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Summary

  • Back in April, Microsoft acquired Nokia’s handset business for $9.5b.
  • Microsoft claimed that the acquisition is expected to result in faster innovation, synergies, and unified branding & marketing.
  • I examine how the acquisition has affected Microsoft’s overall core operating profitability in terms of ROIC.

(click to enlarge)

Source: SEC Filings, author's own adjustments

(click to enlarge)

Source: SEC Filings, author's own adjustments

Gross profitability

As seen above, Microsoft's (NASDAQ:MSFT) revenue has grown from $58b in 2009 to $86b in 2014, with growth rates ranging from -5.3% to 17.8%, the latter largely stemming from MSFT's acquisition of Nokia's (NYSE:NOK) handset business.

Over the years, we can see that Microsoft's growth has surged post-financial crisis, however in 2013 the company's revenue dropped, with management citing growth difficulties. In a bid to increase growth, the tech giant acquired its much smaller competitor, and begun transforming itself into a devices & services business.

Clearly, this transformation has resulted in increased costs for the industry titan, with cost of revenue increasing from $12b to $26b, or 20% to 31% of revenue, leading to depressed margins (falling from 80% to 69% of sales).

Operating profitability

Research & development expenses increased from $9b to $11b, however has remained steady at about 13% of sales in the past years.

Sales & marketing expenses increased from $12b to $15b during the same period, remaining steady at about 20% of sales.

General & administrative expenses barely increased from $4.0b to $4.8b, remaining at about 6% of sales.

Taking operating expenses into consideration, EBIT margins vary from 32% to 38%, dropping to 32% in 2014, the lowest in 6 years.

Other expenses that were deemed as non-recurring and one-time were excluded from the analysis. This is because such expenses distort the core operating profitability of the company. Hence, I have normalized the company's financial performance in order to discern the true picture of the company's operations.

Taxes have decreased from about 25% to 20%, thus giving us EBIAT margins of about 25% in Microsoft's latest fiscal year.

Invested capital

Now, simply looking at the company's profitability is naïve. This is because operating profitability can increase by large amounts, but value is not created if that increase is matched by a similar proportional increase in reinvestment.

To illustrate simply, suppose we have two companies. Both companies increased their profits by 100%. However, one company reinvested 50% of their previous accounting period's profits to achieve that profit growth, while the other reinvested 25%. It is apparent which company is superior. Hence the need for consideration of reinvestment.

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Source: SEC Filings, author's own adjustments

As seen above, total operating assets amount to $45b in 2009, increasing to $77b in 2014. These operating assets are the assets that the company uses to conduct it is core business operations, any non-core assets are excluded.

Now, I have included the cash balances as operating assets, mainly due to its large variability in value over the years. Normally, I would exclude cash balances or assume a small percentage of it is operating and the remainder excess, however that only applies for companies with little variability in their cash balances, proving that they barely use their cash for operating purposes.

Obviously, I have excluded short-term marketable securities (over $70b), which consist of the bulk of the tech titan's asset base. Marketable securities mainly consist of money market securities, with US government treasury bills being a prominent example. These securities clearly have nothing to do with Microsoft selling devices and software, and are merely a location to park excess cash.

Normally, I would exclude goodwill and intangible assets as for most companies, they are non-core assets. Being a technology company, intangible assets and the like are valuable core assets.

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Source: SEC Filings, author's own adjustments

As seen above, total operating liabilities amount to $21b in 2009, increasing to $40b in 2014.

Summing operating assets net operating liabilities, we arrive at invested capital, which increases from $24b to $36b over the 2009-2014 period.

ROIC hence increases from 62% in 2009, surging to an impressive 101% in 2013, and decreasing to 60.8% in 2014. Keep in mind that these ROIC numbers will differ greatly from other calculations, as I have excluded assets/liabilities that I believe are non-core, while other aggregate calculators treat all assets/liabilities as core, something I believe distorts the true reinvestment a company undertakes during its operations.

A deal gone wrong?

Intuitive readers will be able to ascertain that the large increase from 2009-2013 can be largely attributed to the global recovery post-financial crisis, and the large drop from 101% to 60.8% in 2014 is highly likely due to the Nokia acquisition.

Clearly, the industry mammoth has invested large amounts of capital which did not pay off, hence the large fall in ROIC. Does this mean this is the end of the road?

On the surface, the Nokia acquisition seems to be a total disaster. Although the company is still generating large amounts of value (ROIC exceeds cost of capital by large margin), it could have generated more if it had not acquired Nokia.

Of course, this simplistic view would lead many to conclude that Microsoft's management is losing its Midas touch.

However, the shrewd speculator would correctly identify that Microsoft, empirically, is a technology company. By virtue of being in that industry, products and services take time to bear fruit.

Microsoft's most prized asset, Office, is able to generate large amounts of value due to sheer product brilliance, continuous and relentless improvements, insane economies of scale and the huge barriers to entry.

Did that happen overnight?

Astute observers would know that such brilliance takes time to develop and bear fruit. Microsoft acquired Nokia in April, and simply not enough time has passed to determine if the acquisition was a blunder or a brilliant move.

Investors can determine whether the Nokia acquisition has borne fruit by keeping a close eye on Microsoft's core operating profitability, invested capital, and ultimately ROIC.

If you believe that the company's management can overcome these challenges like I do, phone your broker.

My analysis of Microsoft on Excel can be viewed here.