Analyst's Toolkit: Don't Hate on Microsoft

REDMOND, WASH. ( TheStreet) -- Microsoft's ( MSFT) stock hasn't rebounded since plummeting last Friday, when the world's largest software maker said second-quarter revenue missed analysts' estimates by more than $1 billion.

Some have argued that since revenue was soft on weak demand and the company only met earnings expectations, Microsoft is in poor shape. However, when considering the accruals ratio paired with traditional gauges such as price-to-earnings ratio and retained earnings, Microsoft appears to be a strong information-technology bet.

As discussed last week, accruals cover all manners of sin in reporting financial results. As net operating accruals go up, the company is simply shifting forward costs or incorrectly recognizing revenue before it's earned. This leads to unsustainable earnings levels and, as a result, poor earnings quality.

Companies that report lukewarm results on poor earnings quality are prime candidates to miss estimates by a wide margin in future quarters due to the reversal of accruals. That isn't the case with Microsoft. Despite a quarter in which the company only matched expectations, future performance wasn't sacrificed.

Microsoft's accruals ratio dropped from pre-meltdown levels in the teens to a far more palatable range. In the first quarter, a healthy decline in accruals helped correct the balance-sheet inflation that seems to have occurred in the previous year. While accruals began to accumulate again in the first quarter, it's a dramatic improvement from a year earlier. Here are the changes from quarter to quarter:

6/30/2009: 1.9%

3/31/2009: -14.7%

12/31/2008: 6%

9/30/2008: 16.2%

6/30/2008: 11.8%

With quality earnings underlying other gauges, investors can be far more confident that metrics such as the P/E ratio and return on equity show the true state of Microsoft's operations. Regarding those metrics, Microsoft looks like a very attractive investment. The company is undervalued based on its P/E ratio of 13.5 against an average for the information-technology industry of 21.9. It also has a very strong return on equity of 38.4%, more than 13 percentage points higher than the sector.

Sustainable growth is also much more attractive than competitors such as Apple ( AAPL) and Hewlett-Packard ( HPQ). Microsoft has a sustainable growth rate of 27.6% versus 22.7% for Apple and 17.3% for Hewlett-Packard.

The economic recession has weakened companies. Microsoft is in an enviable position, though, with very little debt and a healthy pile of cash to help improve the business, even at a time when cash flow may be slow for some time.

Absolute earnings numbers need to be viewed with an eye for the quality of the presentation. A quarter that wildly beats expectations through the rampant use of accruals will actually be far less attractive than a moderately performing company that has solid and sustainable earnings.

Microsoft is worth a second look for investors put off by the company's second-quarter earnings report and slump in its stock price. At least the shares are at an even more attractive discount.

-- Reported by David MacDougall in Boston. Feedback can be sent to david.macdougall@thestreet.com.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.