Originally this post was supposed to be on how Microsoft Corp. (MSFT) was a great company to invest in. The idea had formed a few months ago because the financials were fantastic. However, some of the things they have started doing has made me completely change my mind. To be fair, the financials are fantastic, but the business has deteriorated to the point where I can no longer recommend them. First let me show you what I loved about the financials. Then I'll show you why the business is underwhelming. This is one of many technological companies that have shown me it is almost impossible to value a company related to technology because their valuations can change fast as the technology shifts.
So let us discuss the balance sheet. In the last 2 years the current assets of MSFT have grown by $30 billion while total assets have grown by around $35 billion. We also see that short term investments and cash combined have gone up by $26.5 billion. This is good because it means the increase in assets is not tied up in long term investments, thus allowing MSFT to optimize the use of their assets. On the other hand debt has also gone up by $15 billion, so that increases equity by $10 billion per year. Some may worry because MSFT has earned roughly $40 billion over this period and not the $20 billion increase in net worth, but they also have to look at the roughly $23 billion returned in dividends and stock buybacks. This shows that half the money is going back to the shareholders. The business has grown for a very long time so to say we can return 50% profits to the shareholders and still grow the business makes it fantastic. Also note that the current assets are more than twice current liabilities and long term assets are quite a bit more than twice long term liabilities. I rate the balance sheet an A. The only bad thing is that their long term debt has gone up in the last 2 years.
Now let us look at the income statement. Look at the profit margins for the last 3 years, they are 30% for year ended June 2010, 33% for year ended June 2011, and 23% for year ended June 2012 but in June 2012 there was a nonrecurring charge of $6 billion which was bad, but MSFT does not have it often enough to make me worry. I would have looked more into it, but the products turned me off from the company before that. Anyways, supposing $6 billion is really nonrecurring we have a margin of around 31%. So business as usual. Even if we take the supposed 23% as normal, that is a fantastic margin. So the income statement I would actually give an A+ to because there is so little that has gone wrong.
Now we look at the cash flow statement. Always remember that the cash flow statement is the most important statement. It shows how much money you really made, not just what the income statement allows you to. And if free cash flow is consistently a lot less than net income there might be fraud at the company, or it's just a bad business. Either way, it's a bad sign. Now in Microsoft's case the FCF year ending June 2010 is around $22 billion, year ending June 2011 FCF is $24.5 billion and year ending June 2012 FCF is an astounding $29 billion! Not bad huh? All years these values are more than the net income. The net income over the last 10 years has grown by more than 10% compounded. People may be more enamoured with AAPL but remember that they were much smaller 10 years ago. So the Cash Flow Statement is also given an A+.
Now realize if we think that FCF can be sustained at $29 billion we get a 12.6% return or P/FCF of around 8, and considering that the growth rate of this business has been 12% it has a PEG (price to earnings to growth) ratio of around 1. Which makes it fairly priced and for an outstanding company like MSFT it is a buy. Also if we take the average FCF of around $25 billion you get a yield of 10.8% or a P/FCF ratio of 9.2. So you would expect me to rate this a buy under normal circumstances because it can reasonably return 12%-15% and thus beat the market over the next 5-10 years. Not a bad return. However, the new products worry me. Let us discuss them.
The first new products that I saw were the new Windows Surface Tablets. I'm not going to go into whether it is a good product or not. The reality is time will tell. I personally prefer Windows 7, but that's probably because I'm used to it. The problem I have is that they're more expensive than the latest Ipad. To be fair a lot of them come with keyboards, but come on! That's not enough to make it more expensive than the Ipad. So I think there is a higher than expected price. The second issue is that they are making the tablets themselves. This is foolish. Remember the laptop market. Microsoft did well because they sold the software all laptops needed and let the others compete on price. Apple can charge more because they have built it themselves for many years and have shown what they can do, nobody knows what will happen with a Microsoft built tablet. Secondly, as everyone is getting into it now, we can expect them to start the ferocious price wars that will lower the prices on all tablets. So why get into it? Just make the software and reap the rewards. I would have also made 2 types of software, one for touch screens, and one without. However, that's just me. It is possible that Microsoft is fantastically successful with these, but this gets them away from what they are strongest and makes me nervous. I give the tablets a D-.
The second new "product" that Microsoft has unveiled is the new retail stores. As anybody will tell you retail is a ferocious business. If you ever watched Dragon's Den, any time a new entrepreneur would propose a retail strategy, the wealthy businessmen would refuse to invest in that business unless it was proven (only 1 was, all others were rejected, and they still had a hard time with the one proven guy). Now you may wonder why this is and the answer is your competitors are endless. Seriously. Have you seen a retailer's margins? Typically less than 5%. Secondly, even when Apple first went into it their first design was so bad that Steve Jobs thought they would never succeed. To be fair they eventually did, but not before many design changes. What they did was build one store, and kept changing and changing it until they got it right. Then they mass launched the stores all across the country. Now to be fair that may be Microsoft's plan as they don't have too many stores, however they have it in many different cities including Toronto, Canada. So the question is did they already get the concept right, or are they still experimenting. After visiting the Microsoft Store, I really hope they're still experimenting, because it sucks! It's like an Apple Store but worse. I am not good with descriptions, so if you don't understand what I'm saying go to your nearest Microsoft Store, and then describe it for me in the comments section so others understand. But the store is just bad, and I hate the retail business. Few succeed and the margins are terrible. So in my humble opinion bad idea. I give the retail store an F.
So with all these reasons you must now be confused. The financials are fantastic but the stores and tablets are a bad idea. So what would I do? Well in my opinion the stores and tablets are bad ideas, but let us remember this is Microsoft. They are a talented company and has always done very well. The question is without Bill Gates how well will they do? The tablets and stores may be a good idea but I don't see it. So I say neither go long or short on this business because it could go either way. However, if I had to go one way I would lean towards buying, but not enough to actually recommend doing it. If anybody knows why the stores or tablets are a good idea, let me know in the comments section. But for now we should wait and see how the stores or tablets play out. If they do really well, then maybe buy.
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