MICROSOFT (MSFT)
Initiating Coverage with Neutral Rating
Jacob R. Clark
Clark_255@cob.osu.edu
August 17 2004
Summary of Investment Recommendation
•
Catalysts
o Management focus on cost efficiency provides some
upside potential to stock
o Anticipated release of Longhorn will provide earnings
momentum
o Special dividend of $3 per share will provide investors
will excellent yield with potential for multiple
expansion ex-dividend
o Potential for increased IT spending in the 4th quarter
Risks
o
o
o
o
Stock Rating
Recent Price (8/16)
Target Price
52-week range
Neutral
$27.00
$29.00
$24-30
•
Stock Data
Market cap
Shares outstanding
Beta
2005 Dividend Yield
$293B
10.86B
1.61
1.19%
•
Current investment climate and expectations for future growth
make this stock a hold for potential future upside. Strong
management execution and focus on maximizing shareholder
value provide a positive outlook for shareholders
Earnings Estimates
2005E
2006E
$1.24
$1.37
2007E
1.60
•
At current pricing levels, MSFT appears slightly undervalued
Valuation (P/E)
2005E
2006E
23.0
20.8
2007E
17.8
Linux open-source operating system
Reduced pace of technological innovation
Delay of Longhorn release
Continued questions about software security
TABLE OF CONTENTS
COMPANY OVERVIEW .................................................................................................. 2
Product Segments............................................................................................................ 2
ECONOMIC OUTLOOK................................................................................................... 5
GDP Growth ................................................................................................................... 5
Inflation........................................................................................................................... 5
Interest Rates................................................................................................................... 6
Capital Flows .................................................................................................................. 6
Corporate Profits............................................................................................................. 6
INDUSTRY ANALYSIS ................................................................................................... 7
Industry Life Cycle ......................................................................................................... 7
Porter’s Five Forces ........................................................................................................ 7
COMPANY ANALYSIS.................................................................................................... 8
Industry Position ............................................................................................................. 8
Products and Business..................................................................................................... 9
Stock Catalysts.............................................................................................................. 11
Management.................................................................................................................. 12
RISKS & CONCERNS..................................................................................................... 12
Competition................................................................................................................... 12
Regulatory..................................................................................................................... 12
Legal ............................................................................................................................. 12
Product Development.................................................................................................... 13
Execution ...................................................................................................................... 13
FINANCIALS................................................................................................................... 13
Income Statement Analysis........................................................................................... 13
Balance Sheet Analysis................................................................................................. 14
Cash Flow Statement Analysis ..................................................................................... 14
ROE Analysis................................................................................................................ 14
Financial Ratio Analysis ............................................................................................... 15
Consensus Estimates..................................................................................................... 15
VALUATION................................................................................................................... 15
DCF Valuation .............................................................................................................. 15
P/E Multiple Valuation ................................................................................................. 15
Price/Sales Multiple Valuation ..................................................................................... 16
Price/Book Multiple Valuation ..................................................................................... 17
PEG Ratio Valuation..................................................................................................... 17
Absolute Valuation Multiple Chart for Microsoft ........................................................ 18
Valuation Multiple Chart for MSFT Relative to S&P 500 ........................................... 18
Valuation Multiple Chart for MSFT Relative to IT Sector........................................... 19
Price Momentum Index................................................................................................. 20
Prospective Growth & Margin Check........................................................................... 20
Valuation Summary ...................................................................................................... 21
CONCLUSION................................................................................................................. 21
COMPANY OVERVIEW
Microsoft Corporation develops, manufactures, licenses and supports a wide range of
software products for various computing devices throughout the world. The Company's
software products include scalable operating systems for servers, personal computers
(PCs) and intelligent devices; server applications for client/server environments;
information worker productivity applications; business solutions applications, and
software development tools. Microsoft provides consulting services and product support
services, and it trains and certifies system integrators and developers. The Company sells
the Xbox video game console, along with games and peripherals. Its online businesses
include the MSN subscription and the MSN network of Internet products and services.
The Company's seven product segments are: Client, Server and Tools, Information
Worker, Microsoft Business Solutions, MSN, Mobile and Embedded Devices and Home
and Entertainment1.
Product Segments2
Client
Client segment includes Windows XP, Windows 2000, and other standard Windows
operating systems. Client has overall responsibility for product delivery, engineering and
technical architecture for the Microsoft Windows operating system, and new media
technology, as well as relationships with manufacturers of personal computers and nonPC devices, including multinational and regional original equipment manufacturer
(OEM) accounts. The segment includes sales and marketing expenses focused on
business development efforts for the Windows platform, as well as integration of
technology and products into non-PC devices.
Server and Tools
Server and Tools segment consists of server software licenses and client access licenses
(CALs) for Windows Server, SQL Server, Exchange Server, and other servers. It also
includes developer tools, training, certification, Microsoft Press, Premier product support
services, and Microsoft consulting services. Microsoft server products offer a
comprehensive range of solutions designed to meet the needs of developers and IT
professionals, and are designed to flexibly run the programs and solutions that enable
information workers to obtain, analyze, and share information quickly and easily.
Microsoft servers provide capabilities ranging from messaging and collaboration to
database management and ranging from e-commerce to mobile information access.
Server and Tools segment includes the integrated product development and marketing
that delivers Microsoft Windows Server System products. In addition, the segment
provides information about the extended Microsoft platform through a variety of content
offerings, such as web-based training for developers and IT managers. Through this
1
2
http://finance.yahoo.com
MSFT 2003 10-K
Page 2 of 21
segment, Microsoft offers a broad range of consulting services for advanced technology
requirements, including custom solutions services, enterprise application planning,
architecture and design services, and proof-of-concept services. The Server and Tools
segment includes the Enterprise and Partner Group, which is responsible for enterprise
sales strategy, enterprise sales learning and readiness, enterprise solution selling,
enterprise partner sales strategy, and enterprise field communications. This group is also
responsible for technical selling, field competitive strategy, and all competitive sales
engagements.
Information Worker
Information Worker segment is responsible for developing and delivering technologies
that focus on improving productivity for information workers in corporations. It consists
of the new Microsoft Office System of programs, servers, services, and solutions. The
Microsoft Office System features integration with Microsoft intranet collaboration
technologies, Information Rights Management, and support for industry standard XML.
The Information Worker segment also includes Microsoft Office Live Meeting, resulting
from the acquisition of PlaceWare, Inc., Microsoft Office Live Communications Server
2003, and an allocation for CALs. The segment also includes professional product
support.
Microsoft Business Solutions
Microsoft Business Solutions segment includes the businesses of Great Plains, Microsoft
bCentral, and Navision. Microsoft Business Solutions develops and markets a wide range
of business applications designed to help small and mid-market businesses become more
connected with customers, employees, partners, and suppliers. Microsoft Business
Solutions applications provide end-to-end automation for financial reporting, distribution,
project accounting, electronic commerce, human resources and payroll, manufacturing,
supply chain management, business intelligence, sales and marketing management, and
customer service and support. Microsoft Business Solutions products are designed to
meet the broad spectrum of business application needs of small to mid-market businesses,
a group that generally consist of businesses with $1 million to $800 million in annual
revenue. The business solutions are fully and seamlessly integrated across the application
areas of enterprise resource management (ERM), customer relationship management
(CRM), supply chain management (SCM) and business intelligence. These business
solutions are sold, implemented, and supported through a partner network consisting of
more than 4,500 value added resellers, systems integrators, consultants, ISVs, accounting
firms (national, regional, and local), application service providers (ASPs), and eBuilders.
MSN
MSN segment includes MSN Subscriptions and MSN Network services. MSN
Subscription services include MSN Internet access and premium services such as MSN
Extra Storage, MSN Bill Pay, MSN Radio Plus and MSN Mobile, which are offered to
consumers regardless of their Internet Service Provider. The MSN Network delivers
Page 3 of 21
online communication services such as email and online instant messaging through its
MSN Hotmail and MSN Messenger products. It also delivers popular information
services, such as MSN Search and content from top partners like MSNBC, ESPN,
Expedia, and Access Hollywood.
The segment is responsible for building and operating the MSN Network and for
delivering MSN Subscription services. Revenue is principally generated from subscribers
to MSN’s Internet access and premium services and from advertisers on the MSN
Network. MSN delivers its services direct via its MSN Network and through partnerships
with network operators such as Verizon, Qwest, Charter Communications, and Bell
Canada.
Mobile and Embedded Devices
Mobile and Embedded Devices segment consists of Windows Mobile software, Windows
Embedded device operating systems, MapPoint, and Windows Automotive. Windows
Mobile software powers Pocket PC, Pocket PC Phone Edition, and Smartphone products.
Windows Embedded, including Windows CE.NET, Windows XP Embedded and
Windows NT Embedded, is a family of operating system software used in non-PC
computing devices. Windows Embedded software is used widely in advanced consumer
electronics devices including digital televisions, IP-based set top boxes, network
gateways, and portable media players, as well as in enterprise devices including industrial
controllers, retail point of sale systems, and voice-over-IP phones. The MapPoint family
of location-enabled products and services includes the MapPoint Web Service, a hosted
programmable XML web service that allows developers to integrate location intelligence
in applications, business processes and web sites, and business and consumer oriented
mapping CD-ROM products. Windows Automotive is an automotive grade software
platform that provides developers with the building blocks to quickly and reliably create
a broad range of advanced telematics solutions.
Home and Entertainment
Home and Entertainment segment includes the Microsoft Xbox video game system, PC
games, the Home Products Division (HPD), and TV platform products. Home and
Entertainment segment oversees development and business strategy for the Microsoft
Xbox video game system, including hardware, third-party games development, games
development published under the Microsoft label, Xbox and Xbox Live operations,
marketing, research, and sales and support. The segment leads the development efforts of
our HPD product lines. The segment also carries out all retail sales and marketing for
Microsoft Office, the Windows operating systems, Xbox, games, and HPD products. The
segment is responsible for the development, sales, and deployment of Microsoft’s TV
platform products for the interactive television industry.
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ECONOMIC OUTLOOK
The current economic environment is shrouded in uncertainty. It seems as if every time a
positive economic variable is reported, that report is followed by a less optimistic report.
Great uncertainty currently exists over oil prices, geopolitical concerns, and the U.S.
election. Interest rates are still very low relative to historical levels despite recent actions
by the Federal Reserve. Inflation expectations are low relative to historical standards.
Consumer confidence levels are high despite a lack of strong job growth. The near-term
outlook for the U.S. economy is steady growth driven by government expenditures
with low inflation expectations in a rising interest rate environment.
GDP Growth
The past 12 months have provided for a perfect storm of economic growth. GDP growth
accelerated behind government spending, strong consumption, and increased investment.
Consumption was driven both my easy monetary and fiscal policy. Many consumers
took advantage of record low mortgage rates several times to both extract equity from
their homes and lower their monthly obligation. As consumers spent, corporate profits
grew substantially from increasing revenues and contained costs. Corporate capital
spending was the big surprise, as spending well-exceeded expectations.
Future economic growth looks much more sanguine than the previous 12 months.
Mortgage refinancing is slowing and consumers have less disposable income. The
employment picture is tenuous, as job growth has continued to slow. Corporations are
delaying their capital investments due to increased geopolitical concerns and uncertainty
about the impending presidential election. Growth should average between 3-5% over
the next year, as these concerns will continue to weigh heavily on consumers and
corporations.
Inflation
Inflation has remained well contained over the past year. The CPI reached a low point of
1.7% year-over-year growth. Food and energy costs remained a volatile portion of the
measurement, but were also well contained during this period. Once the easy monetary
and fiscal policies took hold, prices started to accelerate as the demand for money
increased significantly. The increase in inflation during this period still remained well
contained and below the historical average.
Inflation expectations for the near-term future appear to be increasing. Recently,
increases in the price of crude oil per barrel to more than $45 have quelled much of the
economic optimism from both the consumer and corporate side. Excluding food and
energy costs, inflation should remain well contained over the next year as the Federal
Reserve continues to manage inflation concerns with increases to the Federal Funds rate.
Inflation should continue at a rate of 2-3% over the next year.
Page 5 of 21
Interest Rates
Interest rates remained low compared to historical averages. Despite mixed signals on
economic growth, the Federal Reserve continued its proactive approach to the
management of the economy by increasing the Federal Funds Rate by 25 basis points at
each of the last two meetings. The increases in interest rates are intended to keep the
economy from overheating and producing a considerable increase in inflation.
The easy monetary policy of the Fed is over. Interest rates will increase over the shortterm through a continued attempt to contain inflation. The Federal Funds rate should see
at least a 100 basis point increase over the next year, while a lessened impact on longterm Treasury yields will also occur. Longer-term rates should experience diminished
marginal returns from the interest rate increases due to the capital flows into the sector
and liquidity preference. The Federal Funds rate should fall between 2-3% over the
next year.
Capital Flows
During the recent year, investor capital has searched for higher yields in a low interest
rate environment. With the 3-month T-bill rate at all time lows, investors were willing to
take additional risk to increase their returns. As a result, real estate saw a significant
inflow of capital. Since interest rates were projected to increase, investors were less
willing to invest in bonds since their prices act inversely to yields. Most recently, the
stock market also gained investor capital due to a more positive outlook for corporate
profits.
Due to the great uncertainty in the global economy, real estate and risk free securities
continue to hold favor with investors. Investors are seeking inflation-adjusted returns in
the current economic environment. With corporate profits showing signs of a slowdown,
capital flows to equities will likely prefer large cap companies.
Corporate Profits
Recently, corporate profits have expanded greatly. The necessity to cut costs at the
corporate level and the top-line revenue growth from the easy monetary and fiscal
policies fueled a surge in corporate profitability. Input prices have remained stable and
despite a lack of increased pricing power for outputs, volume increased significantly.
For the months ahead, the outlook for corporate profits appears flat. Most of the fat
from a decade of economic expansion and corporate excess has been trimmed and input
prices appear to be headed upward. Oil prices in particular are attracting heavy attention,
as conflict around the global oil supply continues.
Corporations and their bottom line will feel the overall impact of the uncertainty of
domestic and global economies. Equity prices will continue to trade flat for the months
to come until some uncertainty is removed from economic indicators and geopolitical
Page 6 of 21
concerns. Demographics also will play a negative part on equity markets for years to
come as the baby boomer generation prepares for retirement and seek a more certain
return on their investments. Although volatility has been great over the past few years, a
reduction in the risk premium for equities is probable as investors are becoming more
accepting of risk. This will bode well for equities since investors will require less return
for each unit of risk accepted. Microsoft should benefit from the economic
environment in the future due to their more secure revenue stream and lack of longterm debt.
INDUSTRY ANALYSIS
Industry Life Cycle
The industries within the Information Technology sector continue to remain favorable.
Although industry growth has waned from the growth experienced during the latter half
of the 90’s decade, growth should still outpace overall economic growth. Many
companies within the sector have matured and have become true cash flow generators.
While innovation is still occurring in the sector, it is confined to very specific industries
within the sector. Consolidation is occurring and the large cap companies in the sector
are fighting for the same customers along very different product lines.
Companies like Microsoft, IBM, Dell, HP, and Intel, the well-known names within the
sector are expanding their business opportunities and competing with each other. The
consolidation, which is occurring within the sector, presents Microsoft with new
challenges. Alliances and joint ventures with companies like Symantec are making the
entry into new product lines more difficult for large companies like Microsoft. Microsoft
has a great advantage during this consolidation, which is the value of its operating
system. By leveraging its operating system into developing products like handheld
devices and video game units, Microsoft will remain at the forefront of change within the
technology sector.
Porter’s Five Forces
Barriers to Entry
Microsoft maintains a strong competitive edge due to its dominance of the operating
system and productivity software. The Windows XP operating system and Office
software command a 95% market share. Microsoft continues to leverage these strengths
into new product lines in an attempt to prevent future competition. The desktop, once the
most valued piece of technology real estate is being moved to the television, the cell
phone, and the automobile navigation system. Microsoft has an advantage due to the
high switching costs associated with learning a new operating system or productivity
software. While companies like IBM are trying to change the game with the acceptance
of open source programming like Linux, Microsoft still maintains an advantage that
should insulate itself from future competition.
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Power of Suppliers
The main input for Microsoft’s products remains human capital. While innovation is key
to the development of new products, it remains in greater supply than ever before. The
global economy has provided great access to new sources of human capital from other
nations that maintain a lower standard of living and cost of labor.
Power of Buyers
Nearly 80% of Microsoft’s revenue comes from corporate purchases. In recent years, IT
managers have become savvier in negotiations and better timed their purchases. As a
result, tech companies have seen little growth in gross margins from corporate purchases.
Consumers have also become more powerful buyers with the increasing acceptance of the
Internet as a purchasing point. The switching costs Microsoft maintains also help negate
some buyer power.
Threat of Substitutes
Microsoft’s main threat is not from one of the companies within its sector as is typical in
most industries. The open source model for software is the greatest threat to the
Microsoft kingdom. Linux, an open source operating system, is the current substitute to
the Windows operating system. Other firms within the sector are beginning to accept
Linux and are pushing to get the platform into their systems.
Rivalry among Existing Firms
Since the industry is entering the end of the growth stage of the life cycle and
approaching maturity, rivalry remains strong. Consolidation among existing firms is
inevitable and will bring about great change within the industry. Firms will begin to
integrate vertically and horizontally to protect the viability of their products. Microsoft
holds a nice position given its core product line and lack of long-term debt.
COMPANY ANALYSIS
Industry Position
Microsoft is the leader in its main revenue producing business segments, Client and
Information Worker, with a market share of 95%. While risks from the development of
the Linux platform and other open source code software programs are significant, the
position held by Microsoft is still dominant.
The position held in the Server Platform segment, while not dominant, is still respectable
and growing. Margins in the Server Platform segment are considerably lower and serve
to represent the lack of differentiation among competitors.
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The Business Solutions segment is a very fragmented industry with a differentiation
focus. Many firms operate in this industry and provide specific software solutions to
firms for specific business needs. Recently, Microsoft announced a planned purchase of
SAP, a leader in this industry, but has subsequently backed away from the acquisition.
Little guidance from management has been given for the change of heart so some
industry insiders believe that a future purchase is possible. The Justice department of the
U.S. government has recently taken a position against a hostile merger between Oracle
and Peoplesoft. Further consolidation within this industry is expected in the future.
MSN segment provides an operating margin of 23%, but continues to feel pressure in this
highly undifferentiated industry. Recent plans for Microsoft include enhancing their
search technology to Google’s technology to gain marketing revenue from the highly
used search engine.
Mobile and Embedded Devices is the segment with the highest revenue growth.
Advances in mobile technology will provide Microsoft with a great source of future
profits. Since this industry is still growing rapidly, new competitors are quickly entering.
Microsoft maintains an advantage due to its dominance in software.
The Home and Entertainment segment is the least profitable of Microsoft’s businesses.
The Xbox is a commodity product that faces strong industry leaders in Sony and
Nintendo. The focus in this industry is on cost and the ability to get the best software
since the hardware is homogenous.
Products and Business
The table below provides a comparison of Microsoft’s main business segments, its recent
profitability, life cycle stage, and next product innovation:
Segment
Client
Operating
Margin
82%
Server Platforms
37%
Information
Worker
Business
Solutions
MSN
74%
Mobile/Embedded
Devices
Home &
Entertainment
Page 9 of 21
-16%
Life Cycle
Next Product
Growth - Mature Windows XP
Service Pack 2
Growth - Mature Yukon
Growth - Mature Office for
Longhorn
Growth - Mature Project Green
23%
Growth
MSN Search
-22%
Pioneer
None
-29%
Mature
Xbox 2
Anticipated
Release
Summer 2004
Q2 2005
2007
2007
Late 2004
Christmas 2005
The charts below demonstrate the share of Microsoft’s revenue, recent annual revenue
growth rate, and operating margin by business segment.
4Q Revenue by Segment
Information Worker
$2.9B
▲ 23%
Client
$2.8B
▲ 9%
Mobile and
Embedded
Devices
$70M
▲ 59%
Server & Tools
$2.3B
▲ 20%
MSN
$588M
▲ 5%
Microsoft
Business
Solutions
$196M
▲ 9%
Home & Entertainment
$499M
▲ 3%
4Q Operating Income by Segment
50%
47%
40%
40%
Client
Server Platforms
Information Worker
Business Solutions
MSN
Mobile/Embedded Devices
Home & Entertainment
30%
20%
16%
10%
3%
0%
-10%
-1%
% of Operating Income
Page 10 of 21
-1%
-4%
The charts above show that Microsoft’s most profitable businesses; Information Worker
and Client are also very slow growing. The recent increased growth of the Information
Worker segment is attributable to the release of the most recent Microsoft Office version.
While nearly every business segment has a new product in the pipeline, clearly the most
critical product to come to market in the next few years is the new operating system
codenamed Longhorn. Longhorn will also provide a new version of Office specifically
for the new operating system that will drive future earnings growth. Current management
and analyst expectations for Longhorn release are early in 2007. Given that most of the
revenue generated by Microsoft is from the operating system and productivity
software, the delay or early release of Longhorn will have a significant impact on
the price of the stock.
Stock Catalysts
Dramatic near-term catalysts for the stock are not present. Microsoft will see its next big
catalyst in 2007 with the release of Longhorn. Currently, the Client segment is set to
introduce Service Pack v2 for the Windows XP operating system. This new service pack
will provide some very important security features. Microsoft has suggested that they
will come to market soon with an antivirus software package despite their alliances with
Symantec. This new product could provide some upside to the stock if it does not
delay the release of Longhorn. Microsoft has been a visible target for hackers for years
and they continue to enhance their software code and work to keep workstations and PC’s
secure.
PC demand was particularly strong towards the end of last year. Many IT managers took
it upon themselves to replace outdated systems last purchased at the end of the tech
bubble. According to IT manager surveys, the budget for technology purchases remains
an area of uncertainty. Most managers indicate a desire to make purchases toward the
end of 2004. Additional growth in technology purchases will drive growth of
operating systems and productivity software.
Recent internal documentation from management indicates a further commitment to cost
efficiency. Management has been very effective in reducing costs over the past year, but
clearly there remains additional opportunity for operating margin growth through cost
cutting. While the markets generally do not reward cost cutting as heavily as topline revenue growth, some upside remains in the stock with additional cost
reductions.
With the uncertainties explained in the economic outlook of the report, investors are
likely to shift their stock holdings to lower beta stocks. Since Microsoft maintains no
long-term debt and low operating leverage, they will be a good choice for more uncertain
investors. A shift from higher beta stocks to lower beta stocks will expand multiples
and drive the share price higher.
Page 11 of 21
Management
Microsoft management remains one of their greatest strengths. Management execution
has always been and continues to be strong. Most recently, Steve Ballmer issued a
challenge to Microsoft employees to increase innovation. Executive management has
demonstrated strong execution of strategic initiatives over the years, which has
entrenched Microsoft as one of the most admired companies and most dominant
companies in the world.
RISKS & CONCERNS
Competition
The main competitive force is from Linux. As previously shown, the Windows operating
system is the lifeblood of the company. The first computers with the Linux operating
system are already being delivered. The open source environment is favored among the
technically savvy and may continue to become more mainstream. One area of
disadvantage to an open source operating system is that there is no company to provide
strong service and support. Consistency is important among business users who share
files and other work product. Security for an open source operating system may also
present concerns for an IT manager to properly secure the system.
Other competitive concerns are present among major technology companies such as IBM,
HP, and Dell. Since many of the technology products are becoming more homogenous
and reaching maturity in the product life cycle, consolidation and product integration will
become greater concerns.
Regulatory
Most recently, Microsoft settled the U.S. government’s competitive concern. Microsoft
will be somewhat disadvantaged from establishing itself in other industries in the future
due to its large market share. Government regulators in the U.S. and other markets will
make a careful consideration of anticompetitive activity as Microsoft continues to grow.
Legal
Microsoft faces very few legal issues domestically with the resolution of the Justice
department’s lawsuit. International anticompetitive lawsuits are still unresolved, but they
impact revenues much less than the U.S. case. Due to the closure of the U.S.
government’s lawsuit, Microsoft elected to distribute $75 billion of cash over the next
four years, which was held partly to deal with any potential legal costs.
Page 12 of 21
Product Development
Microsoft has been struggling to continue its history of innovation. CEO, Steve Ballmer
indicated in his most recent email address to employees that a lack of innovation is their
biggest concern. Microsoft has become such a large company that it has become difficult
to maintain the level of innovation once experienced during the late 90’s. Innovation has
been limited to tweaks in the Windows operating system and accompanying Office
productivity software.
In order for Microsoft to continue as one of the strongest U.S. companies, they must
successfully implement the new Longhorn operating system, maintain their software code
to prevent malicious attacks on users of their software, and continue to push innovation in
the mobile/embedded devices segment.
Execution
Management execution has historically been one of Microsoft’s greatest strengths. Once
a company becomes as large as Microsoft, it becomes more difficult to execute on
existing and new products. Of most immediate concern is the ability of management to
decrease the time to patch discovered security flaws in their software and the importance
of the new operating system Longhorn. Microsoft has also been vigilant in defending
against software piracy, which also remains an important execution risk. Developing
nations in Asia are the fastest growing countries in the world, but they also are the largest
culprits in software piracy.
FINANCIALS
Income Statement Analysis
As shown in the income statement analysis from Exhibit I, revenue growth has been
accelerating at a rate of 13% per annum on average. This appears to be a normative
growth rate expectation based upon the time period analyzed. While this growth rate is
significantly lower than the 10-year average growth of 23%, it still provides solid growth.
During the past two years, research and development expenses have increased to
approximately 21% of revenue, which is up from 15% of revenue in 2002. The increase
in fiscal year 2004 is attributable to $1.31 billion of stock-based compensation expenses
related to the option transfer program in the second quarter. A 3% growth in R&D
headcount also occurred over the past fiscal year.
General and Administrative expenses grew to 14% of revenue in 2004. This large
increase is attributable to legal expenses of $1.92 billion to settle the Sun Microsystems
case, a $605 million fine imposed by the European Commission, and $280 million of
stock-based compensation.
Page 13 of 21
Fiscal year 2003 results were restated to recognize the acceptance of SFAS 123 as it
relates to stock-based compensation.
Balance Sheet Analysis
Of significance on the balance sheet is the large decrease in unearned revenue relative to
2003. Unearned revenue decreased $838 million from prior year, which reflects a faster
recognition of revenue from multi-year licensing than new additions. The recognition of
revenue was primarily driven by Upgrade Advantage licensing agreements and a $489
million decline in revenue deferred for undelivered elements. Starting in April of 2003,
revenue deferred for undelivered elements reflected lower deferral rates, partially offset
by lengthened product life cycles for the underlying products licensed. As a result, a
higher proportion of revenue is earned sooner. Exhibit II contains information from the
balance sheet.
Cash Flow Statement Analysis
Cash flows from operations decreased slightly over the past year due to legal costs related
to the Sun Microsystems case and the European Commission fines.
Cash flow from financing, while still negative, was nearly $3 billion more than usual.
The increase in cash flows from financing is related to the lack of share repurchases in
the year, an increased cash dividend, and a more conservative cash policy.
Cash flow from investing was also less negative than usual. The increase in cash flow
from financing is attributable to a shift in duration of investments held. Longer-term
maturities were exchanged for more liquid investments. The statement of cash flows is
shown in Exhibit III.
Microsoft recently announced a distribution of $75 billion over the next four years
in the form of a special $3 per share dividend payable on December 2nd, an increase
in the annual dividend to $0.32 per share (doubled), and an aggressive share
repurchase plan. The announcement was well received in the market and justified due
to the settlement of many large legal cases in which Microsoft served as defendant.
ROE Analysis
Return on equity has fallen considerably since 1997. While some decrease is expected
due to the changing fundamentals of the economy and equity markets since 1997, ROE
has fallen from 39% to 19% in the past seven years. A closer look at the DuPont
equation indicates that the fall in ROE is mainly caused by poorer asset turnover. Since
1997, ROA has fallen from 0.98x to 0.44x. This demonstrates the nature of the tech
industry and it’s falling margins and slower top-line revenue growth due to the
industry becoming more mature.
Page 14 of 21
Other areas of the DuPont equation are relatively the same. Operating profit margin is
still roughly 45% once the change from expensing stock options is factored into R&D
and G&A expenses, but is down from the highs seen in 2000 at 62%. No debt is
employed in Microsoft’s capital structure, so interest burden is still 1.0. The tax burden
has increased to 68% from 65% in 1997. Leverage, as measured by assets to equity is
also down slightly from 1997 levels to 1.3x.
Financial Ratio Analysis
A complete analysis of financial ratios from the financial statements is located in Exhibit
IV. The ratio analysis shows increasing liquidity, slower cash conversion, lower asset
turnover, lower margins, and decreasing return on equity. Decreases in these ratios
further indicate a maturing industry, stronger competition, and increased buyer power.
Microsoft will continue to benefit from its strong competitive position, but will need
to spark new innovation to remain a leader in the tech sector.
Consensus Estimates
Some variation exists among analyst earnings estimates for fiscal year 2005. A total of
32 analyst estimates are included in the First Call estimates, which range from $1.21 to
$1.27 per share. The current mean estimate is $1.24 per share with a standard deviation
of $.02 per share. Recently, all analyst estimates have been revised to reflect Microsoft’s
announcement to distribute $75 billion to shareholders thru share buybacks, a special $3
per share dividend, and an increased annual dividend. A good portion of this distribution
is being made from the cash balance Microsoft held due to the uncertainty of pending
lawsuits. Also, a shift to more liquid investments and future distributions to shareholders
has reduced investment income projections by $0.09 - $0.12 per share.
VALUATION
DCF Valuation
A 10-year DCF valuation model is included as part of Exhibit V. The DCF valuation
indicates an implied value per share of $31.48. The valuation is very sensitive to a
variety of assumptions and is therefore not heavily weighted in the reconciliation of a
target price for the stock. While this measure is highly sensitive to many forwardlooking assumptions, it does provide a meaningful look at future earnings. Other relative
measures are more heavily weighted when determining the target price of the stock and
are explained in more detail in the sections that follow.
P/E Multiple Valuation
Since the consensus earnings estimate falls between $1.22 and $1.28 per share at a 95%
confidence level, the P/E multiple valuation method provides another method of
valuation. The current forward year estimated P/E multiple for Microsoft is 21.4x, which
Page 15 of 21
seems to suggest that the stock is slightly undervalued compared to the historical mean
P/E ratio of 31.0x as shown in the valuation chart below. Assuming mean reversion, the
historical P/E ratio suggests an implied value of MSFT shares of $39.11. Some caution is
needed with this estimate as well since it incorporates both the stock market bubble
valuations and years when Microsoft earnings were growing faster than current levels.
On a relative basis, Microsoft shares also appear to be undervalued when compared to
both the S&P 500 and the IT sector by 26%.
Measure
MSFT Historical
Relative to
S&P 500
Relative to IT
Sector
Current
Multiple
21.4x
Mean
Multiple
31.0x
Implied MSFT
Value
$39.11
1.41x
1.78x
$34.08
1.11x
1.47x
$35.76
Price/Sales Multiple Valuation
The price/sales multiple valuation method can be considered more accurate because it
focuses on sales and does not have other variable items included in the valuation.
Assuming reversion to the mean multiple, it appears as if Microsoft shares are
undervalued by 32%.
Measure
MSFT –
Historical
Relative to
S&P 500
Relative to IT
Sector
Page 16 of 21
Current
Multiple
7.98x
Mean
Multiple
12.18x
Implied MSFT
Value
$41.21
5.69x
7.51x
$35.64
3.17x
4.40x
$37.48
Price/Book Multiple Valuation
The price/book multiple valuation method computes an implied value of the stock based
on the book value of the company. Assuming mean reversion, Microsoft shares appear to
be undervalued by 55%.
Measure
MSFT –
Historical
Relative to
S&P 500
Relative to IT
Sector
Current
Multiple
3.9x
Mean
Multiple
9.7x
Implied MSFT
Value
$67.15
1.35x
3.12x
$62.40
1.07x
1.66x
$41.89
PEG Ratio Valuation
The PEG ratio measures the valuation of a stock based on P/E multiples divided by the
implied growth rate in the stock. This methodology captures the essence of the growth
rate expectations for a company. The data below suggests that Microsoft may be slightly
overvalued at current levels given its level of expected future growth.
Measure
MSFT –
Historical
Relative to
S&P 500
Relative to IT
Sector
Current
Multiple
1.8x
Mean
Multiple
1.7x
Implied MSFT
Value
$25.50
1.41x
1.40x
$26.81
1.31x
1.39x
$28.65
Below are the valuation multiple charts for Microsoft from Stock Val:
Page 17 of 21
Absolute Valuation Multiple Chart for Microsoft
M IC R O S O F T C O R P O R A T IO N ( M S F T ) P r ic e 2 7 .0
1994
1995
1996
1997
1998
1999
2000
2001
S to c k V a l ®
2002
2003
2004
2005
HI
LO
ME
CU
60
40
20
6 6 .7
1 9 .4
3 1 .0
2 1 .4
0 8 - 1 2 -1 9 9 4
0 8 - 1 3 -2 0 0 4
0
P R IC E / Y R -F O R W A R D E P S E S T S
HI
LO
ME
CU
24
16
8
3 0 .8 8
6 .6 9
1 2 .1 8
7 .9 8
0 8 - 1 2 -1 9 9 4
0 8 - 1 3 -2 0 0 4
0
P R IC E / S A L E S
HI
LO
ME
CU
18
12
6
2 1 .5
3 .9
9 .7
3 .9
0 8 - 1 2 -1 9 9 4
0 8 - 1 3 -2 0 0 4
0
P R IC E / B O O K V A L U E
HI
LO
ME
CU
2
2 .7
0 .8
1 .7
1 .8
1
0 8 - 1 2 -1 9 9 4
0 8 - 1 3 -2 0 0 4
0
P R IC E / Y R -F O R W A R D E P S E S T S / G R E
Valuation Multiple Chart for MSFT Relative to S&P 500
M IC R O S O F T C O R P O R A T IO N ( M S F T ) P r ic e 2 7 .0
1994
1995
1996
1997
1998
1999
2000
2001
S to c k V a l ®
2002
2003
2004
2005
HI
LO
ME
CU
2 .4
1 .8
1 .2
2 .6 3
1 .0 3
1 .7 8
1 .4 1
0 8 -1 2 -1 9 9 4
0 8 -1 3 -2 0 0 4
0 .6
P R IC E / Y R - F O R W A R D E P S E S T S R E L A T IV E T O S & P 5 0 0 C O M P O S IT E A D J U S T E D ( S P 5 A ) M - W td
HI
LO
ME
CU
8
1 2 .4 9
5 .0 2
7 .5 1
5 .6 9
6
0 8 -1 2 -1 9 9 4
0 8 -1 3 -2 0 0 4
4
P R IC E / S A L E S R E L A T IV E T O S & P 5 0 0 C O M P O S IT E A D J U S T E D ( S P 5 A ) M - W td
HI
LO
ME
CU
4
3
2
4 .8 2
1 .1 8
3 .1 2
1 .3 5
0 8 -1 2 -1 9 9 4
0 8 -1 3 -2 0 0 4
1
P R IC E / B O O K V A L U E R E L A T IV E T O S & P 5 0 0 C O M P O S IT E A D J U S T E D ( S P 5 A ) M - W td
HI
LO
ME
CU
1 .8
1 .5
1 .2
1 .8 5
0 .9 8
1 .4 0
1 .4 1
0 8 -1 2 -1 9 9 4
0 8 -1 3 -2 0 0 4
0 .9
P R IC E / Y R - F O R W A R D E P S E S T S / G R E R E L A T IV E T O S & P 5 0 0 C O M P O S IT E A D J U S T E D ( S P 5 A ) M - W td
Page 18 of 21
Valuation Multiple Chart for MSFT Relative to IT Sector
M IC R O S O F T C O R P O R AT IO N (M S F T ) P rice 27.0
1 994
1995
1996
1997
1998
1999
200 0
2001
S to ckV al ®
20 02
200 3
2 004
20 05
HI
LO
ME
CU
2
2.03
0.75
1.47
1.11
1
08-12-19 94
08-13-20 04
0
P R IC E / YR -F O R W A R D E P S E S T S R E LA T IV E T O S & P IN F O T E C H . S E C T O R C O M P O S IT E A D J (S P -45) M -W td
HI
LO
ME
CU
5
4
3
5.91
2.05
4.40
3.17
08-12-19 94
08-13-20 04
2
P R IC E / S A LE S R E LA T IV E T O S & P IN F O T E C H . S E C T O R C O M P O S IT E A D J (S P -45) M -W td
HI
LO
ME
CU
3
2
1
3.03
0.73
1.66
1.07
08-12-19 94
08-13-20 04
0
P R IC E / B O O K V A LU E R E LA T IV E T O S & P IN F O T E C H . S E C T O R C O M P O S IT E A D J (S P -45) M -W td
1.6
1.2
0.8
0.4
P R IC E / YR -FO R W A R D E P S E S T S / G R E R E LA T IV E T O S & P IN FO T E C H . S E C T O R C O M P O S IT E A D J (S P -4 5)
Page 19 of 21
HI
LO
ME
CU
1.94
0.76
1.39
1.31
08-12-19 94
08-13-20 04
Price Momentum Index
The price momentum index indicates current investor sentiment and attempts to identify
oversold/overbought conditions based on momentum. The chart below seems to indicate
that the shares are priced correctly, with a slight overbought measure from the recent cash
distribution announcement.
68
M IC R O S O F T C O R P O R A T IO N (M S F T )
S to c k V a l®
P R IC E
2 7 .0
63
D A T E 0 8 -1 3 -2 0 0 4
57
57
53
53
49
49
45
45
41
41
38
38
35
35
32
32
29
27
29
27
25
25
23
23
T h e O h io S t a te U n iv e r s it y
F is h e r C o lle g e o f B u s in e s s
21
1999
+2
2000
2001
2002
2003
21
2004
+2
+1
+1
0
0
-1
-1
-2
-2
P R IC E M O M E N T U M IN D E X (O V E R B O U G H T /O V E R S O L D )
Prospective Growth & Margin Check
The growth and margin check provides a quick summary level check on the growth rates
anticipated in the future. As seen from the chart below, growth is expected to slow
somewhat, but should still provide some upside in the stock.
S to c k V a l ®
P r o s p e c t iv e G r o w t h & M a r g in C h e c k
M IC R O S O F T C O R P O R A T IO N ( M S F T )
P r ic e 2 7 .0 2 0 0 8 /1 3 /0 4
P e rc e n t C h a n g e
Q u a rte r
R evenue
REV
RPS
EARN
EPS
A c tu a l
Year
P r o fit
EPS
Ago
M a r g in %
M o m e n tu m %
SF
REV
EPS
Sep 02
7 ,7 4 6 .0
26
29
14
16
0 .2 5
0 .2 2
3 5 .2
+3
+23
Dec 02
8 ,5 4 1 .0
10
13
-4
-2
0 .2 4
0 .2 5
3 0 .6
+1
+11
+15
-2
M ar 03
7 ,8 3 5 .0
8
11
6
8
0 .2 6
0 .2 4
3 6 .0
+2
+8
+8
+6
Jun 03•
8 ,0 6 5 .0
11
14
4
7
0 .2 3
0 .2 2
3 1 .0
0
+10
Sep 03
8 ,2 1 5 .0
6
6
-4
-4
0 .2 4
0 .2 5
3 1 .8
-3
+6
-4
Dec 03
1 0 ,1 5 3 .0
19
19
17
17
0 .2 8
0 .2 4
3 0 .1
-2
+20
+16
M ar 04
9 ,1 7 5 .0
17
17
16
15
0 .3 0
0 .2 6
3 5 .5
+1
+16
+16
Jun 04•
9 ,2 9 2 .0
15
15
0
0
0 .2 3
0 .2 3
2 6 .9
-3
+14
0
3 6 ,8 3 5 .0
14
14
7
7
1 .0 5
T4Q
3 1 .0
Sep 04 E
8 ,9 5 7 .9
9
9
25
25
0 .3 0
0 .2 4
3 6 .4
+8
+23
Dec 04 E
1 0 ,6 0 7 .8
4
5
14
14
0 .3 2
0 .2 8
3 2 .8
+5
+14
M ar 05 E
9 ,5 4 6 .1
4
4
7
7
0 .3 2
0 .3 0
3 6 .4
+4
+7
Jun 05 E •
9 ,7 3 9 .0
5
5
30
30
0 .3 0
0 .2 3
3 3 .5
+5
+24
5
6
18
18
1 .2 4
F4Q E
3 8 ,8 5 0 .8
P o in t-to -P o in t G r o w th R a te s (% )
Y e a rs
REV
RPS
EARN
3 4 .7
L o n g -T e rm G ro w th R a te E s tim a te s (% )
M e d ia n E s tim a te
EPS
1 2 .0 %
1
14
14
7
7
N u m b e r o f E s tim a te s
3
13
14
4
5
S t a n d a r d D e v ia tio n
5
13
13
8
9
D e fa u lt G R E E s tim a te
1 0 .0 %
10
23
21
25
24
A n a ly s t G R E E s tim a te
1 0 .0 %
15
29
27
31
29
20
35
31
31
28
E x p e c te d R e p o rt D a te
1 0 /2 5 /0 4
Page 20 of 21
19
3
Valuation Summary
The different valuation methods above seem to indicate that Microsoft is slightly
undervalued. Only the PEG ratio suggests that the stock is price accurately. Based upon
the nature of the industry and the product life cycle for Microsoft, a target price of
$29 per share is set to reflect a slight undervaluation in the market with a dividend
yield of 1.1%. Holding MSFT shares over the next year based upon these factors should
yield investors a relatively stable return of 8.5%. Based upon this valuation, Microsoft
shares are rated neutral at current pricing levels.
CONCLUSION
As stated previously, Microsoft carries a neutral rating. Based upon the current valuation
of the stock, its prospects for future growth, the current state of the industry, and the
overall health of the U.S. economy, the stock remains a great stock to hold in any
portfolio. A target price of $29 per share is recommended. The following are the shortterm catalysts and near-term risks for the stock:
Catalysts
•
•
•
•
Possible early release of Longhorn
Potential for increased PC demand in the 4th quarter
Management focus on cost efficiency
Special $3 per share dividend could cause upside with multiple expansion exdividend
Risks
•
•
•
•
Linux and other open-source programs
Reduced pace of technological innovation
Delay of Longhorn release date
Software piracy and malicious code attacks
Page 21 of 21
EXHIBIT I
INCOME STATEMENT (In million except per share data)
Year Ended June 30
Revenue
Cost of Revenue
Research & Development
Sales & Marketing
General & Administrative
Total Operating Expenses
2001
25,296
3,455
4,379
4,885
857
13,576
2002
28,365
5,191
4,307
5,407
1,550
16,455
Operating Income
11,720
11,910
Losses on equity investees & other
Investment Income/(Loss)
Income before taxes
(159)
(36)
% Chg
12%
50%
-2%
11%
81%
21%
(92)
(305)
2%
-42%
747%
2003(1)
32,187
6,059
6,595
7,562
2,426
22,642
% Chg
13%
17%
53%
40%
57%
38%
2004
36,835
6,716
7,779
8,309
4,997
27,801
9,545
-20%
9,034
(68)
1,577
-26%
-617%
(25)
3,187
% Chg
14%
11%
18%
10%
106%
23%
-5%
-63%
102%
11,525
11,513
0%
11,054
-4%
12,196
10%
Provision for income taxes
3,804
3,684
-3%
3,523
-4%
4,028
14%
Income before accounting change
7,721
7,829
1%
7,531
-4%
8,168
8%
Effect of accounting change
Net Income
Basic earnings per share
Diluted earnings per share
Weighted average shares outstanding
Basic
Diluted
COMMON SIZE INCOME STATEMENT
Year Ended June 30
Revenue
Cost of Revenue
Research & Development
Sales & Marketing
General & Administrative
Total Operating Expenses
(375)
0
7,346
7,829
$0.69
$0.66
10,683
11,148
$0.72
$0.70
10,811
11,106
0
7%
5%
7%
1%
0%
7,531
$0.70
$0.69
10,723
10,882
2001
100%
14%
17%
19%
3%
54%
2002
100%
18%
15%
19%
5%
58%
2003
100%
19%
20%
23%
8%
70%
2004
100%
18%
21%
23%
14%
75%
46%
42%
30%
25%
-1%
0%
0%
-1%
0%
5%
0%
9%
46%
41%
34%
33%
Provision for income taxes
15%
13%
11%
11%
Income before accounting change
31%
28%
23%
22%
-1%
0%
0%
0%
29%
28%
23%
22%
Operating Income
Losses on equity investees & other
Investment Income/(Loss)
Income before taxes
Effect of accounting change
Net Income
(1) YE 2003 Results adjusted to reflect retroactive adoption of SFAS 123
SOURCE: MSFT 10-K & 8-K
EXHIBIT I
0
-4%
-3%
-2%
-1%
-2%
8,168
$0.76
$0.75
10,803
10,894
8%
8%
8%
1%
0%
EXHIBIT II
BALANCE SHEET (In millions)
2004
15,982
44,610
60,592
%of
assets
17.3%
48.3%
65.6%
6.4%
0.8%
3.1%
1.9%
72.2%
5,890
421
2,097
1,566
70,566
6.4%
0.5%
2.3%
1.7%
76.4%
2,223
13,692
3,128
384
2,161
1,171
81,732
2.7%
16.8%
3.8%
0.5%
2.6%
1.4%
100.0%
2,326
12,210
3,115
569
1,829
1,774
92,389
2.5%
13.2%
3.4%
0.6%
2.0%
1.9%
100.0%
1.8%
1.7%
3.0%
8.8%
3.6%
18.8%
1,573
1,416
2,044
7,225
1,716
13,974
1.9%
1.7%
2.5%
8.8%
2.1%
17.1%
1,717
1,339
3,478
6,514
1,921
14,969
1.9%
1.4%
3.8%
7.1%
2.1%
16.2%
1,823
398
501
15,466
2.7%
0.6%
0.7%
22.9%
1,790
0
1,056
16,820
2.2%
0.0%
1.3%
20.6%
1,663
0
932
17,564
1.8%
0.0%
1.0%
19.0%
Stockholders Equity
Common stock & paid-in capital
Retained earnings
TOTAL STOCKHOLDERS EQUITY
31,647
20,533
52,180
46.8%
30.4%
77.1%
49,234
15,678
64,912
60.2%
19.2%
79.4%
56,396
18,429
74,825
61.0%
19.9%
81.0%
TOTAL LIABILITIES & STOCKHOLDERS EQUITY
67,646
100.0%
81,732
100.0%
92,389
100.0%
Year Ending June 30
Cash & cash equivalents
Short-term investments
Total cash & short-term investments
2002 %of assets
3,016
4.5%
35,636
52.7%
38,652
57.1%
Accounts receivable, net
Inventories
Deferred income taxes
Other
Total Current Assets
5,129
673
2,112
2,010
48,576
7.6%
1.0%
3.1%
3.0%
71.8%
5,196
640
2,506
1,583
58,973
Property plant & equipment, net
Equity and other investments
Goodwill
Intangible assets, net
Deferred income taxes
Other long-term assets
TOTAL ASSETS
2,268
14,191
1,426
243
0
942
67,646
3.4%
21.0%
2.1%
0.4%
0.0%
1.4%
100.0%
LIABILITIES & STOCKHOLDERS EQUITY
Current Liabilities
Accounts payable
Accrued compensation
Income taxes
Short-term unearned revenue
Other
Total Current Liabilities
1,208
1,145
2,022
5,920
2,449
12,744
Long-term unearned revenue
Deferred income taxes
Other long-term liabilities
TOTAL LIABILITIES
(1) YE 2003 Results adjusted to reflect retroactive adoption of SFAS 123
SOURCE: MSFT 10-K & 8-K
EXHIBIT II
2003(1) %of assets
6,438
7.9%
42,610
52.1%
49,048
60.0%
EXHIBIT III
STATEMENT OF CASH FLOWS (In millions)
Year Ended June 30
Operations
Net Income
Cumulative effect of accounting change, net of tax
Depreciation, amortization, and other noncash items
Stock based compensation
Net recognized loss on investments
Stock option income tax benefits
Deferred income taxes
Unearned revenue
Recognition of unearned revenue
Accounts receivable
Other current assets
Other long-term assets
Other current liabilities
Other long-term liabilities
Net Cash from Operations
2001
2002
2003(1)
7,346
375
1,536
0
2,221
2,066
(420)
6,970
(6,369)
(418)
(482)
(330)
774
153
13,422
7,829
0
1,084
0
2,424
1,596
(416)
11,152
(8,929)
(1,623)
(264)
(9)
1,449
216
14,509
7,531
0
1,393
3,749
380
1,365
(894)
12,519
(11,292)
187
412
(28)
35
440
15,797
1,186
5,734
(1,296)
1,100
(1,479)
11,777
(12,527)
(687)
478
34
2,063
75
14,626
Financing
Common stock issued
Common stock purchased
Repurchase of put warrants
Common stock dividends
Other, net
Net Cash used for Financing
1,620
(6,074)
(1,367)
0
235
(5,586)
1,497
(6,069)
0
0
0
(4,572)
2,120
(6,486)
0
(857)
0
(5,223)
2,748
(3,383)
0
(1,729)
0
(2,364)
(1,103)
0
(66,346)
5,867
52,848
(8,734)
(770)
0
(89,386)
8,654
70,657
(10,845)
(891)
(1,063)
(89,621)
9,205
75,157
(7,213)
(1,109)
(4)
(92,495)
5,561
85,302
(2,745)
(898)
(908)
3,361
9,517
2
61
27
3,922
3,016
3,016
6,438
6,438
15,982
Investing
Additions to property and equipment
Acquisitions of companies, net of cash required
Purchase of investments
Maturities of investments
Sales of investments
Net cash used for investing
Net Change in Cash and Equivalents
Effect of exchange rates on cash & equivalents
(26)
Cash and equivalents, beginning of year
Cash and equivalents, end of year
4,846
3,922
(1) YE 2003 Results adjusted to reflect retroactive adoption of SFAS 123
SOURCE: MSFT 10-K & 8-K
EXHIBIT III
2004
8,168
EXHIBIT IV
MICROSOFT RATIO ANALYSIS
2002
2003
2004
Internal Liquidity Ratios
Current Ratio
Quick Ratio
Receivables Turnover
Collection Period
Inventory Turnover
Processing Period
Payables Turnover
Payment Period
Cash Conversion Cycle
3.81
3.44
5.53
66
7.71
47
4.30
85
28
4.22
3.88
6.19
59
9.47
39
3.85
95
3
4.71
4.44
6.25
58
15.95
23
3.91
93
-12
Operating Efficiency Ratios
Sales/Total Assets
0.42
0.39
0.40
Operating Profitability Ratios
Gross Profit Margin
Operating Profit Margin
Net Profit Margin
Return on Equity
82%
41%
28%
15%
81%
34%
23%
12%
82%
33%
22%
11%
EXHIBIT IV
EXHIBIT V
MICROSOFT (MSFT)
DCF Value Model
WACC Assumptions
1
Risk Free Rate
Equity Risk Premium
Beta
Long-term growth rate
Equity Capitalization %
LT Debt Capitalization %
Tax Rate
Cost of Equity
Cost of Debt
WACC
Revenue
Growth
Operating Margin
Other Income
4
Equity Stock Option Grant Value
Earnings Before Interest & Taxes
Income Tax Expense
Depreciation & Amortization
Capital Expenditures
Free Cash Flow
NPV Calculation
2
Terminal P/E Multiple
Terminal Value
PV of Terminal Value
PV of FCF
MV of Cash
MV of Debt
Current Option Value3
MSFT NPV
Basic Shares Outstanding
NPV per Share
4.25%
4.00%
1.35
4.0%
100.0%
0%
33%
9.65%
0%
9.65%
17.7
431,744
171,846
117,198
60,592
0
(10,178)
339,458
10,785
31.48
2004A
2005E
2006E
2007E
2008E
2009E
2010E
2011E
2012E
2013E
2014E
38,107
40,774
44,852
50,234
55,258
60,231
65,049
70,253
75,171
80,433
86,063
7%
10%
12%
10%
9%
8%
8%
7%
7%
7%
45%
45%
45%
45%
45%
45%
45%
45%
45%
45%
45%
2,092
1,234
1,234
1,234
1,234
1,234
1,234
1,234
1,234
1,234
1,234
(1,590)
(1,653)
(1,773)
(1,951)
(2,169)
(2,364)
(2,603)
(2,811)
(3,094)
(3,342)
(3,678)
17,650
17,930
19,644
21,888
23,931
25,974
27,903
30,037
31,967
34,087
36,284
(5,825)
1,128
(810)
12,144
(5,917)
1,015
(826)
12,202
(6,483)
913
(843)
13,232
(7,223)
932
(859)
14,738
(7,897)
950
(877)
16,107
Notes
1- Rate of 10-Year U.S. T-bond
2-Terminal Multiple = 1/(WACC-g)
3-Black Scholes value of options
4- Estimated of Equity Stock Option Grants for Year
Earnings Model adapted from Goldman Sachs report on MSFT dated 7/27/04
EXHIBIT V
(8,571)
969
(894)
17,477
(9,208)
989
(912)
18,772
(9,912)
1,009
(930)
20,204
(10,549)
1,029
(949)
21,498
(11,249)
1,049
(968)
22,919
(11,974)
1,070
(987)
24,394
CAGR
8.5%
-5.1%
8.7%
7.5%
-0.5%
2.0%
7.2%