A Further Look At Microsoft: This Time, Free Cash Flow

Sep. 4.14 | About: Microsoft Corporation (MSFT)

Summary

Previously, I discussed how Microsoft’s apparent disastrous acquisition of Nokia may not be such a bad thing after all.

Today, I analyze Microsoft free cash flows in order to determine its appropriate valuation range.

I discover that Microsoft is undervalued by over 25%, even with conservative assumptions.

In my previous article, I went into detail about how Microsoft's (NASDAQ:MSFT) acquisition of Nokia's (NYSE:NOK) devices and services business may not be such a disaster. In this article, I value Microsoft using the industry staple modus operandi - discounted cash flow analysis.

Click to enlarge

Source: SEC Filings, author's own estimates

As seen above, Microsoft's revenue is projected to increase from $86b in 2014 to $108b in 2020. As Microsoft is a relatively mature company, it is extremely hard for it to achieve high levels of growth, hence my conservative revenue estimates of 6.2% starting in 2015 and slowly declining to 1.2% in 2020.

Cost of revenue is projected to remain steady at 30%, pretty high relative to the past years, however I predict that Microsoft would have higher costs in the future as a result of the Nokia acquisition. Hence, gross margins remain at 70% for future years.

Research and development, sales and marketing, and general and administrative expense are projected to be 13.7%, 20% and 6.3% of sales in the foreseeable future. These numbers are derived from the average of the previous years as Microsoft has shown that it is able to manage its operating expenses and not letting them get out of hand.

EBIT margins are hence projected to be 30.1%, growing from $27b in 2015 to $32b in 2020. Microsoft has shown its ability to improve margins as seen in the years 2009-2013, with 2014's EBIT margin being the lowest in 6 years as a result of the Nokia acquisition. I have already discussed why this may not be a bad thing in my previous article on Microsoft and hence will not be going into it here.

Tax rates have been decreasing in the past years, but are projected to remain steady at 21.5% as I feel that this is a more conservative estimate.

Thus, EBIAT margins are projected to be 23.6%, with EBIAT increasing from $21b in 2015 to $25b in 2020.

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Source: SEC Filings, author's own estimates

Non-cash charges

Depreciation, amortization and other have been hovering around 4.4% of sales to 6% of sales during 2009-2014, and hence are projected to remain steady at 4.6% in future years, with it growing from $4.2b in 2015 to $4.9b in 2020.

Stock-based compensation has been relatively steady at 2.8% to 3.3% from 2009-2014 and are projected to remain at 3% of sales in future years, with it increasing from $2.7b in 2015 to $3.2b in 2020.

Deferred income taxes have been all over the place in previous years, ranging from -0.4% to 1.3%. However since it is such a small charge compared to the others, a simple average would suffice. Hence, deferred income taxes are projected to remain at 0.3% of sales, increasing from $273m in 2015 to $329m in 2020.

Deferral of unearned revenue has ranged from -41.8% to -60% of sales, however 2013 seemed unusually high, hence I projected it to remain at 48.5% of sales in future years, with it increasing from -$44b in 2015 to -$52b in 2020.

Recognition of unearned revenue, similar to its counterpart, has also been all over the place. For the same reasons, I projected it to be 46.5% of sales in future years, with it growing from $42b in 2015 to $50b in 2020.

Changes to working capital

Accounts receivables have varied from -3.6% to 3.8% of sales, hence I project it to be an average of the previous years, remaining at 1.2% going forward. Thus, accounts receivables are projected to grow from -$1.09b in 2015 to -$1.27b in 2020.

Inventories have ranged from -1.1% to 0.2% of sales in the past, hence are projected to be -0.3% of sales in the foreseeable future. Inventories hence are projected to grow from $283m in 2015 to $331m to 2020.

Other current assets have ranged from -1.8% to 0.7% in the past, hence are projected to be -0.2% of sales, growing from -$219m in 2015 to -$257m in 2020.

Other long-term assets have hovered from -0.7% to 0.1% of sales in the past, hence are projected to be -0.4% of sales in the future, increasing from -$373m to -$437m from 2015-2020.

Accounts payables have varied from 0% to 0.7% of sales in the past, hence are projected to remain at 0.2% of sales in the future, increasing from $202m to $237m from 2015-2020.

Other current liabilities have ranged from -5.8% to 2.1% in the past, hence are projected to be -0.6% of sales in future years, growing from -$518m to -$607m from 2015-2020.

Other long-term liabilities have ranged from 0.2% to 2.9% of sales in the past, hence are projected to be 1.7% of sales in the future, growing from $1.5b in 2015 to $1.7b in 2020.

Capital expenditures and free cash flow

Capital expenditures have ranged from -3.2% to -6.3% of sales, hence are projected to be -4.5% of sales in the future, in line with depreciation, amortization and other. Hence, capital expenditures are projected to increase from -$4.1b to $4.8b from 2015-2020.

With adjustments to non-cash charges, changes to working capital and capital expenditures projected, we arrive at free cash flow, which are projected to remain at 28.2% of sales, growing from $26b in 2015 to $30b in 2020.

Valuation

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Source: SEC Filings, author's own estimates

As seen above, I have discounted free cash grow to the present, projected and discounted terminal value, arrived at enterprise value and equity value, eventually at an implied share price of $57.12, which signifies that Microsoft, under these assumptions, is undervalued by over 25%.

Conclusion

As always, most investors would find it hard to believe that a well-known and followed company such as Microsoft is trading at such an undervalued price. However, keep in mind that the assumptions I used in these valuations are reasonable and not astronomical in any way. The main drivers of value - revenue growth, profit margins and reinvestment are in line with historical performance and do not deviate too much from the norm.

The main reason why I feel that Microsoft is trading at such an undervalued price is due to its recent setbacks. It acquired Nokia's handset business - I analyzed how that acquisition has worked out previously, and concluded that such a short period of time post-acquisition is simply not enough to determine whether it was a disaster or a brilliant move. Another probable reason for its current trading price is due to the apparent failure of its new devices such as Surface and Windows Phone relative to its competitors.

However, the market is focusing too much on these setbacks and not on Microsoft's staple and core operating profitability. Ingenious products such as Office are still the cash-cows that they always were, and will continue to be in the foreseeable future. However, investors should not expect much growth from such products as the markets for them have been relatively saturated. In order to achieve further growth, it is prudent from Microsoft to either innovative and develop new products organically (Surface) or acquire companies such as Nokia and grow from there.

Sure these might fail and be huge expenses in a vacuum. However, relative to Microsoft's sheer free cash flow generation, it is a drop in the bucket. As long as these failures do not spill over to the cash cows that are Office and the rest of Microsoft's productivity software, investors need not worry about Microsoft not being able to maintain its earnings potential.

Hence, I am a believer in Microsoft, and I am sure that with the company's huge war-chest and cash-generating potential, they would be able to discover new markets to cater to in the future, to boost organic growth.

As always, my analysis of Microsoft on Excel can be seen here.

Disclosure: The author is long MSFT.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.