I always start analysis of a company with a look at financials because it’s the fastest way to eliminate poor investments. Microsoft barely needs a glance in this department, it’s a solid company.
– Return on assets of 12% suggests great returns on investment, as does net profit margin of 23%.
– Interest cover of 60x and debt over equity of 20% show it has no financing problems on the horizon.
– Decrease in EPS in 2012, due to a $6bn write-down so not gamebreaking.
– PE ratio of 15 vs 5 year average of 13 suggests it’s worth looking at but not exactly cheap.
– Plenty of cash flow so nothing dodgy immediately obvious about profits.
So no red flags, let’s dig out the 10-K and move on.
The business is split into 5 operating segments.
1. Windows & Windows Live (Revenue: $18bn, Operating Profit: $11.5bn)
Windows operating system makes up 75% of this divisions revenues and is highly correlated with the PC market. Other products are Windows Live suite and some hardware devices (Windows Surface). Revenue and profits are in decline, not because of a poor overall PC market, but because the PC market growth is driven by emerging markets were the selling price of Windows is lower.
2. Server and Tools (Rev: $19bn, Op: $7bn)
Develops and markets server software, services and solutions. 55% of revenue comes from multi-year volume licensing agreements. This segment faces intense competition from big names such as IBM, Oracle and Amazon. Revenue and profits are increasing in double digit %’s.
3. Online Services (Rev: $2.8bn, Op: -$8bn inc exceptional $6bn charge)
Includes Bing, MSN, adCenter and advertiser tools. Bing and MSN count for virtually all revenue, generated by search and display advertising. Main competition is Google, who are better in my opinion. Revenue has been increasing but is a long term loss maker with no real improvement in sight.
4. Microsoft Business (Rev: $24bn, Op: $12bn)
Over 90% of this segments revenue is generated by Microsoft Office (80% from sales to business). It is relatively independent of the PC market. Emerging competition from Google and others, but not as advanced. Strong revenue and very strong profit growth in last few years.
5. Entertainment and Devices (Rev: $10bn, Op: $0.3bn)
Xbox 360, Kinect for Xbox 360, Xbox games, Skype and Windows Phone. Consistent growth in revenue, however income quite erratic and inconsistent.
In depth Financials
A more in depth look at their financials shows there are essentially two aspects to this investment. There is the operating cash flow, and the large store of cash on the balance sheet. I have selected important components of the financials below. I performed a thorough analysis of far more things but these are in my opinion the most important for valuation and monitoring purposes.
First thing I noted was the falling profit margins. This seems to be part of a long term trend as business shifts from the high margin Windows segment to the slightly lower margin Server and Business segments. Margin decline looks set to continue into the future. Next thing is that tax rates have changed over time, due to geographical and segment changes. These appear to be long term shifts but to be conservative, pre tax profits will be looked at for growth calculations.
Adjusted pre-tax income grew on average at 7.6% annually compounded over 10 years, and 7.2% annually compounded over 5 years.
Free cash flow exceeds the stated profits, most likely due to early revenue recognition. I will use reported profits for the purposes of discounted cash flow modelling.
Notable balance sheet items are the $56bn in marketable securities. Cash will be assumed to be necessary for the working of the company. These securities are not operating assets, however they do affect the income statement. Almost all of this is held by foreign subsidiaries and therefore would be subject to repatriation tax if brought to the US to return to shareholders. There is also a liability of $20bn for unearned revenues, which is what this cash relates to. I don’t think it’s appropriate to include this, it will be included in profits at a future date. Removing this gives a value of $36bn. The tax also reduces the value to a shareholder by around 30% to $25bn.
In valuing the company I will include this sum, therefore I will exclude the income from the income statement as otherwise I would be double counting the value. That is given in the green row above. Note that the growth rate of 7.2% is still ok to use conservatively.
Debt is negligible, and matched almost exactly by other long term securities (mainly equities) which balance eachother out (I haven’t included these in the table above). Hence I won’t make any adjustment to value for debt or these long term investments.
Hence with a market cap currently of $230bn, subtracting $25bn in liquid securities gives a $205bn value to future earnings. On adjusted earnings of $21.3bn that is a P/E ratio of 9.6, which looks attractive. Hence from a purely financial point of view, if it can continue to grow profits at 7.2% per annum as it has over the last 5 years, and can return excess cash to shareholders and not squander it away this investment looks like a no brainer. But the quantitative analysis is only half of the story. Next we look at the qualitive.
Their market provides great returns due to the coupling of devices with services. For example the XBox, once someone has invested in the device there is a constant revenue for Microsoft from XBox online services and games with little competition as the customer has committed through the purchase of an XBox.
The servers and tools division is expanding strongly as businesses continually upgrade their IT infrastructure to a cloud based environment. This shift is likely to continue and again once this product is installed there is a large barrier to replacing it with a competitors product.
Lots of their revenues are paid far in advance, which gives them a ‘float’ and means they need little leverage to operate.
Most of their cash is in US treasury bonds, with short maturities (0-5 years) which means low risk.
The overall PC market was stable in 2012 however MSFT revenues declined due to most of the growth coming from emerging markets were average selling prices are lower. This trend is likely to continue. Moreover if the PC market starts to experience decline this could hit Microsoft even harder. There is already a decline in the western world with new products like smart phones and tablets. This trend could shift to emerging markets once the prices for these items come down.
The $6bn dollar writedown relates to the aQuantive acquisition and means almost entire value paid has been written off. Clearly a board mistake which I discuss in more detail below.
Law-suits – there are a lot of them and in the tech world everyone seems to be sueing everyone else. There is a risk that any adverse judgement against Microsoft could materially affect its profits. Conversely however, any ruling for it could boost its cash. Having checked through the notes there doesn’t appear to be anything that could have a significant impact on their operations however.
Q1 and Q2 earnings – revenues were down and earnings were down even more. Revenue growth in some segments is good but not as expected. The launch of Windows 8 has had an impact on quarterly results, but they have provided adjusted measures to take account of free upgrade offers which paint a less bleak picture.
The Ugly (The Board)
In 2011 Skype was acquired for $8.6bn in cash. After searching online, it appears Skype lost $99m in 2009 and made $13.2m in 2010. It’s a fast growing company which are hard to value, but even so this is a huge price to pay considering the cash it generates. It’s hard to see how it can make much money too, as most people use it for free. Combine that with the aQuantive acquisition and I don’t really have faith in the acquisitions the board is making.
I also think the explanation for the fall in profits in the last two quarters results leaves a lot to be desired. Revenue changes were explained well but profits hardly mentioned. One can only take from that that it is likely margins have been permanently impaired and it appears to be a deterioration in gross margins.
Overall, the future is very uncertain for Microsoft but they clearly have some very strong lines of business. Given the recent weakness in results, I think it demonstrates that although they may grow sales in the future their margins could deteriorate as their business changes. To protect from this and be conservative I would value them at a PE of 10, which assumes no profit growth at a discount rate of 10%. That’s after the cash on the balance sheet is taken account of, hence a market cap of $235bn I think is fair value.
That’s its current market cap, I would be looking for at least a 20% discount which is a market cap of $188bn. MSFT has been added to the watchlist.
Disclosure: No position in MSFT.