Saturday, January 21, 2012

MSFT - the stock popped, should one buy more or sell?

Microsoft reported its earnings this week and the stock popped as it beat analyst estimates. Let us look at the business as a whole to see if one should buy more or less?

The company's operating income for the first six months of the year decreased by ~1% and declined by ~2% in the December quarter. It is not huge but shows the business dynamics as a whole. The slow down is mostly because of the windows client slow down which will eventually show up in other businesses. However, the net income was up because of other income and a more favorable income tax rate. It didnt hurt that the number of shares outstanding declined by some 2.1%.

The other measure one must watch out for is the growth in share holder equity. The company pays out nearly 7 billion in dividends every year from its cash flows. The shareholder equity increased by about 7 billion dollars for the first six months of the year compared to June 2011. All the increase is from goodwill from the Skype purchase.  Since Skype doesn't add to the bottom line yet, this increase in share holder equity will have to wait out to see how it does over time.

The company has prodigious cash flows even though it is somewhat stagnant/slightly declining year over year. The company is impacted by windows client decline but has had increases in server & tools, microsoft business division (where growth is moderating to low single digits) and declining losses in the search business. The entertainment and devices division is showing a larger decline in profits this year probably because of the acquisition of Skype.

With operating income of 27 billion in 2011 that is slightly declining year over year and not much in capex other than people that can be disposed of, a case can be made that Microsoft is under valued. However, a declining business has its own risks and there are many under valued investments available in today's market and will continue to be available. Microsoft provides a good yield that should remain reliable with increasing stock buy back even with declining cash flows. Microsoft's businesses remain solid but their hold on the market may be declining as customers flock to other form factors such as the tablet where Microsoft has been lagging.

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