On Thursday afternoon, Microsoft (MSFT) announced its fiscal first quarter earnings. On a non-GAAP basis, the company produced revenues and earnings that were much higher than expectations. However, if you exclude revenues and earnings deferred for the Windows Upgrade Offer, Windows 8 Pre-Sales, and the Office Offer, Microsoft's GAAP revenues and earnings missed. These numbers were seen as a disappointment, and Microsoft shares declined nearly 3% on Friday.
Personally, I give Microsoft a pass on the first quarter results because of the Windows 8 situation. Everyone knows that Microsoft's second quarter will be huge, with current expectations calling for approximately $23 billion in revenues, and earnings about 70% higher than the just reported quarter. Microsoft is flush with cash and the balance sheet improved despite the "misses" on revenue and earnings. Investors have given Apple (AAPL) two passes in the past year or so while they waited for a new iPhone to be released, so why can't we give Microsoft a pass on Windows 8? You should, and I'll show you today why the stock is still a strong buy.
First Quarter Results:
Taking out the deferred revenues and earnings, Microsoft came in at just over $16 billion in revenues and $0.53 in earnings. Analysts were expecting $16.42 billion in revenues and $0.56 in earnings.
Despite the down results, there still were some positive numbers. The server and tools segment showed 8% growth over last year. Online services saw a 9% increase in revenues, as online ad revenue grew 15% due to an increase in revenues per search. Xbox continues to be the top selling game console in the US, and now has a 49% market share. Additionally, Skype continued its explosive growth and now has over 280 million users.
In addition to the poor top line results, costs came in a bit hotter than expected, and that is reflected in Microsoft's margins, seen below. For a full analysis of Microsoft's results, check out the company's 10-Q. The numbers below are based on the GAAP results.
Revenues were down 7.85% for the quarter, while the cost of goods sold increased by 10.35%. The increase was due to Nokia (NOK) platform payments, as well as the inclusion of Skype costs (Microsoft finished acquiring Skype in Q2 last year), as well as growth in cloud infrastructure and enterprise services. Gross margin dollars fell by more than $1.75 billion, a decline of 12.9%. You can see that above as Microsoft's gross margins fell by 430 basis points year over year. Microsoft stated that excluding Surface, it expects its cost of goods sold to increase in the high single digits for the fiscal year.
Microsoft saw an increase in operating expenses as well. Research and development expenses rose by 5.62% for the period, mostly due to an increase in headcount. Sales and marketing expenses rose by 1.55%, mostly due to increased amortization of intangibles, headcount, and the marketing of Windows 8. General and administrative expenses declined by 3.1%, mostly due to lower legal costs, but offset by a rise in headcount. Overall, operating expenses for the period rose by $140 million, or 2.19%. That helped contribute to a drop of nearly $1.9 billion in operating income, a fall of 26.31%. The fall in operating income, mostly due to the decline in gross profit, led to an 830 basis point decline in operating margins over the past year.
Things got a little better further down the income statement. Microsoft's "other income" more than doubled to $226 million, primarily due to the sale of the MSNBC stake. Also, the company's effective tax rate was just 19.30% in the quarter, compared to the prior year period's rate of 21.46%. The change was mostly due to a favorable impact of foreign currency exchange rate movements on their foreign tax provisions.
Overall, net income for the period declined by $1.272 billion, a decline of 22.17%. Earnings per share fell from $0.68 to $0.53. The diluted share count rose slightly, by 4 million shares, to 8.494 billion.
Balance Sheet Strength:
The following table shows some key financial ratios and balances from the company's balance sheet.
Microsoft's balance sheet got stronger in the period. The total amount of cash and short-term investments (number in the table above also includes long-term investments) increased by $3.6 billion in the quarter, primarily thanks to nearly $8.5 billion in cash flow from operations during the quarter. The amount of domestic cash edged down to about $8.6 billion from $9.0 billion at the end of the prior quarter. I don't see Microsoft's cash position as an issue, even though some question the company's ability to fund buybacks and pay dividends with such low cash levels in the United States. Yes, most of the company's cash is located overseas. However, the company's cash position will continue to increase next quarter, after the Windows 8 release.
Additionally, the current ratio improved and working capital increased. While current assets decreased by about $1 billion, current liabilities declined by almost $1.3 billion. Microsoft's total asset base rose by $605 million in the period, while total liabilities fell by roughly $1.5 billion. That explains the improvement in the debt (liabilities to assets) ratio. I expect these financial ratios to improve going forward after what should be a very good fiscal second quarter.
The value proposition:
Microsoft can be considered a value name for many, because the company trades at a reasonable valuation, pays a dividend, and is buying back stock. Microsoft bought back another $1 billion in stock during the quarter, which offset some executive option dilution. The share count has risen slightly over last year, but would you rather they didn't buy any stock back and it rose faster? Probably not.
Microsoft also raised its dividend recently, from $0.20 to $0.23 per quarter. After Friday's fall, Microsoft is now yielding 3.21%. That's 28 basis points more than a 30-year US Treasury bond.
So how does Microsoft compare value wise to some other top tier tech names? Well, I'll show you some comparisons to Apple, Cisco Systems (CSCO), and Intel (INTC). I chose those names because they are all paying dividends, all buying back stock (Apple just started doing that), and all are expected to grow revenues in their current fiscal year. For purposes of this argument, I'm using 2013 as Intel's current fiscal year because 2012 is just about over. I'm not using names like Hewlett Packard (HPQ) or Dell (DELL), because those names are expected to show flat to declining revenues.
So the following table shows the revenue and earnings growth (or decline) expected for each of the four names in their current fiscal year (2013 for Intel like I said). I also included the current dividend yield and the price to earnings ratio, based on the expected earnings for the current fiscal year.
We all know that Apple is growing faster than the rest, but you don't get as much of a dividend or as much of a buyback. Investors are willing to trade off the dividend and buyback for the growth. In terms of Intel, the dividend is great, and the yield has kept rising as the stock has fallen. Intel recently reported its quarterly earnings, which has led to analysts taking down their growth forecasts. Intel's revenue growth forecast for 2013 has been cut in half in the past week, and earnings estimates have been cut by 15 cents in the past week. Intel trades at an 11% premium to Microsoft currently, and I think that's a real stretch. In terms of Cisco, Microsoft has a slightly higher dividend, but offers a bit more growth. I think that the premium you are paying for Microsoft in comparison to Cisco is well worth it.
Based on the numbers you see here, I would think a fair valuation for Microsoft is 10 to 10.5 times the current fiscal year's earnings. Currently, analysts expect $2.99 for Microsoft. That gives a range of $29.90 to $31.40, with a midpoint of $30.65. That's my current fair value for Microsoft, meaning I believe the stock is undervalued by roughly $2, or about 7%. I think there is a decent amount of upside for Microsoft going forward, and you're being paid more than 3.2% to hold the shares. Additionally, more experienced investors could also use a number of various option strategies to increase their yield. I'm not going to recommend any today, but the option is out there for some.
Conclusion - Buy on the dip:
Microsoft is down almost $2 from its recent late-September high, and I think that provides a good opportunity for investors to initiate a position or increase their current one. While the quarter's numbers missed expectations, you have to give them a pass. We've given Apple two passes in the past year or so. If you include the deferred revenues and earnings, Microsoft crushed estimates. Those revenues will be included in future periods. Now if Windows 8 flops or the next quarterly report is bad, I will surely criticize them at that point. But for now, I believe Microsoft gets a pass, and so should you.
Windows 8 is almost here, and Microsoft will generate tons of revenues from this new operating system. The server and tools segment is still growing, and don't forget Xbox and Skype. Windows 8 will be big, but like I recently stated, Microsoft is more than Windows 8. This is still a company generating huge cash flows, allowing it to pay a very nice dividend and buy back stock. The valuation is very fair, and in my opinion undervalued, when compared to some other top tech names. The recent pullback offers a nice opportunity for investors to consider Microsoft.