Sell Microsoft

| About: Microsoft Corporation (MSFT)

Summary

Microsoft impressed the market with non-GAAP earnings.

GAAP earnings tell another story.

LinkedIn acquisition a concern.

Fair value introduced.

Rumors surfaced that Salesforce.com (NYSE:CRM) would have needed to raise its bid to win LinkedIn (NYSE:LNKD) from Microsoft (NASDAQ:MSFT). This excuses Microsoft from the massive premium it is paying, albeit not by much. Investors do not seem to mind, either. The company's fourth quarter results boosted shareholder confidence. This optimistic view looks misguided.

If there's one good point about Microsoft buying LinkedIn, it is LinkedIn ending the plug-in that allowed for joining LinkedIn data with contact records in the Salesforce CRM software. This feature addition gives Microsoft's own CRM product an edge. Unfortunately, much of the $26.2 billion cost Microsoft is paying will likely end up as a goodwill write-down. History is a good guide. The company wrote off $7.6 billion for the phone division. aQuantive became a $6.2 billion write-off. In a few years' time, expect Microsoft correcting its current overestimation on the value of LinkedIn users. This will mean a goodwill write-off from the acquisition.

Microsoft Click to enlarge

Fourth quarter GAAP earnings weak

Microsoft rallied by over five percent on July 19 after beating non-GAAP consensus estimates. Non-GAAP add-backs netted a 77 percent addition to the company's reported EPS of $0.69 per share. With impairment, integration and restructuring expenses ($900 million) and net impact from Windows 10 deferrals ($1.5 billion) included, Microsoft's GAAP earnings were $0.39 a share. The company also applied a 7 percent tax rate on GAAP earnings, compared to 15 percent on non-GAAP.

Strength in cloud

Microsoft's Azure cloud services business grew by 102 percent but server products and cloud services revenue grew by just five percent, or $253 million. Intelligent cloud income fell 17 percent to $443 million. Higher research and development costs added to the 22 percent increase in expenses.

Results in mobile mixed

Microsoft highlighted 50 million monthly active devices on iOS and Android using Office 365. The four-fold increase over last year is a bright spot compared to the company's phone division. Microsoft wrote down $200 million in hardware inventory. While Phone revenue fell 71 percent, the company gave no hint to its strategy in growing its market share in the smartphone space. The company only acknowledged revenue fell due to lower volume in phones sold.

Microsoft will clearly focus its efforts on mobile software applications instead of hardware. Skype, which Microsoft bought for $8.5 billion in 2013, faces an uncertain future. If it fails to clear end-user confusion over the release of incompatible Skype and Skype for Business soon, Microsoft may lose users.

Valuation

Microsoft trades at 26.9x price / EPS and an EV / LTM EBITDA of 13.2 times. By comparison, Oracle's (NYSE:ORCL) EV/LTM EBITDA is 10.4x while Salesforce.com's is 51.7 times. The sector average, which includes VMWare (NYSE:VMW) and RedHat (NYSE:RHT), is 12.4 times.

Benchmark Companies

Historical EBITDA Growth

ORCL

VMW

CRM

RHT

Sector

MSFT

5Y CAGR

0.4%

17.3%

47.1%

14.7%

5.7%

4.0%

3Y CAGR

-5.0%

7.7%

512.8%

13.7%

5.7%

-4.3%

Latest Twelve Months

-9.7%

13.1%

262.0%

20.4%

-3.7%

-18.7%

Historical EBITDA Profit Margin

Prior Fiscal Year

43.8%

22.7%

3.1%

19.2%

7.3%

38.1%

Latest Fiscal Year

40.8%

23.3%

14.8%

19.4%

7.1%

34.8%

Latest Twelve Months

40.8%

22.8%

14.5%

21.2%

6.8%

32.4%

Current Trading Multiples

EV / LTM Revenue

4.2x

3.6x

7.5x

5.9x

1.6x

4.3x

EV / LTM EBITDA

10.4x

15.6x

51.7x

27.6x

12.4x

13.2x

EV / LTM EBIT

12.5x

20.3x

390.2x

36.9x

16.9x

16.9x

Click to enlarge

Source: Finbox.IO

By applying an average EV/LTM EBITDA of 13.2 times, Microsoft is worth $53.68, a 5 percent downside to the $56.57 closing price on July 22:

Low

Mid

High

Benchmark EV / LTM EBITDA

10.4x

21.6x

51.7x

Sector EV / LTM EBITDA

0.0x

0.0x

641.1x

Selected EV / LTM EBITDA

10.0x

12.4x

15.0x

(NYSE:X) LTM EBITDA

28,119

28,119

28,119

(=) Implied Enterprise Value

281,190

348,676

421,785

(-) Non-shareholder Claims *

70,473

70,473

70,473

(=) Equity Value

351,663

419,149

492,258

(/) Shares Outstanding

7,808

7,808

7,808

Implied Fair Value Range

45.04

53.68

63.05

Upside / (Downside)

-20.4%

-5.1%

11.4%

Click to enlarge

Your takeaway

Microsoft is trading at historically high EV/EBITDA multiples.
MSFT Chart

MSFT data by YCharts

Shareholders are banking on continued revenue growth as users move from the desktop to the cloud. This is a valid assumption since desktop PC sales are falling but mobile device are going up. Still, Microsoft's overpayment of LinkedIn and a half-hearted effort in the mobile device market is a concern. Investors should consider taking some profits off the table.

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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.