Working Out the Details With Microsoft

Readers often ask me how I analyze a company. So look over my shoulder as I perform an Earnings Power scrub of Microsoft (MSFT - commentary - Cramer's Take), which recently filed its 10-K for the fiscal year ended June 30. I don't own this stock, but if I did, here are some items that would interest me. (The case of U.S. vs. Microsoft is an issue unto itself and, for brevity, is omitted from this report.)

Financial Risk: The first thing I do is assess the possibility of default. In Microsoft's case, the likelihood of financial bankruptcy is nil, as its $765 million of capitalized operating leases, which are its only debt, is dwarfed by its $38.7 billion in cash and marketable securities. Microsoft is truly the Fort Knox of corporate America.

Profits and Losses: My next step is to run key numbers from the income statement, balance sheet, statement of cash flows and footnotes through my two alternate P&Ls. As we see in Exhibit 1, per-share accrual, defensive and enterprising profits for fiscal 2002 are $1.41, $1.78, and $1.09, respectively.

Let's work through each of the limitations of the income statement.

With capital spending at $770 million and depreciation totaling about $1.1 billion, Microsoft's investment in fixed capital was negative $314 million. This is a source of cash in the defensive income statement, which increases defensive profits. (Investment in fixed capital is not a direct expense in the accrual and enterprising income statements.)

Working capital was negative $5 billion on June 30, 2001, and negative $4.9 billion on June 30, 2002. Thus, Microsoft's investment in working capital for fiscal 2002 was $112 million. This is a use of cash, which reduces defensive profits. (Investment in working capital is not a direct expense in the accrual and enterprising income statements.)

Intangibles included $4.3 billion of research and development and another $1.2 billion of advertising (the latter disclosed in the footnotes). Add them up and you get $5.5 billion of expenses in the accrual and defensive income statements. But because the enterprising income statement converts intangibles from operating expenses to capital assets (to match current sales with current expenses and future sales with future expenses), the direct charge here is only $4.9 billion.

Because Microsoft is financed almost entirely with equity, no interest expense appears in the accrual and defensive income statements. In the enterprising P&L, however, the imputed cost of the roughly $50 billion in corporate net worth (average two years) plus capitalized operating leases, capitalized intangibles, etc., less excess cash and marketable securities works out to $2.7 billion.

(You sharp-pencil types will notice the amounts in Other and Taxes vary. These differences result from adjustments to the defensive and enterprising ledgers for things like defined pension fund gains, stock-based compensation, the tax deductibility of accrual interest and the effects of converting intangibles from expenses to assets.)

Quality of Profits: Now I build a Quality of Profits chart, as you can see below. I use this chart to make sure a company's three alternate earnings figures are in close proximity to one another. Based on this chart, Microsoft enjoys high-quality accrual earnings; i.e., the company is profitable the way defensive and enterprising investors think about profits.

Source: company reports; EarningsPower.com

Earnings Power Box: Microsoft has been situated in the Earnings Power Box every fiscal year since at least 1987, a truly impressive feat. Yes, 2000 and 2001 interrupted the staircase pattern, but 2002's numbers represented a continued push to the upper right -- a good thing.

Source: company reports; EarningsPower.com

Sales Growth: Per-share (diluted) sales growth for fiscal 2002 was 13%. In contrast, average annual sales growth for the past five years was 20%.

Unearned Revenue: Microsoft's "cash" revenue last year was $30.6 billion, or 8% higher than its $28.4 billion of accrual revenue. (The figures below are in millions.)

You can argue that higher cash revenue should translate into higher defensive and enterprising profits. While I don't disagree, my analysis uses the lower (and more conservative) accrual figure.

Related Stories

Of Gold Mines and Sinkholes

Stock-Based Compensation: According to the footnotes, stock-based compensation last year was $1.2 billion, or 16% of accrual profits. In the enterprising income statement, this is treated as an expense (with a corresponding adjustment made to enterprising taxes.)

Bad Debt Reserve: The bad debt reserve on June 30, 2002, was $209 million, practically the same amount as three years earlier, even as accounts receivable rose to $5.1 billion from $2.2 billion. Consequently, bad debt as a percentage of accounts receivable is 4.1%, down from 9.1%.

Put Options: Gates & Co. is out of the put option business, which cost $1.4 billion in fiscal 2001.

Valuation: I use 15 indices to determine whether a company's enterprise value is compelling. (Enterprise value is market value plus debt, less cash and marketable securities. Do not confuse this with the enterprising income statement.)

As we see, Microsoft is substantially cheaper today than it was on June 30, 1999. Still, the company is not cheap in the classic "deep value" sense of the word.

The one valuation tool where Microsoft looks enticing is its enterprise defensive yield. This is the cash-on-cash return you get if you buy the entire business lock, stock and barrel at its current price and assume all the debt and debt-equivalents (e.g., capitalized operating leases, put option liability, defined pension benefit liability). The higher the yield, the more out-of-favor the business, but the bigger the bang for your investment dollar (provided, of course, no subsequent deterioration in assets or earnings power).

Based on a recent stock price of $47.50, Microsoft's enterprise defensive yield is 4.4%. In comparison, five-year Treasuries yield 3.2%.

So Microsoft turns in another year of high-quality earnings that will please both the defensive investor who wants to avoid committing ruinous mistakes and the enterprising investor who wants to own companies more promising than most. I'm concerned, though, about the decline in year-over-year revenue growth, and I will revisit this issue again after the company files its 10-Q for the first quarter with the SEC three months from now.

---

Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].