MSFT valuation:
From the fool.com
By Matt Richey
Over the course of the holiday weekend, both Microsoft (Nasdaq: MSFT) and American Express (NYSE: AXP) reported "better-than-expected" earnings per share, each topping the consensus estimate by exactly two pennies. Logically, then, Microsoft was taken out back and beaten black and blue today for a 15.6% loss, while AmEx was awarded a gain of 4.9%. Ahhh, the maddening subtleties of understanding stocks! Clearly, only one of these companies really outperformed expectations. Let's focus on the one that didn't.
By all appearances, the once mighty Microsoft is looking rather forlorn, weary, and defeated today. Government antitrust woes are now being compounded by concerns over appreciably slower revenue growth. The stock got hammered today and, at $66 5/8, is trading at levels not seen since late 1998. Over $300 billion of wealth has evaporated since the shares hit their all-time high of $120 earlier this year. Our minds can't really comprehend the impact of such a massive erasure of wealth, but needless to say, there are a lot of us looking at our brokerage account statements and noticing a bit of "asset deflation," as Alan Greenspan calls it.
Contrary as it may seem, Microsoft's fiscal third-quarter numbers looked quite solid. Starting at the top of the income statement, revenues grew 23.1% to $5.7 billion, representing substantial fundamental business growth, and well ahead of our 10% revenue growth minimum. Revenues grew a lot but material costs grew only a little, resulting in higher gross margins -- up several percentage points to 86.7%. One expense that grew quite a bit faster than sales was research and development (R&D). During the third quarter alone, Microsoft spent nearly $1 billion in its search for the software solutions of the future. That level of spending -- investing, to be more accurate -- was up 49% year-over-year and represents one of the highest levels of research spending for any public company. Even so, that didn't hinder Microsoft's ability to produce a net profit margin of 42.2% -- the highest ever.
The balance sheet was similarly outstanding. Ponder these numbers: $21.2 billion in liquid cash, plus another $21.3 billion in long-term investments, for a total war chest of $42.5 billion. That's all, of course, without any debt. During the quarter, the total war chest increased by $4.9 billion. We don't yet have a cash flow statement, but I don't think we need one to verify that Microsoft is still producing mucho cashola. It's interesting to note that Microsoft's war chest makes up more than 80% of its total asset base. As Zeke has been explaining in his ongoing series on software companies -- most every Friday in this space -- the software business is attractively non-capital-intensive.
Last but not least on the balance sheet, Microsoft's Flow Ratio came in at only 0.36. That's up from 0.29 a year ago, but it breaks the string of four consecutive quarters of rising Flowies. The culprit in the rising Flow Ratio has been the rising level of Days Sales Outstanding (DSOs), which represent the number of days it takes to collect booked sales. DSOs have been increasing every quarter for the past several years because of the rapid sales growth in Asia, where collection times are much slower than here in the U.S. During the most recent quarter, for example, Asian sales grew twice as fast as the overall average and accounted for more than 20% of the overall growth. Clearly, the costs of suffering those slower collections is well worth the extra revenue they create.
As you can see, through our old-fashioned, long-term Rule Maker glasses, Microsoft is attractive as ever -- and even more so at these lower levels. Today's pummeling was the result of slower-than-expected revenue growth and what could be described as almost pessimistic guidance on the conference call. As I mentioned earlier, revenue growth for the quarter came in at 23%, but that was a tad lower than the 25% forecasted in the January conference call. So, in a sense, Microsoft fell short of revenue estimates. Business PC sales remained sluggish until the tail end of the quarter when the launch of Windows 2000 served as a catalyst.
Looking ahead, Microsoft CFO John Connors steered analysts to lower their EPS estimates for both the coming quarter and the coming fiscal year (which begins in July). Connors also cautioned that revenue growth for the coming year (FY01) was likely to be closer to 15% instead of the 20% that many analysts had modeled. Hence, all of the bearishness surrounding the shares today. That's on top of the renewed speculation of a government breakup, as mentioned in this morning's Fool Breakfast News.
When it comes to Microsoft, I think Foolish investors do best to watch what Softy does rather than what Softy says. During the question and answer period of the conference call, Connors admitted that his forecast for the coming year didn't include any of the potentially positive factors such as the strong chip demand reported by Intel (Nasdaq: INTC), the introduction of the PocketPC software for handheld devices (check out this impressive demo), and the success of Microsoft's Internet properties, which are generating usage on par with that of Yahoo! (Nasdaq: YHOO). Microsoft also stands to benefit immensely from Windows 2000 and the associated server products, which I discussed more fully in last week's Dueling Fools.
I'm not sure why Microsoft management would talk down the numbers, but I see many positive catalysts for Microsoft in the coming year that would appear to make Microsoft a bargain relative to its strong cash flow generation, which continues to grow at a double-digit pace. If Microsoft's free cash flow grows 15% in the coming year, it will total over $15 billion. Within the universe of public companies, you'd be hard-pressed to find another economic model that consistently spits out that kind of cash.
For more on Microsoft's earnings and a replay of the conference call, I encourage you to peruse the company's investor relations site, which is the best I've come across. Microsoft is a model of full and fair disclosure to all shareholders, big and small alike. If you'd like to see other companies live up to this standard of disclosure, please take a look at the Fool's new special on the Battle Against Selective Disclosure.
Finally, not to give AmEx short shrift, but I at least want to mention our financial Rule Maker's continued excellent results. As mentioned in the earnings press release, net income increased 14% and revenues rose an outstanding 16%. Growth appears to be accelerating as the company benefits from the popularity of the American Express brand name, and the multitude of financial services that are offered under that name. Return on equity for the quarter rose to 25.4%, up from 25.1% a year ago. Nothing flashy, just solid business growth in a manner that rewards shareholders.
--Matt
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