Microsoft Corp. (MSFT), the gigantic developer of operating system and application software, also sells video game consoles, music players, and computer peripherals. The company is also determined to become a major player in the online advertising business, putting it in direct competition with Google (GOOG). The pursuit of this objective is why Microsoft is currently engaged in an increasingly testy battle to acquire Yahoo (YHOO). Last year, Microsoft paid $6 billion for the aQuantive advertising network, and they spent $240 million to acquire a 1.6 percent stake in Facebook.
Our earlier financial analysis of Microsoft's results from the fourth quarter of calendar year 2007 produced an Overall Gauge score of 55 points. This figure, a very good outcome, was boosted by a perfect 25-point score on the Growth gauge and an excellent 21-point Profitability gauge score.
Now, with the available data from the March 2008 quarter, which was the third quarter of Microsoft's fiscal year, our gauges display the following scores:
- Cash Management: 10 of 25
- Growth: 20 of 25
- Profitability: 15 of 25
- Value: 15 of 25
- Overall: 58 of 100
Before we examine each gauge, let's compare the latest Income Statement to our expectations, which were based on both on company guidance and trend analysis.
| ($M) | | March 2008 (actual) | March 2008 (predicted) | March 2007 (actual) |
| Revenue | | 14454 | 14450 | 14398 |
| Op expenses | | | | |
| | CGS | (2514) | (2890) | (2140) |
| | R&D | (2035) | (1878) | (1750) |
| | SG&A | (5496) | (4046) | (3919) |
| | Other | (0) | 0 | 0 |
| Operating Income | | 4409 | 5635 | 6589 |
| Other income | | | | |
| | Investments | 0 | 0 | 0 |
| | Interest, etc. | 401 | 325 | 382 |
| Pretax income | | 4810 | 5960 | 6971 |
| Income tax | | (422) | (1788) | (2045) |
| Net Income | | 4388 | 4172 | 4926 |
| | | $0.47/sh | $0.44/sh | 0.26/sh |
| Shares outstanding | | 9428 | 9500 | 9862 |
Revenue in the recent quarter was just slightly above the midpoint of the $14.3 to $14.6 billion range forecast by the company in January. The Revenue increase over the year-earlier quarter was 0.4 percent. Sales in the March 2007 quarter were boosted by the long-delayed release of the Vista operating system and Office 2007. Year-over-year Revenue growth has now slowed to 17 percent.
We conservatively expected the Gross Margin to equal 80 percent of Revenue, and the actual value was 82.6 percent. In other words, the Cost of Goods Sold was only 17.4 percent of Revenue.
Research and Development expenses were 14.1 percent of Revenue, compared to our 13 percent estimate. Microsoft attributed rising R&D costs to increased numbers of personnel earning higher salaries. Sales, General, and Administrative expenses were 38 percent of Revenue, a shocking 10 percent above the 28 percent estimate. SG&A expenses were extraordinarily high in the March 2008 quarter because Microsoft incurred $1.5 billion of charges associated with a fine payable to the European Commission.
The better-than-expected Gross Margin was outweighed by the higher-than-expected R&D and SG&A costs. Operating Income was 21.8 percent below the forecast value and well below the company's guidance that Operating Income would be between $5.6 to $5.7 billion.
Non-operating income was $76 million more than expected as a result of "higher net gains on equity, interest rate, and commodity derivatives." The Income Tax Rate of 9 percent was well below the predicted 30 percent because various tax matters were resolved. These two Non-operating factors overcame the below-forecast Operating Income and enabled Net Income to exceed the prediction by 5.2 percent. Net Income was 11 percent below the super quarter of March 2007.
Cash Management. This gauge decreased from 12 points in December to 10 points now.
| March 2008 | 3 mos. ago | 12 mos. ago | |
| Current Ratio | 1.5 | 1.7 | 2.0 |
| LTD/Equity | 0% | 0% | 0% |
| Debt/CFO | 0 yrs | 0 yrs | 0 yrs |
| Inventory/CGS | N/A | N/A | N/A |
| Finished Goods/Inventory | N/A | N/A | N/A |
| Days of Sales Outstanding (DSO) | 57.7 days | 67.8 days | 56.2 days |
| Working Capital/Market Capitalization | 5.4% | 4.6% | 7.7% |
| Cash Conversion Cycle Time | -10.8 days | -5.8 days | 18.0 days |
Microsoft has no debt. Current liabilities are up to reflect taxes due. We don't analyze Inventory at Microsoft because they are more of a Services business than a Manufacturing business.
Growth. This gauge decreased from a perfect 25 points in December to 20 points now.
| March 2008 | 3 mos. ago | 12 mos. ago | |
| Revenue growth | 16.9% | 25.7% | 16.2% |
| Revenue/Assets | 81.9% | 86.0% | 77.6% |
| CFO growth | 31.5% | 58.7% | 10.4% |
| Net Income growth | 18.5% | 42.4% | 2.9% |
While the growth rates are all commendable, it is also clear that the rate of growth has slowed from the previous quarter.
Profitability. This gauge decreased from 19 points in December to 15 points.
| March 2008 | 3 mos. ago | 12 mos. ago | |
| Operating Expenses/Revenue | 64.1% | 60.3% | 62.8% |
| ROIC | 60.0% | 59.5% | 46.5% |
| FCF/Equity | 51.0% | 57.1% | 41.4% |
| Accrual Ratio | -3.5% | -5.1% | -18.1% |
Operating expenses are edging up, but we haven't separated from one-time from recurring costs. 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.
Value. Microsoft's stock price decreased from $35.60 to $28.38 over the course of the quarter. The Value gauge, based on the latter price, surged to 15 points from 6 points three months ago.
| March 2008 | 3 mos. ago | 12 mos. ago | |
| P/E | 16.3 | 20.0 | 19.8 |
| P/E to S&P 500 average P/E | 99% | 112% | 125% |
| Price/Revenue | 4.6 | 5.8 | 5.5 |
| Enterprise Value/Cash Flow (EV/CFO) | 11.0 | 14.3 | 14.8 |
Microsoft's share price declined after it made the $40 billion offer for Yahoo, in anticipation of future earnings dilution. It's more or less trading at a market multiple and delivering much more growth.
While the Growth and Profitability gauges each gave up a few points from December's stellar highs, they are still at very good levels. The Value gauge has now joined the party, pushing the Overall gauge score up to 58 points. The last time the Overall gauge score was this high was June 2006. However, this positive story has to be balanced with a caution that quarterly earnings were driven by one-time factors such as legal settlements, tax rate changes, and gains on derivatives.
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Overall score should be 60 and not 58.
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