A lot of speculation about Microsoft Corporation (MSFT)'s future has emerged surrounding the designation of its new CEO, Satya Nadella. To further increase the guesswork, Bill Gates (Trades, Portfolio) has resigned from his role as Chairman of the Board and now holds the title of Founder and Technology Advisor. His replacement at the Board will be independent director John Thompson, who is expected to impulse more shareholder-friendly decisions than Gates did.
While many investors and analysts were looking forward to an outsider taking over the CEO position, I like the final choice. Nadella, an insider already familiar with the company, should provide a smoother transition (which quite important and difficult in a company as complex as Microsoft is) and help it better navigate the new era of cloud technologies.
In this context, I would like to take a closer look at the company’s past: its profitability, debt, capital, and operating efficiency. In addition, I will take a look at which institutional investors have recently bought this stock. Based on this information, we will get an understanding of the Microsoft´s revenues, operating metrics and quality of earnings. As you will see, Microsoft has continued to grow and pay out dividends over the past few years, even in spite of the challenges it has had to face in the mobile, social, cloud, big data, and online advertising segments.
Profitability is a class of financial metric used to analyze a business’ ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section I will study several profitability metrics, such as return on assets, quality of earnings, cash flows and revenues. By analyzing these four metrics, we will be able to elucidate if the company is really making money.
ROA - Return On Assets = Net Income/Total Assets
ROA is an indicator of how profitable a company is relative to its total assets. It gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. In simple terms, ROA tells you what earnings were generated from invested capital (assets).
I am encouraged by the fact that Microsoft´s ROA has increased from 14.77% to 16.58% in the past three years. This indicates that the company is generating more from its assets than it did in 2011.
Quality of Earnings
Quality of earnings is the amount of earnings attributable to higher sales or lower costs, rather than artificial profits created by accounting anomalies -such as inflation of inventory. In order to assess Microsoft Corporation's quality of earnings we will compare the level of income with operating cash flows.
The company augmented its profits at a rate of 34%, but the growth of cash flows was higher. This is strong evidence of profits not being created through anomalies such as inventory or accounting practices.
Working Capital is a measure of both a company's efficiency and its short-term financial health. This ratio indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient.
Microsoft Corporation´s current ratio (working capital measurement) increased from 2.60 in 2011 to 2.71 in 2013. This shows that the company has a strong balance sheet and can pay off its obligations. Looking for companies with current ratios above 1 is a must for long-term investors.
Gross Margin: Gross Income/Sales
The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor what percentage of revenue/sales is left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors -and overall industry- is more efficient. Investors tend to pay more for businesses that offer higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).
Over the past three years, the gross margin has decreased. The ratio shrank from 77.7% in 2011 to 74.0% in 2013. A decreasing margin indicates that the company has been becoming slightly less efficient year-after-year. Nonetheless, Microsoft’s margins (gross, operating and net) are well above its industry’s median values.
Asset turnover measures a firm's efficiency in using its assets to generate sales or revenue - the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.
The fact that the revenue growth has outpaced the assets growth (-17% growth) on a percentage basis, indicates that the company is making money on its assets.
Microsoft seems to be regaining field in the mobile segment. Recently, Chinese market share figures were made public, and the fourth most popular phone among Chinese users is a Huawei Windows OS phone. Despite this, the challenges in the mobile arena remain. Mr. Nadella will have the big responsibility of successfully integrating Nokia's (NOK) recently purchased handset business.
The future also holds other important decision´s for the tech behemoth´s new CEO, and several questions arise. Will the company be able to revamp its cloud software and enterprise segments? Will Nadella spin off the less-profitable Xbox and Bing?
Although much of this is yet to be determined, the situation looks pretty more encouraging than a few quarters back, especially after the company posted its best quarterly results in recent years.
Microsoft’s stock trades at only 13.5 times the company’s earnings, a substantial discount to the 24.1 x P/E industry median. Despite its cheap valuation, the company still offers industry-leading fundamentals. Even based on conservative EPS growth estimates, this ratio should continue to decrease, while the stock price still swells. However, shares are expected to increase their price by only 8.5% over the next 5 years -which is quite low, compared to an average of 18%-19% projected for its industry peers.
I feel encouraged by the fact that George Soros (Trades, Portfolio) and Glenn Greenberg (Trades, Portfolio) bought the stock in the past months at an average price of $33.6. This shows that hedge funds have confidence in the stock.
Currently, many analysts have a good outlook for Microsoft Corporation. Analysts at MSN money are predicting that Microsoft Corporation will retrieve EPS of $2.70 for FY 2013 and EPS of $2.91 for FY 2014. Analysts at Bloomberg are estimating Microsoft Corporation's revenue to be at $84.45B for FY 2013 and $89.79B for FY 2014. On 23/01/2014, Deutsche Bank gave Microsoft Corporation a rating of "Buy" with a target price of $38.33. A $38.33 price target signifies significant upside potential from this point.
From a value perspective, Microsoft is a cheap, safe investment that could slightly outperform the S&P 500 indexes, while paying out a generous dividend yield (more than 3%). Given its moated business and the initiatives to revamp its lagging segments (many of which are already working and providing results, like in the case of Bing and Windows 8), plus a renewed management that has been proving quite effective, I´d recommend buying and holding on to this stock.