Incredible Shrinking Microsoft

Includes: AAPL, MSFT
by: Yankee Group

By Carl Howe

The financial and investing world seems to be going gaga over Microsoft (NASDAQ:MSFT) lately, having been blown away by its recent quarterly earnings report which seems to indicate the company is having record quarter after record quarter. Some analysts are predicting Microsoft's stock price could hit $50 in the not too distant future because of these amazing results. So forgive me if I ask an impolite question:

Why does Microsoft's balance sheet keep shrinking when it is making so much money?

Now this isn't normally the case. If we look at Apple's (NASDAQ:AAPL) latest 10-Q (the official SEC filing where the company reports earnings and balance sheet information), we find that its assets grew from $17 billion to $25 billion between 2006 and 2007. That should be no surprise, since the company is making lots of money from Macs, iPods, and iPhones. As the company makes money, it invests that money unless it gives it back to stockholders. Those investments show up on the balance sheet. Cool.

Except when it's Microsoft. As I noted back in May, Microsoft's asset base has been shrinking over the past year, going from nearly $70 billion in June 2006 down to $66 billion at the beginning of the year and down to $64 billion as of March 31. It hit $63 billion as of the end of July. Yeah, now that's a change of $7 billion that's gone poof from Microsoft's balance sheet. And it's not shareholder dividends -- those only account for less than $1 billion over the period.

Now in Microsoft's latest filing (the balance sheet is on page 2), it managed to push those assets back up to $65 billion, so life should be good, right? Well, not so much. The problem is a little balance sheet item called "Goodwill". That ballooned from about $5 billion to over $10 billion in the last three months. Why? Oh yeah. Because Microsoft paid nearly $6 billion for aQuantive, an advertising company with about $450 million in annual revenue. And since Microsoft paid cash for that company, the value it received over and above the tangible assets go on the balance sheet as goodwill. For aQuantive, that's about $5 billion.

But just because that value is on the balance sheet doesn't mean the asset is actually worth anything like that value. Goodwill values are typically carried for years and eventually written off because companies often overpay during acquisitions. Microsoft, despite its billions in the bank, is no exception to that rule. And if we subtract off Microsoft's overpayment from its balance sheet, the company's assets are down to about $60 billion. That means that excluding the aQuantive goodwill, Microsoft's hard assets have shrunk $10 billion or 15% over 15 months. Wow. A billion here, a billion there, pretty soon you're talking about real money.

So where have those assets gone? Well, about $7 billion went to funding Microsoft's XBox 360 initiative, which bought it the number two spot in next-generation video games. However, the company still loses money on each console sold and while it made money on the Halo 3 launch, there are no future Halo launches scheduled, so we expect that business unit to go back to its money-losing ways. We've already noted that the company has spent nearly $6 billion to get into the advertising business, with few signs of success there. And Microsoft's Online Services Business is continuing to lose money as well.

Some other interesting points in the Microsoft 10-Q statement: the company is under an IRS tax audit for the years 2000-2006. Some of Microsoft's declining shareholder equity is due to a $7 billion increase in reserves Microsoft has booked to account for some of its tax provisions under the new FIN 48 rules, which it must record on the balance sheet if it has less than a 50% chance of its position being upheld. The result: net shareholder equity declined from $36 billion to $32 billion between 2006 and 2007.

Now to be fair, I concede that Microsoft's Windows and Office businesses are generating billions in profit every quarter. But companies like GE (NYSE:GE), Apple, Intel (NASDAQ:INTC), and others seem to use their billions to grow the net worth of their companies. Only Microsoft appears to use those billions to make its company smaller and worth less. And with 9.5 billion Microsoft shares outstanding, it doesn't take much dilution of value before one has to ask whether those shares are worth their current valuation, to say nothing of twice their value. After all, why pay a premium for a depreciating asset?

So the next time someone tries to sell you on Microsoft coming back as the next big growth stock, ask them this simple question: "Why should I invest in a company that has lost 12% in shareholder equity in a year and whose assets are declining?" I'm not sure there's a good answer.