Microsoft Financial Analysis – Destroying Value with Too Much Cash
It can be hard to knock a long time success like Microsoft. Just because a company is successful, however, doesn’t mean that it practices efficient and effective financial management. In fact, big success can lull some companies into a sense of satisfaction that makes them blind to the problems plaguing their operations.
We used the Business Ferret’s 12 financial metrics to tear Microsoft’s finances wide open. We found both good signs and bad signs but, overall, there is huge room for improvement. If Microsoft took our advice, it could revive some of its lost luster and improve its stockholder value.
Real revenue growth
Microsoft’s real revenue growth has been, in a word, inconsistent. In some years real revenue growth was higher than its unadjusted (also known as “nominal”) growth and in other years the opposite is true. The company moved back and forth between working harder for less and working less for more. On top of this, two years of mediocre growth was bordered by two years of real revenue growth in excess of 14%.
Who is at the helm here? This kind of inconsistent growth should be a telling sign both to potential investors and Microsoft’s financial team.
Sustainable revenue growth
Fortunately for Microsoft, both the unadjusted and real revenue growth is completely sustainable and could even be as high as 19% annually. This is great for the company if it can find new products and services that increase annual revenues.
Staying stagnant, however, will destroy the best thing they have going.
Pricing policy is one of Microsoft’s major downfalls. The gross profit margin has been flailing back and forth over the years. In 2011, it finally plummets to the lowest level they’ve seen in the last five years. Microsoft was, for the most part, able to grow the gross profit in line with a bit higher revenue growth but the GP margin was declining at about a half-point annually.
Less than 1% may not seem like much but it equates to an average $300 million of foregone gross profit dollars each and every year over the last five years – a total of $1.5 billion. Ultimately, all this money would have gone right to the pre-tax bottom line. Oops!
Operating expense control
We were surprised to find that Microsoft has done a great job in operating expense control in light of the poor job in gross profit margin maintenance. In 2009, operating expenses to revenues was 45% and by the end of 2011 the percentage fell to 37%. This was the real financial success story for Microsoft.
It’s just too bad this advantage was wasted by a poor pricing policy!
This is another one of Microsoft’s major downfalls – and it is a big one.
Microsoft generates an astounding $20 billion in excess cash every year. In 2011, it was $26 billion excess. The company currently holds $50 billion in working capital cash. In other words, the company is holding an enormous, non-producing asset that is substantially lowering their overall return on assets and increasing its cost of capital. Big mistake.
Microsoft could distribute the entire $50 billion and be back to $25 billion in cash reserve within a year.
Holding large cash balances has the effect of eroding a company’s productive edge. Instead of creating new ideas, a company looks to buy new ideas (Skype? Yammer?), pay too much, and then bury the new purchased company’s products and services within the larger company. Holding large cash balances produces a lazy culture for many companies.
Microsoft needs to put their cash somewhere besides their sock drawer and start innovating again!
Return on assets (ROA)
We mentioned return on assets in the prior metric so what does this mean in relation to Microsoft? The company’s average return on assets is a healthy and strong, 18.5% annually. If we adjusted for excess cash and other assets, the average could be 62% If the ROA is adjusted fully, including efficient financing, it could be 100% – per year!
Two thirds of the adjustment in average ROA from 18.5% to the 62% first level adjustment is due to holding too much cash. This is an astounding mistake on the company’s part and holds down the company’s stock value year after year.
Difficult as it may be to believe, Microsoft could use additional cheaper cost debt in its capital structure mix. The way Microsoft thinks, the additional funds would probably be put back into cash – exactly the wrong place.
Inefficient use of debt and holding too much cash crushes ROA and jacks up the cost of capital as we will see shortly. This does a great job eliminating value!
Net Trade Cycle
Microsoft has learned over time what a correctly run net trade cycle can do for a company. Our question is “why did it take them so long to get it?”
For every day that Microsoft lowers its net trade cycle, an average of $176 million cash comes out of its working capital. It took four years for the company to move from a net trade cycle of 65 days down to 37 days releasing, $4.8 billion out of its working capital.
They could still remove another 10 days out of the trade cycle, freeing up $1.8 billion. This is a great trend for Microsoft to continue.
Cost of Capital (COC) and Economic Value Added (EVA)
Now, we come full circle to where the income statement and the balance sheet intersect. The average annual cost of capital for Microsoft is around 33%, too high. This high cost of capital is due to combining a consistent return on equity with too much expensive equity used to fund their capital structure.
Remember the above discussion about the ROA at 18.5%? With a COC at 33% and a ROA at 18.5%, the company is withholding shareholder. Annual book equity growth (book equity is the original equity investment) is around 15% annually. While this is a healthy growth rate, it is overwhelmed by the inflated capital cost. The COC needs to be reduced or the ROA needs to increase, both of which involve getting rid of that excess cash!
This is an astounding financial oversight by Microsoft’s management and is costing the company in a big way. Microsoft has, unfortunately, become a deceptive wealth destroyer in its maturity.
Edit: Great article from Vanity Fair about Microsoft’s missteps in the last decade. Addresses the culture, the lack of innovation, and Ballmer’s shortcoming’s as a product innovator.