Microsoft: Why This Stock Looks Cheap

| About: Microsoft Corporation (MSFT)
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On July 21 after the bell Microsoft (NASDAQ:MSFT) released fourth quarter 2011 and full year earnings. Fourth quarter EPS came in at $0.69 per share versus the consensus estimate of $0.576, a 20% earnings beat. EPS for the 12 months ended June 30, 2011, were $2.69 versus $2.10 for 2010, a 28% year-over-year increase.

In the wake of the earnings release the stock was a roller coaster in the after-market. It was clear that investors were having different reactions to the earnings release.

The Tax Rate Decreased Dramatically in Q4 2011

One of the issues being discussed that may have led to different interpretations of the earnings release was the fourth quarter and fiscal 2011 tax rate.

For the fourth quarter the effective tax rate was 7% versus 25% for the same period in 2010. For the full year the effective tax rate was 17.5% versus 25% for 2010.

In the earnings press release MSFT provided the following color on their lower tax rate:

Our effective tax rates for the fourth quarters of fiscal years 2011 and 2010 were approximately 7% and 25%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore and Puerto Rico, which are subject to lower income tax rates.

Our effective tax rate was lower than in the prior year due mainly to the adjustment of our previously estimated effective tax rate for the year to reflect the actual full year mix of foreign and U.S. taxable income. In addition, upon completion of our annual domestic and foreign tax returns, we adjusted the estimated tax provision to reflect the tax returns filed and recorded an income tax benefit which lowered our effective tax rate.

To summarize MSFT had a lower tax rate because the business mix skewed more toward jurisdictions with lower tax regimes. Further, in Q4 MSFT adjusted the tax rate to reflect actual tax filings resulting in a benefit recognized in the quarter. The full year rate was also impacted by a partial settlement with the IRS that resulted in a $461mm tax reduction in the third quarter of fiscal 2011.

In light of the lower tax rate some investors may have recalculated Q4 earnings assuming a higher rate in order to compare the results with Q4 2010. If MSFT had the same tax rate (25%) as it had in Q4 2010, earnings would have been $0.56 per share, slightly below the consensus estimate. This could result in the conclusion that the quarter was not as strong as it first appeared.

However, it is important to note that MSFT also beat on the top-line indicated strength. The company also generated $5.4 billion of free cash flow in the quarter and increased cash and investments to $52.8 billion.

And, regarding tax, it appears that going forward MSFT will see lower tax rates as a result of a changing geographical mix. Given this, earnings should be considered at the lower rate and MSFT did beat EPS expectations. Remember that paying lower taxes results in more cash flow and ultimately the value of a company is the discounted value of its free cash flow.

On the earnings conference call the company commented on the geographic mix shift:

PC sales to emerging markets continued to grow at a rapid pace as a record number of people around the world are using Windows PCs. We estimate that this quarter, over 40 million PCs, representing half of all global PC shipments, were shipped to emerging markets.


For the Windows and Windows Live division, we expect revenue to continue to be impacted by market dynamics, similar to what we experienced in the fourth quarter, with emerging market growth significantly outpacing developed market growth.

So, the dynamics that led to the lower tax rate are projected to continue. On the conference call the company also provided the effective tax rate guidance for the first quarter of fiscal 2011 of 19% to 21%. To put these levels in context note that the effective tax rate in Q1 2011 was 25.2%.

So what is the conclusion?

Investors should not expect MSFT to have an effective tax rate of 7% going forward. The Q4 2011 tax rate was low as the company adjusted the previously estimated effective tax rate for the year to reflect the actual full-year mix of foreign and U.S. taxable income. Going forward the company will have lower rates than in the past given the geographic mix shift as indicated in the Q1 tax rate guidance. As a result, while the Q4 earnings “beat” should be analyzed in context, a lower annual tax rate is appropriate.

A Quick Thought on Valuation

MSFT grew year-over-year earnings almost 30%. At a stock price of $27 MSFT is trading at a ridiculously low 10.0x trailing earnings. Stripping out the $6.25 per share of cash and investments on the balance sheet results in a P/E ratio of 7.8x for a company growing EPS at 30%. Given MSFT’s continuing expansion into cloud computing, the Skype deal, the Windows and Office refresh cycles, increased search market share through Bing, and the potential of a Windows 8 release this fall there is more growth to come. And, by the way, in the tablet and smartphone operating system spaces MSFT has nowhere to go but up. The risk/reward dynamics of MSFT at these levels suggests that investors should back up the truck.

Disclosure: I am long MSFT.