Fourth quarter earnings

Microsoft’s fourth quarter earnings showed a strong lift in revenue from a year earlier, yet the shares continue to stagnate relative to the broader technology market. Is everything priced into the stock, or has the market underestimated the recovery in the global PC market? Perhaps the answer lies more in the perception that the company’s flagship products are being overshadowed by new tablet devices than run without the help of Microsoft products.

“Even after so many years of competition from all corners of the computing world, Microsoft’s fortress-like claim on the PC software market provides an enormous war-chest”

Fourth quarter revenue at Microsoft increased by 22.4% to $16.04 billion. Operating profit therefore increased by 48.7% to $5.93 billion. For the full year, revenue of $62.5 billion was 6.9% ahead of the prior year. Operating expenses increased by just 1.6% over the year leading to a solid 14.8% increase in operating profit to $28.6 billion for the 2010 financial year. Net profit increased 28.8% to $18.7 billion.

The launch of Office 2010 during the final quarter provided a good boost to sales in addition to the earlier launch of the latest Windows 7 product. Both are cornerstone products for the company. Windows 7 has sold more than 175 million units so far as the global PC market awakes from its year long hiatus due to the GFC.

The newsworthiness of such a strong product release seems to have far less glamour to it these days compared to the hype surrounding newer products such as Apple’s iPad and iPhone, even though those products sell in much smaller volumes.

Microsoft’s product pipeline is hardly bare either. Along with recent releases of Windows Server, Xbox and its Bing search engine, the company will soon launch new cloud services such as Windows Azure and a set of online business productivity services.

The Windows 7 release is particularly instructive as it reminds investors of the huge installed base of PCs worldwide that run Microsoft products. Along with sales of new desktop, laptop and notebook PCs, the replacement market for software remains large and still growing.

Microsoft estimated that worldwide PC shipments grew approximately 22% to 24% in the fourth quarter and between 16% and 18% for the full year.

In our view then, the market may be suffering from a perception problem about Microsoft’s earnings growth outlook in comparison to the celebrity status of newer tablet devices. But these devices will be commoditised soon enough. Microsoft and a host of other manufacturers are rushing to market with similar devices that will play to each company’s strengths. In Microsoft’s case, its long history in operating systems should stand it in good stead in this regard.

The Microsoft Business Division is, by a whisker, the company’s largest division. It sells the well known Microsoft Office system among other products. At $18.6 billion, net revenue declined by 1.4% after allowing for the net deferral of $254 million of revenue related to eligible upgrades of software. The 2010 version of Microsoft Office was launched in the fourth quarter and should provide some good momentum heading into the new financial year, as with the Windows 7 product.

Operating income from this division increased 1% to $11.8 billion mainly due to careful control of operating expenses.

The Windows Division is the second largest with revenue increasing 23% to $18.5 billion in the full year. Operating income increased by 30% to $12.9 billion.

Many commentators become absorbed with the revenue growth of the company, but we remind Members of the staggering profit margins these two divisions generate. The Business Division operating income margin was 63.2% for the year while the Windows Division was even better at 70.2%. Even after so many years of competition from all corners of the computing world, Microsoft’s fortress-like claim on the PC software market provides an enormous war-chest.

Cash flows from operations in the 2010 financial year increased by $5 billion to $24 billion. From this, the company invested nearly $2 billion in capital expenditure and over $9 billion in net acquisitions.

As at 30 June 2010, the balance sheet held net cash of $30.8 billion, total assets of $86 billion and shareholders’ equity of $46.1 billion.

Consensus estimates place Microsoft on a 10.9 times price to earnings ratio for the 2011 financial year on revenue growth of 9.2% and net profit growth of 10.4% to $20.7 billion.

In our view, that does not look overpriced and perhaps reflects some cynicism about the company’s growth prospects. But it is not short of new avenues and clearly has a huge store of wealth in its dominant Windows and Office products for years to come. It is a potent combination when overlaying the enormous financial strength of the business.

Turning to the charts, the weekly chart shows that the long term uptrend that began in early 2009 has now been broken as the share price has pulled back from the 2010 high of $31.58 which was made on the 23 April. Since then the share price has continued lower breaking below both the 40 week and 200 week moving averages. The recent sell off looks to have found support around the $22 level. The shorter MACD average has turned up, a bullish reversal signal may soon follow.

Looking at the daily chart of MSFT we can see that the price action has now broken back above the 50 day moving average once more. We would now target a move towards resistance at the $27.50 level. The daily RSI is still in an uptrend and yet to give an overbought reversal signal. If the share price manages to break above the $27.50 level we would target a move toward the 200 day moving average.

We will continue to hold Microsoft in the Fat Prophets Portfolio.