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I felt that Microsoft Corporation (NASDAQ:MSFT) was a good investment idea and here is a detailed comparison with an old rival. It actually seems like Microsoft might be better positioned than International Business Machines Corp. (NYSE:IBM) in this latest twist in the fluctuating fortunes of two of the world's most storied technology firms. There will be a lot of web based growth with more people coming online in the future and this will make Bing Search and Microsoft's social media ventures like Socl increase in popularity.

The worldwide shift in ad dollars is what MSFT shareholders are hoping that the Redmond, WA based firm will target. In 2012, digital ad spending hit a record high when it went past $100B, but this only accounted for 19.8% of the total ad spend. In time to come, company executives are going to move from "traditional advertising" - TV programming, radio, and print - to the fast growing digital ad market.

The $8.5B shelled out on Skype was a move in the right direction. Skype fits in well with Microsoft's tradition of bundling its services. As more people get online, the Voice over IP service will be even more widely used.

As for IBM, it has engineered one of the most successful transformations in corporate America. IBM acknowledged that Bill Gates was right and shifted its focus from the low margin hardware business to the high margin software business. There was also a move to provide IT services that saw IBM's net profit margin expand from 14.02% in 2009, to 15.89% in 2012. Furthermore, IBM is actually the most innovative business around as indicated by the fact that it has gotten the most patents since the year 2000.

Let us now examine IBM using DuPont Analysis and see how it compares to MSFT.

DuPont analysis is named after the U.S. chemical company that created this method of analysis in the 1920s to gain more in-depth knowledge of Return on Equity [ROE]. In DuPont Analysis, the ROE is decomposed into factors that can be further analyzed. These factors are commonly a profitability measure, a turnover measure, and a leverage measure.

Three-Step DuPont

The three-step equation breaks up ROE into three very important components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

These components include:

  • Operating efficiency - as measured by profit margin.
  • Asset use efficiency - as measured by total asset turnover.
  • Financial leverage - as measured by the equity multiplier.

Let me briefly touch on the math here.

Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get:

ROE = (net income / sales) * (sales / shareholder's equity)

We now have ROE broken into two components, the first is net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont equation.

ROE = (net income / sales) * (sales / assets) * (assets / shareholder\'s equity)

This equation for ROE, breaks it into three widely used and studied components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

 

ROE

=

Net Profit Margin

×

Asset Turnover

×

Equity Multiplier

Dec 31, 2012

88.37%

 

15.89%

 

0.88

 

6.32

Dec 31, 2011

78.86%

 

14.83%

 

0.92

 

5.78

Dec 31, 2010

64.29%

 

14.85%

 

0.88

 

4.92

Dec 31, 2009

59.47%

 

14.02%

 

0.88

 

4.82

Dec 31, 2008

91.91%

 

11.90%

 

0.95

 

8.13

Source: IBM Corp Annual Reports

As you can see, the ROE has decreased and it can be attributed to the profitability decline as measured by the Net Profit Margin. Asset turnover has also decreased and these are two very negative signs for IBM.

IBM's ROE is very high, but this is a bit misleading when you taking into account the high equity multiplier value. A higher equity multiplier indicates higher financial leverage, which means the company is relying more on debt to finance its assets. IBM's equity multiplier values are almost 4 times those of MSFT over the last 5 years.

Five-Step DuPont

This is called the Extended DuPont Analysis.

As we have seen:

Net Profit Margin = Net Income / Sales

15.89% (2012 value) = $16,604 / $104,507

This can be rewritten using another mathematical identity:

Profit Margin = (Net Income / Sales) = (Net Income / Earnings Before Taxes) * (Earnings Before Taxes(EBT) / Earnings Before Interest and Taxes (EBIT)) * (EBIT / Sales)

Tax Burden = (Net Income / Earnings Before Taxes)

$16,604 / $21,901 = 75.81%

Tax Burden is an indication of how much the company is paying in corporate taxes, or how much of the profit is falling to the bottom line. This calculation indicates that as of the most recent fiscal year, IBM kept almost 76% of every dollar it makes after expenses.

Interest Burden = (Earnings Before Taxes / Earnings Before Interest and Taxes)

$21,901 / $22,360 = 97.95%

Interest Expense reduces Net Income and therefore, lowers ROE. IBM's tax burden and interest burden are the almost the same as Microsoft's.

Sales Margin = (EBIT / Sales)

$22,360 / $104,507 = 21.40%

Sales Margin is yet another way of looking at how profitable each dollar of revenue is after deducting operating expenses but before deducting interest and taxes. The sales margin and the net profit margin are lower than that of Microsoft.

So again, putting the three ratios together we get:

Net Profit Margin = Tax Burden * Interest Burden * Sales Margin

15.89% = 75.81% * 97.95% * 21.40%.

And finally, the complete Extended DuPont Analysis:

ROE1 = (Net Income / EBT) * (EBT / EBIT) * (EBIT / Sales) * (Sales / Assets) * (Assets / Equity)

88.37% = ($16,604 / $21,901) * ($21,901 / $22,360) * ($21,901 / $104,507) * ($104,507 / $119,213) * ($119,213 / $18,860)

ROE = Tax Burden * Interest Burden * Sales Margin * Asset Turnover * Equity Multiplier

1 Values are for 2012

 

ROE

=

Tax Burden

×

Interest Burden

×

Sales Margin

×

Asset Turnover

×

Equity Multiplier

Dec 31, 2012

88.37%

 

75.81%

 

97.95%

 

21.40%

 

0.88

 

6.32

Dec 31, 2011

78.86%

 

75.49%

 

98.08%

 

20.03%

 

0.92

 

5.78

Dec 31, 2010

64.29%

 

75.21%

 

98.17%

 

20.12%

 

0.88

 

4.92

Dec 31, 2009

59.47%

 

74.02%

 

97.83%

 

19.36%

 

0.88

 

4.82

Dec 31, 2008

91.91%

 

73.79%

 

94.83%

 

16.78%

 

0.95

 

8.13

The ROE has decreased and it can be attributed to the profitability decline as measured by the Sales Margin.

Three-Step Net Profit Margin

You can take your analysis further by taking individual components of the DuPont Identity and breaking them down to gain additional insight.

 

Net Profit Margin

=

Tax Burden

×

Interest Burden

×

Sales Margin

Dec 31, 2012

15.89%

 

75.81%

 

97.95%

 

21.40%

Dec 31, 2011

14.83%

 

75.49%

 

98.08%

 

20.03%

Dec 31, 2010

14.85%

 

75.21%

 

98.17%

 

20.12%

Dec 31, 2009

14.02%

 

74.02%

 

97.83%

 

19.36%

Dec 31, 2008

11.90%

 

73.79%

 

94.83%

 

16.78%

I hope you get the idea by now. It can be clearly seen that the Sales Margin has had the biggest impact on the Net Profit Margin and its decline from 2011 to 2012.

Conclusion: IBM's investments versus Microsoft's investments

Investors are always on the lookout for companies that generate profits more efficiently than their rivals. ROE is a key indicator that signifies to investors that a firm is a profit creator and not a profit burner. A DuPont analysis helps in painting a true picture about the ROE value obtained. It was a very helpful exercise indeed to perform the Extended DuPont Analysis on IBM Corp. going back over time to see how the trends have been going with the individual components over time.

The other thing that was very useful was to compare IBM with MSFT. MSFT looks better than IBM in the DuPont Analysis and I think MSFT is better positioned for the future. It is agreed that we are in a dying PC market. Gartner has reported that global PC shipments in Q1 2013 have fallen to levels not seen since Q2 2009. Microsoft has been unable to make inroads into the highly competitive mobile arena with Apple Inc. (NASDAQ:AAPL) and Google Inc. (NASDAQ:GOOG) being the front-runners. Furthermore, Microsoft is still trying to shed its old-fashioned image in this technology era that is basically dominated by touch and social. But it is a monopoly with its Windows product and that is all that really matters.

As for IBM, it has continued to be very innovative with its Blue Gene supercomputing program winning the National Medal of Technology and Innovation in 2009. IBM looks to be the industry leader in IT services and computer software for the foreseeable future with some big acquisitions made already. There was the $1.2B shelled out for SPSS Inc. in 2009 and in 2012, IBM bought recruitment software maker Kenexa for $1.3B in cash. In addition, this month started off with the announcement that IBM was acquiring SoftLayer Technologies, a leading web hosting service, for $2B.

Even with all this Microsoft appears more attractive for the simple reason that it has a monopoly. IBM always has to look over its shoulder. For instance, take the purchase of business intelligence software company Cognos Inc. in late 2007. This was a $5B deal that had to happen because SAP AG (NYSE:SAP) had acquired Cognos's larger rival Business Objects for $7B the previous month. Moreover, Oracle Corporation (NYSE:ORCL) had purchased Hyperion Solutions Corp. for $3.3B earlier in 2007.

IBM is having to finance more and more of its investments with debt and it is already highly leveraged with a debt-to-equity ratio of 1.75. On the other hand, Microsoft has a much lower debt-to-equity ratio of 0.19. While I like both these giant tech stocks, I think MSFT will turn out to be a better value play.

Note: All material is sourced from Morningstar and MSN Money.

Source: How Does IBM Stack Up?