Report created Mar 16, 2012 Page 1 OF 5 Microsoft is the world's largest independent software developer. The company's business is organized into five divisions. The Windows & Windows Live division includes the Windows operating system cluster of products; the Server and Tools division includes the Windows Server operating system and enterprise-oriented products; the Online Services Business includes web-based advertising, MSN and the Bing search engine; the Microsoft Business Division includes the MS Office suite of products; and, finally, the Entertainment and Devices division features the Xbox 360 game console, video games such as 'Halo 3,' and software for mobile and embedded devices. Analyst's Notes Analysis by Joseph Bonner, CFA, March 15, 2012 ARGUS RATING: BUY Upgrading to BUY with target of $39 With Windows 8 likely to launch in calendar 3Q12, Microsoft may finally have an operating system that can compete in both the PC and tablet environments. We believe that a successful launch of Windows 8 will provide a revenue and margin boost for Microsoft, while also creating a 'halo effect' for the company's other business lines. We are maintaining our FY12 EPS forecast of $2.72 and our FY13 forecast of $3.04. With a trailing enterprise value/ebitda multiple of 7.9, MSFT is trading below its peer group average of 9.4 and at the low end of the five-year historical range of 7.9-9.9. INVESTMENT THESIS We are raising our rating on Microsoft Corp. (NGS: MSFT) to BUY and setting a target price of $39. With Windows 8 likely to launch in calendar 3Q12, Microsoft may finally have an operating system that can compete in both the PC and tablet environments. Based on early reviews, it looks like the company has gotten the technology right; success will now depend on execution and marketing. While the consumer PC market remains soft due to both component supply disruptions and ipad competition, we expect it to rebound in 2H12 with help from the Windows 8 refresh. Meanwhile, the company's enterprise business continues to benefit from a strong IT refresh cycle. We believe that a successful launch of Windows 8 will provide a revenue and margin boost for Microsoft, while also creating a 'halo effect' for the company's other business lines. We view Microsoft shares as undervalued by historical standards and relative to peers. RECENT DEVELOPMENTS Microsoft has launched the consumer preview of its new Windows 8 operating system. Data Pricing reflects previous trading week's closing price. 200-Day Moving Average Price ($) Rating EPS ($) 35 30 25 Target Price: $39.00 52 Week High: $32.95 52 Week Low: $23.65 Quarterly 0.40 0.74 0.45 0.51 0.62 0.77 0.56 0.69 0.68 0.76 0.63 0.68 NA NA Annual 2.10 2.65 ( Estimate) 2.75 ( Estimate) 3.04 Revenue ($ in Bil.) Closed at $31.52 on 4/6 Quarterly 12.9 19.0 14.5 16.0 16.2 20.0 16.4 17.4 17.4 20.4 17.2 18.8 NA NA NA NA Annual 62.5 69.9 ( Estimate) 73.7 ( Estimate) 0.0 FY ends Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Jun 30 2010 2011 2012 2013 BUY HOLD SELL NA NA Argus Recommendations Twelve Month Rating SELL HOLD BUY Five Year Rating SELL HOLD BUY Rating Weight Under Over Weight Weight Argus assigns a 12-month BUY, HOLD, or SELL rating to each stock under coverage. BUY-rated stocks are expected to outperform the market (the benchmark S&P 500 Index) on a risk-adjusted basis over the next year. HOLD-rated stocks are expected to perform in line with the market. SELL-rated stocks are expected to underperform the market on a risk-adjusted basis. The distribution of ratings across Argus' entire company universe is: 46% Buy, 49% Hold, 5% Sell. Key Statistics Key Statistics pricing data reflects previous trading day's closing price. Other applicable data are trailing 12-months unless otherwise specified Overview Price $32.85 Target Price $39.00 52 Week Price Range $23.65 to $32.95 Shares Outstanding 8.39 Billion Dividend $0.80 Overview Technology Rating OVER WEIGHT Total % of S&P 500 Cap. 19.00% Financial Strength Financial Strength Rating HIGH Debt/Capital Ratio 17.3% Return on Equity 34.6% Net Margin 32.6% Payout Ratio 0.29 Current Ratio 2.60 Revenue $72.05 Billion After-Tax Income $23.47 Billion Valuation Current FY P/E 12.40 Prior FY P/E 15.64 Price/Sales 3.83 Price/Book 4.29 Book Value/Share $7.65 Capitalization $275.64 Billion Forecasted Growth 1 Year EPS Growth Forecast 26.19% 5 Year EPS Growth Forecast 8.00% 1 Year Dividend Growth Forecast 35.71% Risk Beta 0.93 Institutional Ownership 63.37%
Report created Mar 16, 2012 Page 2 OF 5 The company says that Windows 8 has the flexibility to work on ARM-based tablets as well as on traditional Intel x86 systems, and reviews of the so-called 'metro user' interface have also been quite positive. Microsoft has designed Windows 8 to be smaller and faster, i.e., to use less processing power and system memory than previous versions, which is crucial if it is to work on a tablet and match the speed of the ipad. One downside risk for Windows 8 will be the inability of ARM-based devices to support legacy applications, which could limit its market. Microsoft is also looking to leverage its cloud-based services in Windows 8, so that personal settings can be shared across devices. The Microsoft Skydrive virtual desktop is also available with Windows 8. However, with Windows 8 now in beta, many questions remain. In particular, has Microsoft missed the boat on tablets? Apple's ipad unit sales exceeded PC sales by any of the top manufacturers in 4Q11 and Android-based tablets also have a multiyear head start on Windows 8. By some estimates, Android tablet sales may even surpass the ipad by 2015. Touchscreen Windows PCs and tablets may be on the way, but they are not here yet. Presumably, enough touchscreen hardware will be available at the time of the expected Windows 8 launch in 2H12, with x86-based systems likely the first out of the box. However, it is unclear whether users will adopt Windows 8 if they have to buy a new device in order to get the full experience. Windows 7 is probably good enough for those who do not want to buy a new PC. However, Microsoft has announced that it will be ending support for Windows XP, which still accounts for 45% of the worldwide operating system market, in 2014. While some XP users may migrate to non-windows tablets, we think a significant portion of these users will accept the forced upgrade to Windows 8. The Windows division accounts for 24% of revenue, though Windows, as the company's flagship operating system, has an outsized importance to other company divisions. EARNINGS & GROWTH ANALYSIS Our FY12 EPS forecast is $2.72 and our FY13 forecast is $3.04. Our forecasts imply about 7% growth over the next two years, below our five-year growth rate forecast of 8%. Microsoft's dominance in operating system software and applications has driven overall results and enabled the company to diversify into a raft of related businesses, including the internet search, videogaming and mobile platforms. The Windows 7 and Office 2010 releases have been strong performers for the company, though both are aging. The company released the consumer preview or beta version of Windows 8 at the end of February, which points to a general release in the second half of calendar 2012, perhaps in time for back-to-school. The consumer PC market has been soft, down 3% in the December quarter, with the predictable impact on Windows division revenue, which fell 6% as OEM revenue fell 7%. The PC market has been beset with problems, including the hard disk drive component supply-chain Growth & Valuation Analysis GROWTH ANALYSIS ($ in Millions, except per share data) 2007 2008 2009 2010 2011 Revenue 51,122 60,420 58,437 62,484 69,943 COGS 10,693 11,598 12,155 12,395 15,577 Gross Profit 40,429 48,822 46,282 50,089 54,366 SG&A 14,784 18,166 16,909 17,277 18,162 R&D 7,121 8,164 9,010 8,714 9,043 Operating Income 18,524 22,492 20,363 24,098 27,161 Interest Expense -1,319-888 -706-692 -605 Pretax Income 20,101 23,814 19,821 25,013 28,071 Income Taxes 6,036 6,133 5,252 6,253 4,921 Tax Rate (%) 30 26 26 25 18 Net Income 14,065 17,681 14,569 18,760 23,150 Diluted Shares Outstanding 9,886 9,470 8,996 8,927 8,593 EPS 1.42 1.87 1.62 2.10 2.69 Dividend 0.52 0.61 GROWTH RATES (%) Revenue 15.4 18.2-3.3 6.9 11.9 Operating Income 12.5 21.4-9.5 18.3 12.7 Net Income 11.6 25.7-17.6 28.8 23.4 EPS 18.3 31.7-13.4 29.6 28.1 Dividend 17.3 Sustainable Growth Rate 34.0 31.4 VALUATION ANALYSIS Price: High $37.00 $34.08 $33.00 $31.36 $29.18 Price: Low $26.48 $18.20 $16.39 $22.25 $22.40 Price/Sales: High-Low 7.2-5.1 5.3-2.9 5.1-2.5 4.5-3.2 3.6-2.8 P/E: High-Low 26.1-18.6 18.2-9.7 20.4-10.1 14.9-10.6 10.8-8.3 Price/Cash Flow: High-Low 16.1-11.5 15.5-8.3 14.1-7.0 10.8-7.7 8.6-6.6 Financial & Risk Analysis FINANCIAL STRENGTH 2009 2010 2011 Cash ($ in Millions) 6,076 5,505 9,610 Working Capital ($ in Millions) 22,246 29,529 46,144 Current Ratio 1.82 2.13 2.60 LT Debt/Equity Ratio (%) 9.5 10.7 20.9 Total Debt/Equity Ratio (%) 14.5 12.9 20.9 RATIOS (%) Gross Profit Margin 79.2 80.2 77.7 Operating Margin 34.8 38.6 38.8 Net Margin 24.9 30.0 33.1 Return On Assets 19.3 22.9 23.8 Return On Equity 38.4 43.8 44.8 RISK ANALYSIS Cash Cycle (days) -7.5-16.1 1.5 Cash Flow/Cap Ex Oper. Income/Int. Exp. (ratio) 522.6 166.6 96.2 Payout Ratio 17.8 The data contained on this page of this report has been provided by Morningstar, Inc. ( 2012 Morningstar, Inc. All Rights Reserved). This data (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. This data is set forth herein for historical reference only and is not necessarily used in Argus analysis of the stock set forth on this page of this report or any other stock or other security. All earnings figures are in GAAP.
Report created Mar 16, 2012 Page 3 OF 5 disruption caused by the Thai flooding, and increased competition from tablets, which has decimated the netbook market. Apple's unit sales of ipads in 4Q11 exceeded the PC sales of any of the major manufacturers. Management expects the recent supply-chain constraints to continue in the current fiscal third quarter. We think the rise of smartphone/tablet computing, which generally does not rely on Microsoft operating system software, is probably the greatest near-term threat to the company's core Windows division. The company's release of Windows 8 is a clear move to stem the movement of customers to non-windows platforms. Based on early reviews, it looks like the company has gotten the technology right; success will now hinge on execution and marketing. Enterprise spending has remained strong, as the business IT refresh cycle continues despite a soft macroeconomy. This has bolstered results, particularly in the Server and Tools division. Microsoft's Bing search engine has been able to make some market share gains, though only at the expense of players other than the dominant Google search engine. However, the monetization of Bing's search results has been a chronic problem; Online Services remains the company's only unprofitable division, with an operating loss of $971 million in 1H12, though this is an improvement from a loss of $1.13 billion in 1H11. As with the rest of the technology industry, Microsoft is expanding its software-as-a-service (SaaS) and cloud based offerings with Office 365 and Azure platforms for business cloud computing. Offering software services through the cloud is obviously different from the traditional user license model, and its impact on Microsoft's key enterprise and consumer businesses is still difficult to quantify. At the Consumer Electronics Show in January, Microsoft and partners introduced a number of new phone handsets and tablets based on the Windows Phone 8 operating system. While we think Microsoft's mobile operating system market share is in the single digits, far behind the market leaders, Google's Android and Apple's ios, the company is at least making a serious effort to remain a player in the key mobile data marketplace. We also think that Microsoft's partnership with Nokia is a plus for Windows Phone, though the stunning success of Apple's iphone and the raft of Android-based devices do not leave much additional room in the market. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating for Microsoft is High, the top of our five-point scale. At the end of 2Q12, debt/total capital was 15.7%, still low but well above the 11.4% at the end of FY10 and the zero debt at the end of FY08. We do not see this as a risk factor, but rather as the initiation of a more tax-efficient capital structure. The company maintains a substantial $51.7 billion in cash and equivalents, far outweighing its $11.9 billion in long-term debt. Free cash flow rose 18.5% to $13.4 billion in 1H12. Microsoft is triple A-rated by the credit agencies, with stable Peer & Industry Analysis The graphics in this section are designed to allow investors to compare MSFT versus its industry peers, the broader sector, and the market as a whole, as defined by the Argus Universe of Coverage. The scatterplot shows how MSFT stacks up versus its peers on two key characteristics: long-term growth and value. In general, companies in the lower left-hand corner are more value-oriented, while those in the upper right-hand corner are more growth-oriented. The table builds on the scatterplot by displaying more financial information. The bar charts on the right take the analysis two steps further, by broadening the comparison groups into the sector level and the market as a whole. This tool is designed to help investors understand how MSFT might fit into or modify a diversified portfolio. P/E 20 15 10 Value MSFT SYMC 5-yr Growth Rate(%) CHKP ADSK SAP ADBE ORCL 7.5 10 12.5 15 Growth 5-yr Net 1-yr EPS Cap Growth Current Margin Growth Argus Ticker Company ($ in Millions) Rate (%) FY P/E (%) (%) Rating MSFT Microsoft Corp 275,637 8.0 12.4 32.6 3.8 BUY ORCL Oracle Corp 151,077 10.0 12.9 25.5 7.7 BUY SAP SAP AG 85,013 9.0 18.0 24.2 12.1 BUY ADBE Adobe Systems Inc 16,954 9.0 13.8 19.8 6.5 HOLD ATVI Activision Blizzard Inc 13,991 15.0 12.5 22.8 9.0 BUY SYMC Symantec Corp 13,269 8.0 11.1 11.6 10.4 BUY CHKP Check Point Software Teches Lt 13,152 10.0 19.9 43.6 11.1 HOLD ADSK AutoDesk Inc 9,090 10.0 19.3 12.9 14.4 BUY EA Electronic Arts 5,537 15.0 19.0-4.5 26.1 HOLD Peer Average 64,858 10.4 15.4 20.9 11.2 EA ATVI P/E Price/Sales Price/Book PEG 5 Year Growth Debt/Capital
Report created Mar 16, 2012 Page 4 OF 5 outlooks. Microsoft's quarterly dividend is $0.20 per share, or $0.80 annually, for a yield of about 2.4%. Our dividend estimates are $0.80 for both this year and next. RISKS Investors in Microsoft face potential losses if the company's operating performance falls short of expectations. Risks include the migration of consumers away from the PC to mobile devices that do not use a Microsoft based operating system; the potential for a prolonged downturn in global software investment spending; the well-publicized security vulnerabilities in the company's products; the possible adoption of Linux, and/or other open-source software applications; increased competition in the internet space; and legal risks. Also, piracy of the company's software in fast-growth developing markets like China and India is an ongoing problem and presents the company with huge missed revenue opportunities. Another risk is management's ability to execute its business plan and deliver new products on schedule. In the case of the Xbox 360, highly aggressive pricing from both Sony and Nintendo as well as a generally soft game console market overall may hamper Microsoft's effort to generate acceptable long-term profits in this area. The company also faces intense direct competition from Google in many areas, including mobile operating system software and internet-based software applications. This competition could potentially erode the dominance of Microsoft's core operating system and Office applications. Google has also established itself as the dominant online search player, and has used its position to branch out into direct competition with Microsoft with its Chrome internet browser and operating system software. Microsoft has struck back through its alliance between its internet search engine Bing and Yahoo. On the mobile operating system front, we think that Apple's iphone operating system and Google's Android platform have clearly been gaining market share, which leaves Microsoft in the position of again playing catch-up. The launch of Windows Phone 7 was a much needed update to the company's mobile software offering, and we think the alliance with Nokia will increase its ability to gain traction in the marketplace. COMPANY DESCRIPTION Microsoft is the world's largest independent software developer. The company's business is organized into five divisions. The Windows & Windows Live division includes the Windows operating system cluster of products; the Server and Tools division includes the Windows Server operating system and enterprise-oriented products; the Online Services Business includes web-based advertising, MSN and the Bing search engine; the Microsoft Business Division includes the MS Office suite of products; and, finally, the Entertainment and Devices division features the Xbox 360 game console, video games such as 'Halo 3,' and software for mobile and embedded devices. INDUSTRY Our rating on the Technology sector is Over-Weight. Factors supporting our rating include solid earnings growth forecasts and reasonable valuations. The sector is now the largest in the market, accounting for 19.6% of the S&P 500. Over the past five years, the weighting has ranged from 15% to 20%. We think investors should allocate 19%-20% of their portfolios to this group. The sector includes industries such as software, hardware, internet services, communication equipment and semiconductors. In terms of performance, the sector has started off strong in 2012, as companies have continued to invest in efficiency-generating hardware and software. Yet despite aggressive IT spending in 2010-2011, the sector's stock performance lagged. Fundamentals for the Technology sector look reasonably balanced. By our calculations, the P/E ratio on projected 2012 earnings is 12.6, in line with the market multiple. The growth outlook is solid, with forecasts for 2012 calling for a 15.4% advance, and estimates have been revised upward. The sector's debt ratios are below the market average of 47%, as is the average dividend yield of 1.1%. VALUATION Microsoft shares have risen 27% over the last year compared to an 11% increase for the S&P 500 on a total-return basis. With a trailing enterprise value/ebitda multiple of 7.9, MSFT is trading below its peer group average of 9.4 and at the low end of the five-year historical range of 7.9-9.9. Our target price of $39 implies a multiple of 12.8-times our FY13 EPS estimate, below the peer average of 18.6 and the historical average range of 13-16, and a potential gain of about 19% from current levels. On March 15, BUY-rated MSFT closed at $32.85, up $0.08.
METHODOLOGY & DISCLAIMERS Report created Mar 16, 2012 Page 5 OF 5 About Argus Argus Research, founded by Economist Harold Dorsey in 1934, has built a top-down, fundamental system that is used by Argus analysts. This six-point system includes Industry Analysis, Growth Analysis, Financial Strength Analysis, Management Assessment, Risk Analysis and Valuation Analysis. Utilizing forecasts from Argus Economist, the Industry Analysis identifies industries expected to perform well over the next one-to-two years. The Growth Analysis generates proprietary estimates for companies under coverage. In the Financial Strength Analysis, analysts study ratios to understand profitability, liquidity and capital structure. During the Management Assessment, analysts meet with and familiarize themselves with the processes of corporate management teams. Quantitative trends and qualitative threats are assessed under the Risk Analysis. And finally, Argus Valuation Analysis model integrates a historical ratio matrix, discounted cash flow modeling, and peer comparison. THE ARGUS RESEARCH RATING SYSTEM Argus uses three ratings for stocks: BUY, HOLD, and SELL. Stocks are rated relative to a benchmark, the S&P 500. A BUY-rated stock is expected to outperform the S&P 500 on a risk-adjusted basis over a 12-month period. To make this determination, Argus Analysts set target prices, use beta as the measure of risk, and compare expected risk-adjusted stock returns to the S&P 500 forecasts set by the Argus Strategist. A HOLD-rated stock is expected to perform in line with the S&P 500. A SELL-rated stock is expected to underperform the S&P 500. Argus Research Disclaimer Argus Research is an independent investment research provider and is not a member of the FINRA or the SIPC. Argus Research is not a registered broker dealer and does not have investment banking operations. The Argus trademark, service mark and logo are the intellectual property of Argus Group Inc. The information contained in this research report is produced and copyrighted by Argus, and any unauthorized use, duplication, redistribution or disclosure is prohibited by law and can result in prosecution. The content of this report may be derived from Argus research reports, notes, or analyses. The opinions and information contained herein have been obtained or derived from sources believed to be reliable, but Argus makes no representation as to their timeliness, accuracy or completeness or for their fitness for any particular purpose. This report is not an offer to sell or a solicitation of an offer to buy any security. The information and material presented in this report are for general information only and do not specifically address individual investment objectives, financial situations or the particular needs of any specific person who may receive this report. Investing in any security or investment strategies discussed may not be suitable for you and it is recommended that you consult an independent investment advisor. Nothing in this report constitutes individual investment, legal or tax advice. Argus may issue or may have issued other reports that are inconsistent with or may reach different conclusions than those represented in this report, and all opinions are reflective of judgments made on the original date of publication. Argus is under no obligation to ensure that other reports are brought to the attention of any recipient of this report. Argus shall accept no liability for any loss arising from the use of this report, nor shall Argus treat all recipients of this report as customers simply by virtue of their receipt of this material. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as an indication or guarantee of future performance. Argus has provided independent research since 1934. Argus officers, employees, agents and/or affiliates may have positions in stocks discussed in this report. No Argus officers, employees, agents and/or affiliates may serve as officers or directors of covered companies, or may own more than one percent of a covered company s stock. Morningstar Disclaimer 2012 Morningstar, Inc. All Rights Reserved. Certain financial information included in this report: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.