at 10 points.

Now, with the available data from the December 2007 quarter, our gauges display the following scores:

Before we examine each gauge, let's compare the latest Income Statement to our expectations, which were based on company guidance and trend analysis.


($M)
Dec 2007
(actual)		Dec 2007
(predicted)
 Dec 2006
(actual)
Revenue
16367
 15850
 12542
Op expenses




CGS (3543)
(2853)
 (3620)

R&D (1885)
(2219)
 (1637)

SG&A (4458)
(4755)
 (3813)

Other 0
 0
 0
Operating Income
6481
 6023
 3472
Other income




Investments
 0
 0
 0

Interest, etc.
 339
 300
 333
Pretax income
6820
 6323
 3805
Income tax
(2113)
 (1897)
 (1179)
Net Income
4707
 4426
 2626


$0.50/sh
 0.47/sh
 0.26/sh







Revenue in the recent quarter exceeded the upper bound of the $15.6 to $16.1 billion range forecast by the company in October 2007. The Revenue increase over the year-earlier quarter was 30 percent. Year-over-year Revenue growth is now 26 percent, which is pretty rare for a large company and a rate not achieved at Microsoft in many years.

We expected Cost of Goods Sold (CGS) to equal 18 percent of Revenue, and the actual value was 21.6 percent. Our target was optimistic, but quarters with Gross Margins over 80 percent have been relatively common at Microsoft. We can't point with certainty to one reason why CGS was higher than our forecast. Using the 10-Q as a guide, our best guess is that the culprit was costs associated with the online services business, including intangible asset amortization and operation of data centers.

Other costs, as a percentage of Revenue, were much lower than expected. Research and Development (R&D) expenses were 11.5 percent of Revenue, significantly less than our 14 percent estimate. Sales, General, and Administrative (SG&A) expenses were 27.2 percent of Revenue percent, well below the 30 percent estimate.

Microsoft significantly exceeded their forecast Operating Income would be between $5.9 to $6.1 billion. By our reckoning, Operating Income was 7.6 percent above a reasonable prediction.

Non-operating income was $39 million more than expected. (We thought the cash spent on share repurchases would lead to a greater reduction in interest income.) The Income Tax Rate of 31 percent exceeded the predicted 30 percent. Net Income exceeded the prediction by 6.3 percent.


Cash Management. This gauge increased from 10 points in September to 12 points now.

The measures that helped the gauge were:
The measures that hurt the gauge were:

Growth. This gauge increased from 23 points in September to the maximum value of 25 points now.

To get the perfect score, all relevant measures helped the gauge:

Profitability. This gauge increased from 18 points in September to 21 points.

All of these measures also contributed to the gauge were:
The decreasing Accrual Ratio tells us that more of the company's Net Income is due to Cash Flow from Operations (CFO), and, therefore, less is due to changes in non-operational Balance Sheet accruals.


Value. Microsoft's stock price increased from $29.46 to $$35.60 over the course of the quarter. The Value gauge, based on the latter price, dropped to 6 points from 11 points three months ago (and 8 points twelve months ago).
The average P/E for the Software and Programming industry is a more expensive 24.9. The average Price/Revenue for the industry is 6.2.


The Overall gauge, led by Growth and Profitability, has now indicated very good scores in the mid-50's for two consecutive quarters. Since the stock price has retreated along with the overall market, the shares appear attractive.
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