Setting the stage
There's no question that Microsoft (NASDAQ:MSFT) has done extremely well by shareholders over recent years, particularly since the depths of the recession, as the stock has returned 22.44% annually (with dividends reinvested) since March 6th, 2009, the market bottom. That is a slight outperformance of the rest of the software industry and NASDAQ, and a significant outperformance relative to the S&P 500. So, despite being one of the largest capitalization companies in the world, shareholders have been well rewarded for sticking with the firm. The firm, also, once again, beat earnings forecasts this past Thursday, much to the delight of investors. That said, after years of market dominance in the high-margin software industry, MSFT is in transition in multiple ways. Not only has the company matured into a value, rather than a growth stock, management has also had to adapt to the changing nature of the software industry and the proliferation of the cloud and improving alternative operating systems, as the world makes the gradual shift away from the PC to the tablet and other devices.
The Fundamental Aspect
I like to typically start my analysis by looking at top-line growth, and see the trend in overall sales. Well, as the below chart illustrates, revenue has been growing fairly steadily until finally taking a significant dip in the last fiscal year. It very well may be an anomalous decline, but it's something to keep a close eye on.
In generating said sales, MSFT has had to spend more dollars per sale as time's gone on over the last decade, and that is a very troubling sign. Of course, it is partly indicative of the end of the halcyon days of high-margin software industry domination. Still, it's a trend that is of concern, because it places a greater importance on the ability of management to implement its transition to the cloud and open-source aspects of the market, with lower margins but fantastic growth opportunities. It's already a very competitive field, however, and MSFT is hardly the prime mover as it was in quality PC software decades ago.
One thing that I do like to see, regardless of the top-line difficulties, is that a tech firm, especially one as established as Microsoft, is still keen on funding research and development in a meaningful way. Tech firms, much like pharmaceutical companies, need to continue to innovate, and the only way to do so is to fund new projects and new design possibilities. That costs money, obviously, but becomes the true lifeblood of any future growth opportunities (organically), beyond simply acquiring other companies. Nothing beats an efficient and effective R&D department. Let's delve into the numbers over the last decade and see what level of commitment MSFT has made in that regard:(click to enlarge)
Now, being somewhat of a cyclical industry, it's understandable that the firm's operating income and earnings overall have been fairly up and down. That's not particularly unusual. What is unusual, at least from this analyst's perspective, is the degree to which earnings have vacillated up and down in recent years. The volatility is a bit much to stomach for conservative investors, yet its seems to have had little effect on the market price of the stock. This suggests to me that the general market sentiment is that the company's foray into the low-cost, high-growth cloud market, and the slow but steady divestiture and decline of the hardware product-lines, will eventually lead to a healthier sales mix and improved margins once again. I am skeptical about this transition, and think that analysts and investors alike have been pricing in near perfection. That is almost always a recipe for disaster, or at least disappointment. Take a look at net income over the last decade, for some perspective:
This volatility is truly eye-popping, and shows the kinds of challenges management has faced in smoothing earnings, while attempting to drive growth in key areas, and wind down others (low-margin hardware), while also having mixed success with various operation system launches during this time-frame. It's been a true boom-or-bust cycle over the last decade when it comes to Windows, and MSFT is slowly learning how to navigate the post PC-dominated world with its offerings. Still the lessons learned have proven costly.
Shareholder Relations and Returns
So, how has MSFT appeased shareholders while operating income, margins, and earnings per share have been so volatile? Well, the firm, like many other blue-chips in recent years, have turned to a massive capital return program, to help prop up share prices, and juice shareholder returns. Generally speaking, I am in favor of healthy share buyback and dividend commitments, but I also get wary when I see companies potentially overextending themselves in such endeavors. These strategies are a great tool to reward shareholders for their loyalty to the company and to encourage future investment, but they are not a panacea of the ills of a company with revenue growth problems and cannot mask earnings trouble for long. Before going into more detail behind the initiative, let's see how management has managed to reduce the number of common shares outstanding over the last 10 years:
So, as one can see, shares outstanding have fallen from nearly 10 billion in 2007, to 8 billion in fiscal year 2016 (MSFT's fiscal years end in June). That is a decline in shares of nearly 20%, and greatly enhances the current EPS, relative to what they would be without such moves. While it is nice to see EPS growth, if it is mostly fueled by buybacks, that is somewhat misleading, and clearly unsustainable. In any event, what's even more important is how has the company been funding such a share-holder friendly policy on such a massive scale? Well, unfortunately, MSFT has been adding to its debt pile at an absolutely alarming rate, both with short-term financing and long-term debt. The following two charts illustrate the deteriorating balance sheet:
Again, it is painfully clear that MSFT has fueled most of its growth in buybacks by going to the debt markets to finance them, while interest rates have remained low. Thankfully, most of the debt is of the long-term variety, and thus was locked-in at very low rates and relative financing costs. The level of short-term debt, however, at nearly $13 billion, creates a serious overhang of debt that either needs to be paid down or at least refinanced, at somewhat higher rates than in the recent past. In any event, seeing a company grow its long-term debt from 0 to nearly $41 billion in 8 years, and its overall debt from 0 to $54 billion is startling, and does not bode well for future interest costs and shareholder equity. In fact, shareholder equity has already begun to suffer.
The above chart shows a sudden reverse in trend of overall shareholder equity, and should be something that astute investors keep a close eye on. The change from steady rise to sharp decline is not something that generally indicates a sustainable financial situation. Another metric that is very telling, is the debt-to-equity ratio, and measures the degree to which a company has leveraged its balance sheet. Unfortunately, the picture here has gotten considerably worse over time, as one would expect given the information already presented.
To go from a 0 in 2008, to 0.85 in 2017 (debt/equity ratio) is alarming, in my opinion, and is something that management will need to address if it wants to be able to sustain its current cash flow and capital return programs at similar levels.
As mentioned earlier, margins have taken a bit of a hit over the preceding years. Well, operating margin in particular has seen a very disconcerting downward trend, as the sales mix has become less reliant on high-margin software, while low-margin hardware continues to drag on the numbers. Also, while there is tremendous growth opportunity in cloud computing, margins are not as high as traditional software product suites, and management will have an challenging environment in which to try and stabilize the situation.
Per Share Information
While I have taken a largely top-down macro approach to the analysis, so far, I'd like to now shift gears a bit and look at the micro per-share metrics. One of the nice things for existing shareholders has been the growth in dividend income (albeit at a cost to the health of the balance sheet). The following graphic shows quite an impressive growth in dividends over the years:
That is a dividend growth rate of 13.55%. That has certainly been a real boon to shareholders. What concerns me, however, is that the dividend payout ratio, or the ratio of dividends to earnings per share, has grown even more, even exceeding 100% in the last fiscal year. The following chart tells the tale:
One of the last valuation metrics I'll share is the book value per share. While it is debatable how useful such a metric is for a tech company, it is at least another piece to the puzzle, and illustrative of the trend in what's been happening to MSFT's balance sheet, and essentially, the resultant deterioration that compressing margins have had on the financial health of the company.
Finally, as price-to-earnings and price-to-sales ratios indicate, MSFT is trading at a significant premium to both the market, and to its own previous 5-year trading history. Currently, the firm trades at 30x earnings, whereas the tech industry trades at 27 or 28, and MSFT's 5 year-average is about 20, or one third less than its current multiple. That is another headwind for investors, and is again indicative of a market expecting near perfect execution of management's long-term initiatives. Personally, I think that is a very high price to pay, given the deteriorating balance sheet, spotty revenue and earnings numbers, and an increasingly challenging competitive environment.
The Final Verdict
While Microsoft has grown its cash position significantly, going from $23.4 billion in 2007 to $113.2 billion in 2016, it has not all been due to stellar earnings or bottom-line profitability. Rather, the company has been content to hoard cash while it's been cheap, both for a growing dividend commitment, and a sizable share buyback program, not to mention the health R&D spending. Still, the growing debt/equity figure and the rising interest rate environment we're heading into, only add increased headwinds to an already dicey situation with regards to overall corporate strategy. Windows was the goose that laid the golden egg, and while that continues, its significance as a segment of Microsoft's sales mix is shrinking, and margins along with it.
Financial engineering cannot cover up the fact that executives at the top are at a real crossroads, and their decisions on how to execute the strategy they've laid out will determine where the stock ultimately goes from here. Personally, I think the stock is a bit overpriced at a price-to-earnings of 30, and price-to-sales of about 6, considering the murky growth picture ahead. While it's certainly an unpopular notion to ever short Microsoft, I'm not so sure it's unwarranted in this case. At minimum, I would purchase some long-dated puts on any positions in the stock, and protect your investment, because there is not much room to run for the foreseeable future. That said, markets can remain irrational longer than one can remain solvent, so as always, take any recommendation with a grain of salt. Just because a stock may be overvalued, it doesn't mean the market will recognize that fact any time soon.
*All financial data courtesy of Morningstar Investment Services.
*All charts created by the author, using data exported from Morningstar's database.
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.
Additional disclosure: I included the excel workbook once again, just in case the article is classified as PRO, etc. It's just there to back up my work, if needed.