Monitoring Microsoft (MSFT)

[AF Addendum: The Online Stock Study of Microsoft, discussed below, is also summarized in the January 2010 issue of Better Investing magazine.]

Microsoft is the world’s largest software company (based on revenues) and about 80% of its revenue comes from sales of its Windows, Office and Server & Tools software.  However, cloud computing, sometimes called “Software as a Service” (SaaS) is a direct and serious challenge.  As a response, Microsoft’s newest version of Office, now in early testing, will offer online versions of Word, Excel, and PowerPoint that can be used on a computer, Web browser, or mobile phone.

MSFT was the Online Stock Study at the Better Investing website for September that was led by Jim Thomas.  Jim is a director and volunteer educator with the Puget Sound chapter, a software engineer who used to work for Microsoft, and was recently appointed to the board of IClubCentral. Thanks Jim for volunteering.

Each month, the Online Stock Study completes a SSG in about one hour with the judgments made by the online participants using consensus decision-making.  The Consensus SSG, Jim’s presentation slides, and the Value Line report are all available to BI members for downloading.  The recorded session should be available sometime soon.  [AF: it took one month, but the recording finally became available for downloading on 10-6-09]

Jim used the Online SSG which is much more limited than our SSG software.  Among its many limitations, the Online SSG projects future growth only from the last Fiscal Year, ignores Relative Value & Projected Relative Value and provides only one method to decide the Forecast Low Price in the next 5 years.  

 COMPANY BACKGROUND:

– Jim gave a very thorough report on Microsoft’s operations: 95,000 FT employees, 60% in U.S.; 5,000 to be let go by FY 2010; new products include Windows 7 and Office 2010.

– 32% of FY 2009 revenue generated by MSFT’s Business division, 90% from sales of MS Office and 80% of that from sales to business; 25% of revenue from its Client division, 80% from Windows Vista pre-installed on PCs; 24% of revenue from its Service and Tools division, 50% from multi-year licensing agreements; 13% from its Entertainment & Devices division (Xbox, Zune, mice & keyboards); and 5% from its On-Line Services (BING, MSN, Windows Live).

– R&D spending 15% of FY 09 revenue, up from 14% in each of prior two years; revenue down 3% in FY 09, EPS down 13%.

– Jim also reported on: revenue by operating unit and by geographic area; long-term debt; share buy-backs; and dividends.

DISCUSSION:

– I analyzed MSFT previously (on 9-30-08 and 11-21-08) and compared my two SSGs to AnnC’s and to Take Stock;  if you’re interested, see: Monitoring Microsoft

– In the table below, I compare the Consensus SSG to two of mine and to Take Stock.  Armin-1 is my SSG as of 8-18-09, before the Online Stock Study, while Armin-2 reflects my updated SSG.  Following the table, I discuss issues highlighted by the comparison.

MICROSOFT          (MSFT)	Consensus      SSG	Armin-1	Armin-2	Take Stock
Date	9-8-09	8-18-09	9-17-09	9-17-09
Data	S&P Online	S&P	Same	Hemscott- Mstar
Price	$24.80	$23.58	$27.66	$25.30
52 week High &     Low Price	$29.74 &        $14.87	$28.01 &           Same	$27.66 & Same	Not Included
Last Q of                  Reported Data	Q ending          6-09	Same	Same	Same
Software Used	Online SSG	TK 5	Same	TS Online
Project Growth      From End of	Last FY	Last Q	Same	Last FY
Sales Growth	07.80%	09.00%	Same	-03.2
EPS Growth	10.07%	10.00%	Same	-11.0
High PE	17.4	20.5               (four year ave with 2005 out)	Same	22.0
High EPS	$2.65	$2.41	Same	$0.90
High Price	$46.11	$49.40	Same	$19.79                (55% < VL’s        low end)
Value Line Estimated High Price = $45-50 as of 8-21-09
Low PE	09.1	14.0                  (four year ave with 2005 out)	Same	15.8
Low EPS	$1.64                (last FY EPS)	$1.65                   (ttm EPS)	Same	$1.62
Low Price	$14.92                 (low PE x low EPS)	$17.70               (70% of current price)	Same	$25.60                (higher than current price)
Ave % Payout	27.00%(reduced from 78.7%)	26.9%           (four year ave with 2005 out)	Same	Not  Considered
Upside/Down	2.15	4.4	3.1	Impossible to Calculate
Total Return	14.74%	17.3%	15.6%	05.4%
SSG Buy Under	Not Included	$25.63	Same	$10.80
RV/PRV	Not Included	82.7/76.5         (2005 out)	89.0/82.2(Same)	Not Included
Quality	Not Printed	B+	Same	.50(unacceptable)
PTPM – 5 yr ave	41.30%           Trend N/A	Same              Trend down	Same	39.1%                  Trend N/A
ROE – 5 yr ave       End Equity	36.97%            Trend N/A	37.00%            Trend even	Same	Not Included
ROE – 5 yr ave      Start Equity	Not Included	35.7%              Trend up	Same	35.1%                    Trend N/A
Debt to Equity –        5 yr ave	Not Included	01.9%              Trend up	Same	Not Included

(A) THE CONSENSUS SSG:

(1) Quality

– Jim evaluated four aspects of MSFT’s quality and found that 3 were satisfactory: Sales growth at 11.9% over the past 10 years; EPS growth at 11.4%; and Pre-Tax Profit Margin stable at 34-38%

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.

– Return on Equity merited further study, Jim concluded, but presumably was satisfactory as it was not considered a red-flag or barbed-wire fence not to cross.

– The Online SSG does not explicitly report the PTPM and ROE trends like our SSG software and Jim missed that PTPM was trending down which is typically considered a red-flag warning sign. 

** However, MSFT’s 5 year average PTPM is 40.30%, some 300% better than its industry average of 13.6% using S&P data, so I’m not worried.  To make this type of comparison, see: Investigating Industry Info.

(2) Estimating Sales Growth

– Jim gave the group three specific choices to estimate Microsoft’s future Sales growth: 11.9%, last 10 year historical growth; 10.0%, Value Line’s Sales per share estimate; and 7.8%, a composite rate that Jim devised (6 year historical + Yahoo Finance FY 2010 & 2011 estimates + VL FY 2012-2014 estimate) .

– He also offered two other choices that seem pointless: higher and lower.

– Jim did not consider MSFT’s more recent historical Sales Growth (6.9% and 11.4% last 3 and 5 years) and did not mention other analyst estimates for Sales growth (not Sales per share growth): Zacks at 10.62% estimated Sales growth for the next 5 years.

– The Consensus chose 7.8% which is no surprise since that seems to be the only realistic option out of the 5 choices offered.

(3) Estimating EPS Growth

– Because Jim used BI’s Online SSG, all projections were from the end of the last FY (2009, $1.64 EPS) unlike our SSG software which has options to project from the end of the last quarter or from the trend line.  This had no impact on MSFT because the end of its FY was also the end of its last Q.

– Jim also gave participants three choices to determine MSFT’s future EPS growth: $2.89 or 12.0% from S&P’s estimate; $2.73 or 10.7%, another composite rate Jim derived from Yahoo Finance’s FY 2010 & 2011 estimates and VL 2012-2014 estimate; and $2.65 (no rate mentioned), next 3-5 year estimate by Value Line .

–  He also offered the same two other choices: higher and lower.

– Surprisingly, Jim did not consider Yahoo Finance’s EPS estimate for the next 5 years (10.17%) which seems way more appropriate than relying on its EPS estimates for the next two years.  And, while he mentioned MSFT’s historical EPS growth (11.40%), he did not offer it as an option to the group.

– Perhaps most importantly, Jim did not consider the long-term EPS estimates from other analysts which I discuss under Armin’s SSGs.

– The Consensus chose 10.7%, Jim’s composite rate.

(4) Forecasting High & Low PEs

– Jim offered three choices to Forecast MSFT’s High and Low PEs for the next 5 years: 20x & 16x, from 10% plus or minus VL’s forecast of 18x; 17.4 & 9.1, from 2009 actual; and 15x & 10x, from Jim’s “visual” inspection of the range over the last year.

– Again, he also offered the same two other choices: higher and lower.

– The Consensus chose 17.4 & 9.1, from 2009 actual.

(5) Estimating Average % Payout

– Microsoft paid a special dividend in 2005 that distorted the five-year average. So Jim reduced the 78.70% average to 27.00% in order to estimate the average % payout for the next 5 years.  That is equivalent to treating 2005 as an outlier and averaging the last four years.  This issue was not mentioned in the Presentation Slides.

(6) Forecast High & Low Prices, Upside/Downside Ratio and Total Return

– These also were not mentioned in the Presentation Slides.

– The Consensus did not get a SSG Buy with an Upside/Downside Ratio of 2.15 (under the 3.0 minimum criteria) and a 14.74% Total Return (under the 15.00% minimum criteria).

(B) ARMIN’S SSGs:

(1) Estimating EPS Growth

– When I did my SSG on 8-18-09, the six analysts I always check were estimating long-term EPS at an average of 10.73% with S&P high at 12.00% and Value Line low at 10.00%.  At FactSet CallStreet via CNN Money.com, the Consensus was 11.00% (from 8 analysts who ranged from 13.0 to 5.0%); Zacks.com was 10.62%; Reuters.com was 10.61% (from 11 analysts who ranged from 13.0% to 7.00%); and FirstCall/Reuters via YahooFinance.com was 10.17%.

– When I updated my SSG on 9-17, only S&P had changed its estimate to 10.00% (down from 12.00%).

– I estimated 8.00% EPS both times, well under all the consensus estimates.

– Estimating EPS explains how I estimate EPS for all my SSGs.

(2) Forecasting High & Low PEs

– I eliminated 2005 as an atypical outlier and used the four-year historical average as my Forecast High & Low PEs.

– This was the major difference between my SSGs and the Consensus, and explains why both times I got a SSG Buy with Upside/Downside Ratio > 3.0 and a Total Return > than 15.00% while the Consensus did not.

(C) TAKE STOCK:

– Take Stock is a computerized, one-click program at the StockCentral website that produces an almost-SSG and is designed to generate a conservative result.

– Its EPS estimate for the next 5 years was –11.00% (that’s a minus eleven percent) which seems patently unreasonable and irrational compared to the six analysts I checked who averaged 10.72% and even to the very lowest estimate of 5.00% by one analyst at CNNMoney.

– Because of its low-ball EPS estimate, Take Stock’s Forecast High Price was $19.79, also unreasonably low and a whopping 55% below the low end of Value Line’s $45-50 High Price estimate.  If you’re interested in learning how to judge the reasonableness of SSG judgments, see: Determining What’s Reasonable and What’s Not: An Update.

– Take Stock gave Microsoft a quality rating of .50 on a ten-point scale where a minimum of 3.4 is required to pass muster and 6.7 is desired.  On the other hand, S&P gave MSFT a B+ quality rating.

– Armin

Monitoring Microsoft (MSFT)

 

 

 

Microsoft (MSFT) is the world’s largest maker of computer software with 2008 revenues of $60.4 B (up 18%).  Morningstar reports that Windows and Office software account for roughly 60% of MSFT’s revenue with another 22% coming from enterprise server software.

 

Microsoft is a large, mature company which, contrary to conventional wisdom, continues to grow both sales and earnings.  Its 5-year average Sales was 13.2% which increased to 18.1% in 2008 while EPS increased from 18.2% to an impressive 31.7%.

 

The company is remarkably profitable with a 5-year average Pre-Tax Profit Margin of 42.4%, nearly 2.5 times greater than its industry average of 17.3%.  According to Morningstar, MSFT generates more than $1Billion in cash each month and, after buying back $40Billion of its stock over the last two years, still has a whopping $30Billion in cash.

 

While MSNMoney.com is an excellent website (especially its free Custom Deluxe Stock Screener), MSFT’s Online division lost money in 2007.  That’s probably why Microsoft offered to buy Yahoo! in early 2008 for $44.6B or $31 per share, and may try again next year.  However, Morningstar believes that would be “an unmitigated disaster” and suggests other acquisitions that would better compliment Microsoft’s core strengths, such as SAP (enterprise software) or RIMM (the Blackberry mobile phone).

 

In late 2008, Microsoft finally opened an online store where customers can conveniently buy all of the company’s products.  Most of its software is now available for download and all of it can still be bought in a box.

 

Software as an online service directly challenges MSFT’s old business model which sold everything in a box.  Microsoft and the software industry is changing, and Wikinvest reports that revenues from all online software is expected to grow from 5% to 25% in the next three years.  Moreover, Microsoft’s latest version of its Office software will offer online versions of Word, Excel and PowerPoint that can be edited and managed by a computer, a web browser, or a mobile phone.

 

Unlike Apple, Microsoft does not have a reputation for innovative products, snazzy design, or technological excellence.  Opening an online store is hardly a major break-through. And, Morningstar is surprisingly pessimistic about MSFT’s ability to prosper in the long, long term, estimating 8.3% average growth over the next 5 years and fading to merely 3.0% after 2012. 

 

“[I]n the long term, the services model will change

industry economics such that Microsoft’s growth

slows to inflation and its returns fade to match its

cost of capital.”

 

Here’s a comparison of AnnC’s SSG from BI’s First Cut with two of mine and with Take Stock.

 

Microsoft (MSFT)	AnnC	Take Stock	Armin-1	Armin-2
Date	10-3-08	10-22-08	9-30-08	11-21-08
Data	S&P	Hemscott	S&P	same
Price	$26.32	$23.36	$26.15	$19.68
52 week High & Low Price	$87.50 & $23.50	n/a	$37.50 & $23.50	$36.72  $17.50
Project Growth From	Last Annual & Last Quarter are same (A)	Last Annual	Last Quarter	same
Sales Growth	09.00%	12.50%	09.00%	same
EPS Growth	09.20% (B)	09.30%	09.00% (D)	same (E)
High PE	21.5 ave High PE after 2 outs	24.7	20.0 2008 lowest in last 5 yrs	15.0
High Price	$62.60	$72.25	$57.60	$51.90
Value Line Estimated High Price = $50-60 at $21.20 on 11-21-08 and $55-65 at $28.12 on 8-22-08
Low PE	12.0 (C)	18.6	14.5	10.9
Low Price	$21.00 80% x current price	$34.60	$22.20 recent severe low	$10.50 60% of 52 week low
Upside/Down	6.8		8.0	3.5
Total Return	20.1%	27.1%	31.4%	40.5% (untrust- worthy)
SSG Buy Under	n/a	$39.09	$31.07	$20.85
RV & PRV	75.3 & 68.9 (2 outs)	n/a	74.7 & 68.6 (2 outs)	46.8 & 43.1 (2 outs)
RV & PRV (no outs)	n/a	n/a	63.8 & 58.5	39.9 & 36.8
Quality	n/a	TS = 5.8, excellent	S&P = B+	same
PTPM – 5 yr ave	42.2% trend even	39.0% trend n/a	42.4% trend even	same
ROE – 5 yr ave End Equity	32.2% trend up	n/a	32.2% trend up	same
ROE – 5 yr ave Start Equity	n/a	29.6% trend n/a	30.7% trend up	same
Debt to Equity – 5 yr ave	n/a	n/a	-0- trend even	same

 

(A) My SSG file contains data for 4 Qs 2008 and for 2008 annual so starting growth projection at last Quarter or last Annual makes no difference;

 

(B) Ann explains in her SSG from First Cut that she relied on the Preferred Procedure for her 9.2% estimated EPS, even though it was less than the analysts.

 

– For her PP, Ann used 9.00% as her Sales estimate which she said was between 8.3% from Morningstar’s and 10.2% from VL & Yahoo-Finance.  However, when I checked on 10-22, Yahoo-Finance was estimating Sales next year at 9.2% (not 10.2%) and VL was estimating Sales per share at 17.0% (not 10.2%) for the next 3-5 years.  Zacks, the only source that estimates Sales for the next 5 years, was estimating 11.29%.

 

– Moreover, if Ann had just used the VL estimate for Shares Outstanding, her PP would have increased to 13.5% EPS. 

 

(C) For her Forecast PEs, Ann reduced her Low PE from its 15.6 average to 12.0, because of our “very pessimistic market”, but used her High PE average of 21.5.  In contrast, I never adjust one High or Low PE without modifying the other.

 

(D) When I did my SSG on 9-30, the six analysts I always check were estimating long-term EPS at an average of 12.58% with VL high at 17.00% and First Call via Yahoo Finance low at 11.19%.  Zacks was 11.29%, and three were 12.00% (S&P, Reuters via Morningstar, and FactSet Call Street via CNN Money).  No estimate had changed when I checked again on 10-22.

 

(E) When I updated my SSG on 11-21, these six analysts were now estimating long-term EPS slightly lower at an average of 12.26 with VL still high but lowered to 15.50% and First Call via Yahoo still low and still the same at 11.19%.  Zacks was still the same at 11.29%, Reuters via Morningstar was slightly lower at 11.60%, and FactSet CallStreet and S&P were still the same at 12.00%.

 

CONCLUSION:

MSFT has continued to drop in price and, even though I lowered my judgments considerably, I consider my SSG untrustworthy primarily because of its unusually high Total Return of 40.5%.

 

 

 

 

– Armin