Microsoft, Would I buy it again?

14 minutes

 

Microsoft, one of the largest, best-known tech companies out there. They are an interesting mix of trendy and hip. Or old-school tech with their previous reliance on arguably out-dated tech, laptop computers and Windows operating systems. With the advent of cloud computing and data storage, they have recently soared back into our collective conscience with their success in this field.

This company was the first stock I ever purchased so it has a soft spot in my heart. And always will. I have never sold that original purchase and have made additional ones since. I would like to take some time to look at why I bought this stock back then and what I think of the purchase now based on my evaluation of today’s company. Would I have bought it back then knowing what I know now?

Let’s take a look and see.

Business Overview

Microsoft was founded in 1975, and they operate in 190 countries around the world. Microsoft(MSFT) is a technology company “whose mission is to empower every person and every organization on the planet to achieve more. Our strategy is to build best-in-class platforms and productivity services for a mobile-first, cloud-first world.”

Their products include operating systems: server applications, business solution applications, software development tools, video games, and training and certification of computer system integrators and developers. They also design, build and service PCs, tablets, gaming consoles, and of course. Phones.

This is by no means and exhaustive list but a sampling of some of the more well-known products they offer. Of course, the two best known being Windows and Xbox.

For the year ending 2016, Microsoft reported revenues of $85,320 billion which resulted in net income of $16,798 billion. This was a decrease of 9% in revenue from 2015 and an increase of 11% in net income from 2015. The earnings per share increase from $1.48 in 2015 to $2.10 which was an increase of 42%.

Some explanations from MSFT for these changes were in 2016 there was a deferral of net revenue from Windows 10 of $6.6 billion(9%) and an unfavorable foreign currency impact of about $3.8 billion or 4%.

Additionally, the changes in EPS from 2015 to 2016 were due to the negative impact of the Windows 10 net revenue deferral and impairment, integration, and restructuring expenses. This drove down the EPS $0.69 to $2.10. This was an increase over 2015 but not as much as it could have been, obviously.

Some key changes in expenses were:

  • The cost of revenue decreased $258 million or 1%, mainly due to a reduction in phone sales, which was a result of the change in strategy regarding the phone business.
  • Impairment, integration, and restructuring expenses decrease $8.9 billion, due to prior year goodwill and asset impairment charges related to the phone business and restructuring charges associated with changes in the phone business.
  • Sales and marketing expenses decreased $1 billion or  6%, driven by a reduction in the phone business and a favorable foreign currency impact of about 2%.

Some highlights for 2016 were:

  • Commercial cloud annualized run rate exceeded $12.1 billion
  • Office 365 consumer subscribers increased to 23.1 million
  • Microsoft Dynamics CRM Online seat additions more than doubled year-over-year
  • Microsoft Azure revenue grew 113%, with the usage of Azure compute and Azure SQL database more than doubling year-over-year. Enterprise Mobility customers nearly doubled year-over-year to over 33,000.
  • Windows 10 is now active on more than 350 million devices around the world
  • Xbox Live monthly active users grew 33% year-over-year to 49 million.

In June 2016, the big announcement occurred that MSFT was going to buy LinkedIn. The agreement was for $196 per share in an all-cash transaction valued at $26.2 billion.

In other news from MSFT, in May 2016 the announcement of the sale of the entry-level feature phone business for $350 million. The sale is expected to close towards the end of 2016 but no announcement has come yet.

The hope is to streamline MSFT into one Windows experience and continue to focus it’s energies on the cloud experience as the driver of future incomes.

Source Microsoft 10-k 2016

Productivity and Business Processes

The focus of this part of the business is helping people be more productive by bringing intelligence to familiar office apps that they use every day. MSFT recently introduced cloud power intelligence to Word, Excel, Powerpoint, and Outlook. The company is also building intelligence into their apps to provide advanced security for its customers.

Monthly users of Office 365 commercial are now over 85 million, which is up more than 40% year-over-year. Office 365 seats were also up 40% year-over-year and revenue up 54%. Office is available on other devices as well which now has over 45 million users on ios and android, which is an increase of 70% year-over-year.

Productivity and Business Processes revenue increase slightly, due primarily to and in an increase in Office and Dynamics revenue. This revenue included a loss due to foreign currency exchange of 6%. Office commercial revenue saw an increase of $135 million or 1%, which was driven by increases in Office 365 commercial revenue. This was mainly due to an increase in subscribers. This was offset by lower license volume as MSFT has seen a shift in business PC market to Office 365. Office consumer revenue decreased $69 million or 2%, which was driven by the decline in the consumer PC market. This was offset by an increase in Office 365 revenue, mainly due to subscribers. Lastly Dynamics revenue increased 4%, this was mainly because of higher revenue for Dynamics CRM Online. This was driven by seat growth.

Operating Income and gross margin decreased for Productivity and Business Processes for 2016 primarily due to lower gross margin and higher cost of revenue, respectively. Each was down 7% and 4% or $898 million and $970 million. The Gross margin included the unfavorable impact from foreign currency which was 6%.

The cost of revenue increase $1 billion or 26%, this was due primarily to an increased mix of cloud offerings. Lower marketing expenses helped reduce the operating income by $72 million or 1%. The sales and marketing expenses were driven lower by the reduction in headcount-related expenses. This decrease was $82 million or 2%.

Intelligent Cloud

The Intelligent Cloud segment consists of public, private and hybrid server products and services. These services include Windows Server, SQL Server, and Azure. There is also an Enterprise component as well. These are all designed to help the IT professionals be more productive and efficient.

Azure is the main driver of cloud services for Microsoft. It is a scalable cloud platform with computing, networking, storage, database, and management. It is very flexible and allows customers to manage many different aspects of their business and devote more time to the business instead of the management systems.

Revenue from this segment increased $1.3 billion or 6% in 2016. This was primarily due to higher server products and cloud services revenue. This, of course, included a negative foreign currency impact of about 5%.

Server products and cloud services grew revenue $686 million or 4%, driven primarily by growth from Azure of 113%. There was a slight decline in on-premise server products which offset this growth.

Enterprise services revenue grew by $536 million or 11%, this was driven by growth in the Premier Support Services.

Intelligent Cloud operating income was down $513 million or 5% in 2016. The main culprit was higher operating expenses. Operating expenses increased $989 million or 12%, which was due to higher research and development expenses and S&M expenses. The increase in R&D of $567 million or 12% and S&M of $347 million or 9% was due to increase strategic investments and acquisitions to drive cloud sales capacity and innovation.

Gross margin increased $476 million or 3%, which was offset by a higher cost of revenue. This drove a growth in revenue. The costs of revenue increased $851 million or 15%, which was driven by an increased mix of cloud services.

More Personal Computing

This segment is all about everything Windows. It is meant to connect all users from developers, IT professionals, and end users. It includes Windows licensing, devices that include phones, Surface, and PC accessories. Also included in this segment is Xbox revenues and Bing advertising revenues.

Windows 10 has been a transformative event for the company as the software moves away from just an operating system on a PC to a service that can power a full array of devices.

The devices consisted primarily of phones and Surface. With the changes in the phone business, this segment of the business has been hit the hardest with revenue drops. In May 2016 Microsoft announced that they were selling the entry-level phone business.

Next up is the gaming business. Xbox with its multiple streams of revenue has been a big winner for Microsoft. With the launch of Xbox live and it’s ability allow people to connect live and share online experience. The purchase of Minecraft in 2014 has helped enhance the gaming portfolio across many different platforms.

Lastly are Bing and the advertising that it brings to the table.

In 2016 revenue declined for the More Personal Computing segment by $2.7 billion or 6%. This was mainly due to the lower revenue from Devices and Windows. This was offset by the higher revenues from Search advertising and Gaming

Devices revenue decreased $3.7 billion or 32%, which was mainly due to lower revenue from phones. This was driven by a change in strategy in phones. But there was an increase in Surface revenue. The decrease in phone revenue was $4.2 billion or 56% while the increase in revenues from Surface was $486 million or 13%. This was driven by the release of Surface Pro 4 and Surface Book.

Windows revenue decreased $871 million or 5%, primarily from lower revenue from patent licensing. This was driven by a decline in the PC market as less computer sold, the fewer licenses sold per unit.

There was an increase in Bing advertising revenues of $1.7 billion or 46%. This was primarily because of a growth in Bing, due to higher revenue per search and search volume.

More Personal Computing saw an increase in operating income of $1.5 billion or 32%, which was due to a decrease in operating expenses, which did see a decrease of $2 billion or 13%. This was all due lower sales and expenses in marketing and R&D. Sales and marketing expenses decreased $1.3 billion or 19% and R&D decreased $676 million or 10%. All of this was driven by a reduction in phone expenses. Gross margins dropped $564 million or 3%, due to lower revenue and despite a reduction in the cost of revenue. The cost of revenue dropped $2.1 billion or 9%, driven primarily by a decrease in phone sales.

Risks

The risks that MSFT face are twofold. First would be competition in the technology field, which is incredibly fierce. There is a constant battle of who can stay cutting edge and relevant in each field that they compete in. Windows is always going to be in a battle with Mac about which is the better operating system.

There is always someone out there trying to develop something better. MSFT has to devote tremendous time and resources to development to remain competitive. Some of the competitors that exist for a market share of operating systems would be Adobe Systems, Apple, Cisco, Facebook, Apple, Google, among others. Some very big hitters indeed.

In the internet surfing world, which is dominated by Google, MSFT competes with Bing. In the cloud, they face competition from Oracle, SAP, IBM. And finally, in the world of online gaming, they face off against Sony and Nintendo. With the lifecycle of a gaming station being 5 to 10 years there is fierce competition to see who will come up with the next best thing.

Another big risk is the failure of a new product or system. There is incredible time and resources put into the development of any new product or system. This investment is incredibly speculative because if it fails it can really set a company back, both monetarily as well with their reputation. It can take several years to become profitable on any new release which can affect the revenues of the company.

Valuation

My process for evaluating companies has grown over the years, like everyone else’s. Today I have a set of criteria that I initially look for before I will look into the company more deeply. If I come across a company that peaks my interest I will do a quick evaluation with the following ratios. If those ratios don’t meet the standards then I move on to the next idea. The cool thing about value investing is that you don’t need to swing at every pitch. If you don’t like something, don’t swing.

The ratios are as follows:

  1. Equity Growth Rate
  2. Return on Invested Capital
  3. Revenue Sales Growth
  4. Earnings Per Share Growth
  5. Free Cash Flow Growth

The two most important to me are the Equity Growth and ROIC. For all of these, I look for at least 10% of each category. In addition, I will also look for trends, whether it is declining steadily or rising steadily. If there are sharp drops or rises in the growth rates. Basically looking for patterns.

The time periods I use are:

  • 10 Year
  • 5 Year
  • 3 Year
  • 1 Year

This gives me a snapshot of how the company has been doing and what their track record is. It also helps weed out a newer company that you may need to apply different standards for.

Chart courtesy of IRA for Beginners

First up is Equity Growth Rate. As you can see the numbers had been on a steady decline over the last ten years. I attribute this to MSFT being a more mature company that was struggling to stay relevant in the tech world.

Notice that there was a big jump in the last year. I think this is an indication of the new focus of the company and the switch away from its previous plan. With the switch away from personal computers and phones and towards the cloud based technologies they have found a new voice to help them grow as a company, once again.

A longer time period is needed to assess this trend to see if it continues. Based on this ratio I would pass at this time.

Chart courtesy of IRA for Beginners

Next up is ROIC Growth rate. Based on the first look at these numbers you can see they have done a pretty good job of being capital allocators. Ten years ago they were awesome and the last 5 years have seen a gradual decline. None of the numbers are necessarily bad but the decline is a little troublesome.

Another indicator of their allocation of capital is the payment of dividends. On this score, MSFT has been outstanding. They have increased their dividend payments from $.39 to $1.39 a share in 2016. That is a 72% increase!

ROIC is also another indicator of a moat for a company. With the decline in ROIC in the last ten years, you could argue that maybe they have lost some of their moats but I would argue that with the change in direction of the company I think this will be something to watch going forward.

You have to applaud management for seeing the writing on the wall and shifting directions. It is not an easy thing to do but necessary in today’s business world to succeed.

Based on the numbers here this would be a buy, with caution.

Chart courtesy of IRA for Beginners

Third in our list of ratios to look at is EPS Growth Rate. As you can see here it has seen pretty even over the last ten years with a huge spike in the last year. The spike can be attributed to a loss in revenue and EPS, that was reported in the 4th quarter of 2015. When compared to 2016 this comparison drove up the growth rate substantially. This was due to the impact of a $7.5 billion non-cash impairment charge related to assets associated with the acquisition of Nokia Devices, in addition to a restructuring charge of $780 million. These numbers are all GAAP reported.

If you look at the Non-GAAP reporting the EPS and revenue normalize to historical levels. This would show a very slight rise in growth for EPS in 2016. The increase would have been incremental of .47%. Pretty negligible.

Based on the trend of growth for the last ten years, this indicated to me that it is a mature company that right now is looking for an avenue for growth. As we have discussed time will tell on the cloud emphasis.

The current level of these ratios would have me pass.

Chart courtesy of IRA for Beginners

The next ratio we will look at is revenue growth rate. As you can see from the chart above it has been in a steady decline of the past ten years with a sharp drop in the last year. Digging into this further I found out that MSFT deferred $6.6 billion due to the deferral of revenue from Windows 10. The revenue from Windows 10 is realized at the time of billing and is assigned to the More Personal Computing segment. The deferral has been assigned to the Corporate and Other segment, where it is reported.

If you add that revenue back into the current numbers you will still see a decline but it is far less dramatic. And the decline can be attributed partially to a loss of currency exchange of $3.8 billion. The difference with the deferral added back in would be a loss of 1.7%, which given the currency exchange loss helps explain the difference.

Of course, you never like to see a decline in revenue but as we have discussed the company is changing direction and turning a company the size of Microsoft is like turning the Titanic before the iceberg. Slow and laborious but eventually it will move. Maybe not the best analogy, given the circumstances but the illustration fits.

The results of this ratio would be a pass.

Chart courtesy of IRA for Beginners

The last item up for bid today is the Free Cash Flow Growth rate. As you can see, pretty good ten years ago but the last five years or so pretty mundane.

Free cash is the lifeblood of any company and with the lackluster growth in this area, there is a reason for concern. With the decline in revenue over the last ten years and ROIC flattening out as well, you can see why the need for a change in direction.

Microsoft has such a strong balance sheet with so much cash on it. Currently, that number sits at $139 billion. This gives them a tremendous amount of flexibility. So the lack of FCF is not incredibly limiting for them like it might be for other companies.

The results from this ration would cause me to pass as well.

Final Thoughts

Microsoft is one of the world’s most recognizable companies with amazing products and services that are utilized by millions of people around the world every day. They have come a long way from the early days and have become one of the industry leaders in the tech world.

As I stated, in the beginning, MSFT was the first stock I ever purchased so it will always have a place in my heart. We all have our firsts and it is interesting to go back and look at why we bought it in the first place. My rationale honestly was that I was new to this and it was a company that I was familiar with and I read a few articles about them so it seemed like a wise investment.

I have never lost money on the buys that I have made, but I have not made as much as I could have buying other companies.

As my investment knowledge has grown and will continue to grow. Because I will never know it all, that’s what makes it so much fun. My views have changed over the years and I have come to embrace the value investing philosophy. And as I have embraced this set of ideas my valuations of the companies that I buy or look at has changed.

This has been an incredibly fun exercise to work through the numbers and the story of Microsoft. And I have to say I have learned so much about the company. It is a fascinating company with tons of opportunities and I am excited to see where it is going to go.

Having said all that I would have to say that based on what I see currently I would have to pass on buying the company currently. The ratios that we discussed are just not where I would want to see them. I am looking for at least 10% growth in each ratio and ideally to see them growing over the years.

In addition to the ratios, if you look at a quick intrinsic valuation using the graham formula you come up with a value of $17.20. Quite a bit below the current price today, which leads to me feel like the company is currently overpriced and wouldn’t fit into a category where I would feel comfortable buying it.

Microsoft has a lot going for it and I think the switch to the cloud-based platforms that they are developing will lead to growth. Also, another avenue that we didn’t discuss was their recent purchase of LinkedIn. There are many opinions both for and against, and I won’t weigh into those for now. But I know that Microsoft will continue to look for opportunities to grow internally or externally by adding companies that will create more growth for them.

As always thanks for taking the time to read the post. If you found it informative please take a moment to let other know.

Take care,

Dave

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