Microsoft Corp. (MSFT), the gigantic developer of operating system and application software, also sells video game consoles, music players, and computer peripherals. Microsoft is determined to be a major player in the online advertising business, in direct competition with Google Inc. (GOOG); however, its proposed $40+ billion acquisition of Yahoo! Inc. (YHOO) has, as yet, been unsuccessful.
Our earlier financial analysis of Microsoft's March 2008 quarter found that the GCFR Overall Gauge score increased 6 points to a very good 58 out of 100 points. This result, the highest since June 2006, was boosted by a 20-point score, of 25 possible, on the Growth gauge and 15 points each on the Profitability and Value gauges.
Now, with the available data from the June 2008 quarter, which was the fourth quarter of Microsoft's fiscal year, our gauges display the following scores:
- Cash Management: 10 of 25 (unchanged from the March quarter)
- Growth: 16 of 25 (down from 20)
- Profitability: 13 of 25 (down from 15)
- Value: 18 of 25 (up from 15)
- Overall: 59 of 100 (up from 58)
Before we examine each gauge, let's compare the latest Income Statement to our expectations, which were based on company guidance and our trend analysis.
Please note that the tabular format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($M) | | June 2008 (actual) | June 2008 (predicted) | June 2007 (actual) |
| Revenue | | 15837 | 15650 | 13371 |
| Op expenses | | | | |
| | CGS | (2866) | (2817) | (3237) |
| | R&D | (2407) | (2113) | (1948) |
| | SG&A | (4880) | (4695) | (4197) |
| | Other | (0) | 0 | 0 |
| Operating Income | | 5684 | 6025 | 3989 |
| Other income | | | | |
| | Investments | 0 | 0 | 0 |
| | Interest, etc. | 284 | 350 | 295 |
| Pretax income | | 5968 | 6375 | 4284 |
| Income tax | | (1671) | (1913) | (1249) |
| Net Income | | 4297 | 4463 | 3035 |
| | | $0.46 | $0.47/sh | $0.31/sh |
| Shares outstanding | | 9380 | 9400 | 9657 |
Revenue in the recent quarter surpassed the $15.5 to $15.8 billion range forecast by the company in the press release reporting the results of the March quarter. Our target was the mid-point of the range. Revenue in the June 2008 quarter was 18.4 percent more than in the year-earlier quarter. Revenue in the last four quarters grew by 18.2 percent.
We expected Microsoft to attain a Gross Margin of 82 percent of Revenue in the quarter, and they almost made it. The actual value was 81.9 percent: the Cost of Goods Sold was 18.1 percent of Revenue. In the year-earlier quarter, the margin was unusually weak at 75.8 percent because of a $1 billion charge to repair faulty Xbox games.
Research and Development expenses were 15.2 percent of Revenue in the quarter, much higher than our 13.5 percent estimate. Microsoft attributed rising R&D costs to increased personnel ("head-count") expenses and rising product development costs. Sales, General, and Administrative expenses were 30.8 percent of Revenue, a little higher than our 30 percent estimate.
Much higher R&D costs outweighed the strong Revenue growth and led to Operating Income 5.7 percent below the forecast value. Operating Income also fell under the $5.8 to $6.2 billion range indicated in the company's guidance.
Non-operating investment income was $66 million less than we expected because Microsoft's cash balances were lower, as were interest rates. The Income Tax Rate of 28 percent was below the predicted 30 percent because a greater percentage of earnings were in lower-tax jurisdictions.
Net Income in the quarter fell below the prediction by 3.7 percent; however, it was 42 percent above earnings in the June 2007 quarter.
Cash Management. At 10 points, this gauge didn't change from the March quarter.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| Current Ratio | 1.4 | 1.5 | 1.7 |
| LTD/Equity | 0% | 0% | 0% |
| Debt/CFO | 0 yrs | 0 yrs | 0 yrs |
| Inventory/CGS | 33.2 days | 38.5 days | 44.5 days |
| Finished Goods/Inventory | N/A | 34.1% | 48.3% |
| Days of Sales Outstanding (DSO) | 75.3 days | 57.7 days | 73.7 days |
| Working Capital/Market Capitalization | 5.2% | 5.4% | 5.8% |
| Cash Conversion Cycle Time | -7.5 days | -10.8 days | 9.6 days |
We would attribute the downtrend in the Current Ratio to cash spent repurchasing the company's common shares and on corporate acquisitions, such as the $1.2 billion spent on Norway's Fast Search & Transfer ASA. However, Microsoft still has more than $23 billion in cash and short-term investments, and it has no debt. We don't scrutinize Inventory at Microsoft because they are more of a Services business than a Manufacturing business.
Growth. This gauge decreased from 20 points in March to 16 points now.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| Revenue growth | 18.2% | 16.9% | 15.4% |
| Revenue/Assets | 83.0% | 81.9% | 80.9% |
| CFO growth | 21.4% | 31.5% | 23.5% |
| Net Income growth | 25.7% | 18.5% | 11.6% |
Revenue growth and Net Income growth both re-accelerated in the June quarter, which is admirable given that it has new been 18 months since the Vista operating system and Office 2007 launches. It should, however, be noted that changes in currency conversion rates accounted for $542 million of the quarter's Revenue. The drop in the Growth gauge score doesn't reflect any concern with the reported figures, only that comparisons with prior-year results are getting harder to top.
Profitability. This gauge decreased from 15 points in March to 13 points now.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| Operating Expenses/Revenue | 62.8% | 64.1% | 63.8% |
| ROIC | 64.4% | 60.0% | 51.9% |
| FCF/Equity | 50.8% | 51.0% | 49.9% |
| Accrual Ratio | +0.9% | -3.5% | -15.5% |
Although Operating Expenses edged up in the June quarter, they are slightly down when averaged over the trailing four quarters. This is due in part to the Xbox charge occuring in the prior year. 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.
Value. Microsoft's stock price slipped from $28.37 to $27.51 over the quarter, and it is already down another $1.65 on lower-than expected guidance (more about that later). The Value gauge, based on the quarter's-end price, rose to 18 points from 15 points three months ago.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| P/E | 14.6 | 16.3 | 20.2 |
| P/E to S&P 500 average P/E | 85% | 95% | 123% |
| Price/Revenue | 4.3 | 4.6 | 5.6 |
| Enterprise Value/Cash Flow (EV/CFO) | 10.8 | 11.0 | 14.7 |
Microsoft's valuation ratios can be compared with other companies in the Application Software industry here.
Microsoft's share price declined after it made the $40 billion offer for Yahoo, in anticipation of future earnings dilution. The shares are trading at much less than a market multiple, even though the company is growing much faster than the average company.
While the Growth and Profitability gauges gave up a few points, the double-weighted Value gauge moved up to a very good 18 of 25 possible points. The net effect was a small increase in the Overall gauge score to 59 points of 100 possible points. The last time the Overall gauge score was this high was June 2006.
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