Microsoft (NASDAQ:MSFT) is a familiar name to most of us. I, for one, am so immersed in its various products I would struggle to separate myself from Microsoft for a single day without causing myself some serious issues personally and professionally.
From Windows to Office and the xBox to the Surface, Microsoft is well-embedded and increasingly embedding itself in our software and hardware lives.
As a consumer, therefore, Microsoft is everywhere. Indeed, its consumer revenues are generously spread across these diverse and attractive areas as the 2015 Annual Report highlights:
But, actually, the side of the business which faces the consumer directly amounts to less than half of Microsoft's revenues:
Although a vast majority of this commercial revenue comes from licensing software to businesses, a growing proportion is coming from its Azure cloud services and other attractive areas falling under the "other" segment:
Microsoft is therefore a highly attractive business. Its licensing business benefits from a strong economic moat with things such as Office and Windows so embedded in our work and private lives it will take some time (and a lot of effort) to displace it.
It has made some very interesting moves. Shifting its main software packages from one-off, big purchases to a subscription model is interesting and - from a cash flow perspective - very attractive (indeed, in the 2015 report they noted subscriptions for Office365 grew 10 million over the year to 15 million). What's more, its moves into mobile and the Surface tablet/laptop hardware are fascinating. These and other moves leverage the power of their brand and core products well.
Nonetheless, despite this clear strength, does it pass my five free cash flow tests?* These tests I use in the first stage in my analysis of a company. Most recently this has included coffee giant Starbucks (NASDAQ:SBUX) and apparel makers V. F. Corp (NYSE:VFC) and Nike (NYSE:NKE)
Using them provides a detailed (although far from exhaustive) breakdown of the financial health of the company. Its solvency. Its efficiency. Its value.
Cash is king, and these tests look to set the ability of the business to produce free cash flow against its debt, dividends and more besides. I use these as a screen to find businesses for a more wide-ranging analysis later which steps beyond the cash flow statement.
So let's take a look at Microsoft to see how it does.
1: Positive FCF
Our first test is simple: Has the company reported positive free cash flow for each of the last five years? FCF here is defined simply as operating cash flow minus capital expenditures.
So how does Microsoft do? Microsoft gets off to a great start here:
Obviously, Microsoft has managed to pull in pretty significant amounts of cash each year since 2011. Certainly, FCF has shrunk at a rate of about 1.25% each year. This was largely due to OCF barely growing over that period while capex has grown at a rate of about 20% per year.
This is not expected to reverse anytime soon. Within the 2015 Annual Report, the company wrote that:
We expect capital expenditures to increase in coming years in support of our productivity and platform strategy.
Therefore, with revenues expected to be fairly flat and CapEx expected to grow, we should not expect FCF to gallop too much higher in the near term.
Nonetheless, with such mighty FCF figures already in place Microsoft starts off with a sold PASS here.
2: CROIC: Cash Return on Invested Capital
Next is the matter of the CROIC or cash return on invested capital. Rather like the more familiar ROIC this measures the efficiency of the company in generating cash. It's calculated by taking the FCF and dividing it by the sum of the debt and equity of the business.
My target is a CROIC of 10%. This would mean that for every $1 of capital invested in the company, they return at least $0.10 in cash which is a highly attractive return.
So how does Microsoft do? Well, like many technology companies, it produces its FCF pretty efficiently. Indeed, over the last five years it has averaged a CROIC of 28.88%.
However, it has seen this drop dramatically in recent years:
This has been fed by a massive growth in debt over the period (an annualized rate of 18%) as well as a smaller but still significant growth in equity (annualized rate of 7%) which has not been matched by comparable growth in FCF as noted above.
Nonetheless, even with these CROIC headwinds, a CROIC well nicely above 20% set it ahead of my target of 10%. As a result, Microsoft earns a PASS on this test.
3: FCF to Debt
As noted above, in recent years Microsoft has seen its debt grow significantly. From just under $12 billion in 2011 it has marched upward to just $27.8 billion in 2015. Combined with the slower growth in equity this has, predictably, resulted in its debt to equity ratio growing significantly:
Nonetheless, at under 35% it's still only moderately leveraged. What's more, it is not the debt to equity ratio that concerns me here but rather the FCF to debt ratio.
What I look for is a FCF to debt ratio of at least 25%. What this means, in theory, is that the company could repay the entirety of its debt in four years or less.
In Microsoft's case, things still look good despite growing debt levels and flat FCF growth:
Indeed, with a FCF to debt ratio still sitting at 83% Microsoft could - in theory - repay the entirety of its debt in a little over a year using only its FCF. Very impressive. Indeed, Microsoft is one of only a handful of companies with a credit rating in the prime, AAA grade. Judging from the above, it is quite deserved.
Needless to say, Microsoft manages to comfortably PASS this test.
4: FCF Dividend Yield
Next is the matter of the all-important dividend yield. What particularly concerns me here is the matter of the FCF yield. This is the theoretical yield if the company decided to pay out all of its FCF as a dividend.
What I look for is a FCF yield of 3.5% or more. I also look for a FCF payout ratio on the current dividend yield of 75% or less.
So how does Microsoft do here? Again, very well indeed:
Its FCF yield is over 5.6%, easily past my 3.5% target. What's more, it currently only pays out 43% of its FCF as a dividend, leaving plenty of room to grow it. There's a hefty margin of safety baked into this in light of the likely pressure on FCF growth in the near future.
All in all, a very competent PASS for Microsoft here.
5: FCF Valuation
My final test is related to its valuation when compared to its historic price. Here I use the enterprise value to FCF ratio.
If the company is trading around or below its FCF fair value I consider it as having passed this test.
So how does it do? Well, over the last five years Microsoft has seen its EV/FCF valuation grow significantly. This is in line with both a growing value premium and growing enterprise value (that is, the market cap plus debt and minus cash):
This means that over the last five years the average EV/FCF value for Microsoft has been 13.36.
I use this value to multiply the average of the FCF from the last financial year and that predicted for the next two years. I calculate the predicted FCF per share by taking the predicted revenues for both years and multiplying this by the average taken from two FCF/revenues figures:
- The FCF/revenues for the last financial year
- The average FCF/revenues ratio over the last five years.
For Microsoft these were:
This gives us an average of 28.57%. Using this alongside the predicted revenue figures for the next two years and plugging them into my FCF fair value formula above gives us a FCF fair value of $44.45.
This suggests that Microsoft is currently trading a little over 15% ahead of its FCF fair value. Unfortunately, this means Microsoft earns itself its first FAIL here.
Microsoft is clearly a very attractive business. It sailed passed all but the valuation test. Its economic moat is very wide indeed and its moves to leverage its dominance in many facets of our technological universe will, I think, pay off generously over the long term.
Nonetheless, with FCF not looking set to grow for a little while (and likely to shrink modestly) I do find its current valuation a little rich. A fair value of around $45 would be a just reflection of both its quality and its challenges. What's more, it was only a few months ago that it was trading around these levels:
We may therefore find that it tests these levels again in the future. It is certainly on my watch list. I will just have to be patient for a pullback.
* In this article, I use free cash flow as calculated by subtracting capital expenditure from operating cash flow.
Unless otherwise stated, all graphs and tables and the calculations contained within them were created by the author. Creative Commons image reproduced from Flickr user janitors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.