Microsoft: Now We Flip Flop

Oct.28.13 | About: Microsoft Corporation (MSFT)

One thing I don't like about earnings season is trying to analyze companies that don't give a lot of information. Those that don't provide guidance leave investors and analysts going quarter to quarter. This makes it hard when trying to provide recommendations on certain stocks. You can't always tell if something is a one quarter issue or a longer term trend. Today, that is the case with Microsoft (NASDAQ:MSFT). The tech giant reported a huge blowout when it reported earnings last week, but that blowout comes with a huge asterisk. Fortunately, for the time being, Microsoft looks to be changing how we look at the company. Today, I'll break down the results, examine some key fundamentals, and provide my recommendation on the stock.

Fiscal Q1 results:

While you might give Microsoft credit for beating analyst estimates, there is something to be said about those estimates. Think back to last quarter, when Microsoft had the huge revenue and earnings miss. That huge miss and write-down on the Surface tablets caused analysts to panic tremendously, taking a hacksaw to Microsoft's estimates. Remember, Microsoft was not a company to give guidance, so you were basically going quarter to quarter. If one quarter was good, analysts would most likely raise estimates. If the quarter was bad, they would lower estimates. Well, after a really bad quarter, they lowered estimates tremendously. The following table shows Microsoft's estimates at both the Q4 (July) and Q1 (Thursday) reports, against what it actually reported.

I mentioned in my Microsoft article a few weeks ago that the company had missed revenue estimates in all four quarters of the 2013 fiscal year. However, I also noted that estimates had come down so far that a beat was probably likely. If you lower estimates enough, it makes it hard to miss. Analysts lowered their expectations by more than $1.1 billion on the revenue front and 14 cents on the EPS front. That's why this Q1 beat comes with an asterisk. We had a similar situation when Google (NASDAQ:GOOG) reported its results, a large beat thanks to a huge reduction in estimates. The other funny part is that on that July 18th date noted above, Microsoft shares closed at $35.44. So even though the actual Q1 results were roughly $400 million and $0.06 below the expectations on that date, shares are 30 cents higher now. You can thank the Federal Reserve and Ballmer's retirement for that. This shows how Microsoft gets a higher multiple, because you have a higher stock price with lower expectations/results.

Some other key items to note from the quarter:

  • The commercial licensing segment posted 7% year over year growth and represented 66% of the firm's gross margin.
  • Commercial cloud sales rose 103% year over year.
  • Windows OEM sales only fell 7% year over year after a 15% drop in fiscal Q4.

Guidance for Q2:

In the past couple of years, Microsoft has not been one to give strict revenue or earnings guidance. It has given operating expense guidance, but that's not totally helpful. This is why you have such large swings in analyst estimates, because analysts basically have to go quarter to quarter. With no guidance, they take down estimates after a bad quarter (like the last one), and raise estimates after a good one (potentially about to happen).

Well on this quarter's conference call, Microsoft provided detailed guidance for its business segments. In the end, Microsoft guided to quarterly revenues of $23.1 billion to $24.1 billion, above the analyst average estimate at $22.93 billion. As this Reuters article states, this was the most detailed guidance the company has provided on a call in a number of years. Thanks to the higher than expected guidance, Microsoft analysts have raised their estimates, with the current average forecast now for $23.61 billion. However, those added revenues have come at a cost, as analysts have reduced their Q2 EPS number by 4 cents to $0.70. Strangely enough, despite the 8 cent beat in Q1, analysts have taken down their full year number by a penny to $2.69. That's just 4 cents of EPS growth, despite revenues forecast to rise by more than 7%.

Balance sheet update:

Microsoft has a strong balance sheet, and I'm not going to suggest that it doesn't. However, there is one small concern I have. Here are some of the balance sheet numbers, at the end of fiscal Q1 over the past three years, as well as the Q4 period that ended a few months ago. Dollar values in millions.

*Liabilities to assets ratio.

Do you see the big issue? If you don't, it's the fact that Microsoft's US cash and investments balance has declined to less than $4.7 billion, according to numbers compiled from the 10-Q filing. That's important, because Microsoft can only pay dividends and buy back stock from that cash balance. The $76 billion of foreign funds can't be used directly. Microsoft has to either bring them back to the US, and face repatriation taxes, or issue debt against them. Microsoft raised the dividend quite nicely in September and announced a huge buyback. While that's good for investors, it needs cash to accomplish this. The company returned $3.8 billion to shareholders in fiscal Q1, so will that number slow down in Q2? I wouldn't be surprised if Microsoft issued some debt to buy back stock. Remember, Microsoft's $40 billion buyback does not have a set end date.

Valuation and comparables:

When it comes to comparisons for Microsoft, you have to look at the usual suspects, Apple (NASDAQ:AAPL) and Google. But I also look at names that have similar characteristics, like balance sheet size, dividend yields, buybacks, etc. That brings in Intel (NASDAQ:INTC) and Cisco Systems (NASDAQ:CSCO) as well. The following table is one I've used to compare these five names over the past couple of months. It shows the currently expected growth figures for each in its 2014 fiscal year. The growth numbers are as of Sunday, and are likely to change as we get more analysts revising their Microsoft numbers this week and after Apple's earnings report on Monday.

*Non-GAAP values for EPS and P/E numbers.

Google gives you extra growth, but is it worth the huge premium, especially after you convert earnings to GAAP? That's an interesting debate to have. If you convert Cisco's earnings to GAAP, the P/E is in the 11.5 to 12.0 area. So that means that Microsoft is the most expensive of the four dividend and lower growth names.

Is that premium worth it? Well, if you are comparing Microsoft to Intel, it might be. Microsoft projects for more growth than Intel, and is buying back a bit more stock right now. Intel has a higher dividend yield, but Intel's growth story has fallen apart over the past few years. When it comes to Cisco, the premium doesn't seem worth it. Microsoft and Cisco offer similar combined growth (revenues/earnings), and the dividend yields are very comparable. The buybacks are also similar when looking at market caps. So I would say that the Microsoft premium above Cisco is probably not worth it.

When it comes to Apple, the premium for Microsoft is definitely not worth it. Apple has a much better growth profile. While Microsoft has a better dividend yield, Apple only started its dividend a year ago, so Apple will have a lot of dividend raises to come. Also, Apple has the biggest buyback in corporate history, expected to be completed over three years. Apple's buyback is expected to be roughly $20 billion a year for three years, an incredible amount. Apple also has the cash generation power to continue that buyback after 2015. For all of that, Microsoft trades at almost a 10% premium to Apple. In my opinion, that doesn't make sense.

So even if I give Cisco a 12 P/E, the average of CSCO/INTC/AAPL is a P/E of 12.25. If I give Microsoft a small premium, giving them a 12.75 P/E, that implies a fair value of $34.30 based on current year expected earnings of $2.69. That's a 4% premium to where shares are currently trading, so I do think Microsoft is slightly overvalued here. Would I try to short this name for a 4% move? No. However, with it trading at a premium, I would leave it in the "short candidate" bin for now. Remember, Microsoft had missed revenues four times in a row before this quarter, which was beat due to significantly reduced expectations. If analysts go out and raise numbers too much, it could set up a miss next time around.

Final thoughts:

Microsoft reported a solid quarter that beat greatly reduced expectations. Now, analysts will rush to raise all their estimates, especially after the company issued guidance (for the first time in years) that was above expectations. I expect this positive energy to carry shares a little higher from here. However, Microsoft shares seem slightly overvalued at this point compared to others, and the balance sheet seems a bit constrained in terms of US cash. Microsoft shares have met resistance around this $36 level, so you can use the next leg of this rally as your short opportunity.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.