Microsoft (MSFT) David Krauza

Microsoft’s stock price as of 22-August-2010 is 24.23

Business Description
Microsoft is engaged in developing, manufacturing, licensing and supporting a range of software
products and services for different types of computing devices. Its software products and services
include operating systems for personal computers, servers and intelligent devices; server applications
for distributed computing environments; information worker productivity applications; business
solutions applications; computing applications; software development tools, and video games. It
operates in five segments: Windows & Windows Live Division (Windows Division), Server and Tools,
Online Services Division, Microsoft Business Division, and Entertainment and Devices Division. It
also designs and sells hardware, including the Xbox 360 gaming and entertainment console and
accessories, the Zune digital music and entertainment device and accessories, and Microsoft
personal computer (PC) hardware products.1

Investment Thesis
Microsoft earns an exceptionally high return on invested capital (134.7%) 2. The competitive strength
of the firm lies in its domination of the personal computer and enterprise market space. Microsoft
Windows Operating System is installed on over 85% of PCs. Microsoft Office is used in over 80% of
corporations; Microsoft Exchange controls approximately 62% of the enterprise messaging space.
Microsoft has a strong balance sheet with net cash of $22.2 billion. The firm also reports attractive
gross and EBIT margins. Microsoft began paying a regular quarterly dividend beginning Q4FY04 and
has raised the dividend payment four times since the dividend began. Microsoft’s shares appear to
be trading a discount to intrinsic value as calculated using the Discounted Cash Flow Method.

Competitive Advantages, Differentiators, and “Moat”

Microsoft has strong brand awareness and a large established installed base in the corporate market.
Microsoft’s control of the PC Operating System and Office Productivity market represents a significant
barrier to entry for new competitors. Furthermore Microsoft’s increasing share of messaging (via
Exchange) and collaboration (via SharePoint) market space pose additional hurdles for would be
competitors. Over 80% or Microsoft’s revenue is generated from sales of Windows, Office, and
various server tools including Windows Server, Exchange, and SQL Server. Customers that have
purchased these products could potentially face large switching costs to move to a non-Microsoft
product; hence, once a customer has purchased Microsoft software the likelihood of the customer
switching to a competitor in the short term is very low. Due to Microsoft’s significant cash flows the
firm does not need to depend on outside financing, though the company did float its first bond offering
ever in 2009 for “general corporate purposes.” Microsoft’s expense margin has remained relatively
stable over the past four years, indicating that the firm has a good handle on expenses.

Management
The directors and officers of Microsoft collectively own slightly over 12% of the outstanding shares of
the firm. Bill Gates, the Chairman of the Board, is the only individual owning more than 5% of the
firm. CEO Steve Ballmer owns the second largest share with about 4.5% of the shares. Within the
last 12 months there does not appear to have been any significant purchases of stock by insiders.

Management has not been bashful about acquiring other firms to round out Microsoft’s technology
portfolio. With the exception of tendering an offer to purchase Yahoo! two years ago, the firm has
generally stayed away from large acquisitions. While the Yahoo! merger did not materialize there is
no reason to suspect Microsoft might not attempt such a large scale merger again.

The firm began paying a quarterly dividend in 2004 and has increased the payment four times in the
past six years.

1
http://www.google.com/finance?q=msft
2
Operating Earnings / (Total Assets – Goodwill – Intangibles – Current Liabilities + Short Term Debt – Excess Cash)

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Disclosure: This is NOT a buy or sell recommendation. This is for information purposes only
 Microsoft (MSFT) David Krauza

Weaknesses
Due to Microsoft’s low debt level and high operating cash flows the firm is not exposed to a great deal
of financial risk, the firm does have significant business risks. First, Microsoft’s online division has yet
to report a profit. The online division owns Microsoft’s web properties such as Bing.com. Microsoft’s
chief competitor in this space is Google, who has substantial profits in this market space, which they
in turn can use to fund projects to compete against traditional Microsoft strongholds, such as the
enterprise messaging and collaboration. Second, mobile computing and telecommunications has
become an area where technology companies have been focusing in the last several years. As of
this writing Microsoft does not have a compelling mobile platform, however, Windows Phone 7 (due
later this year) has had promising reviews. Third, sales of Microsoft software are highly correlated to
PC sales. During tough market conditions individuals and corporations tend to cut back on
technology purchases, having an adverse impact on Microsoft’s revenue.

Valuations
In Millions of USD (except for per share items and percentages)
Year Ending 30-June-2010 2010 2009 2008 2007
Revenue 62,484 58,437 60,420 51,122
Gross Profit 50,089 46,282 48,822 40,429
Gross Margin 80.16% 79.20% 80.80% 79.08%
Expenses 25,942 26,121 26,551 21,991
Expense Margin 41.52% 44.70% 43.94% 43.02%
EBIT 24,167 21,225 22,271 18,438
EBIT Margin 38.68% 36.32% 36.86% 36.07%

Pre-tax FCF
CapEx 1,977 3,119 3,182 2,264
Net Working Capital3 29,529 22,246 13,356 16,414
Change in NWC 7,283 8,890 7,283 N/A
FCF4 22,287 21,664 18,430 15,532
FCF Margin 35.67% 37.07% 30.50% 30.38%

Balance Sheet
Excess Cash5 29,529 22,246 13,356 16,414
Total Debt 5,939 5,746 0 0
Net Cash 23,590 16,500 13,356 16,414
Invested Capital6 17,885 16,500 13,470 17,365
ROIC 135.12 129.85% 143.96 106.18%
% %
Enterprise Value 186,100

3
Current Assets – Current Liabilities
4
CFO – FCInv + net borrowing
5
Cash – (CL – CA + Cash)
6
Total Assets – Goodwill – Intangibles – CL + Short Term Debt – Excess Cash

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Disclosure: This is NOT a buy or sell recommendation. This is for information purposes only
 Microsoft (MSFT) David Krauza

Discounted Free Cash Flow Analysis

All estimates assume a 9% Discount Rate

Conservative Estimate
Average of previous four years of Free Cash Flow less debt acquired using a growth rate of 1.5%
each year for the next 10 years and then 3% growth forever after that period of time.

Year Growth FCF DFCF

2010 17,993.500
2011 1.50% 18,263.403 16,755.415
2012 1.50% 18,537.354 15,602.520
2013 1.50% 18,815.414 14,528.952
2014 1.50% 19,097.645 13,529.253
2015 1.50% 19,384.110 12,598.341
2016 1.50% 19,674.871 11,731.483
2017 1.50% 19,969.994 10,924.271
2018 1.50% 20,269.544 10,172.601
2019 1.50% 20,573.588 9,472.651
2020 1.50% 20,882.191 8,820.863
Perpetuity 3.00% 358,477.618 151,424.820
Total 275,561.17
Share Outstanding 8,650
Per Share Estimated Value 31.86
Discount/(Premium) to Current Price 31.49%

Moderate Estimate
Average of previous four years of Free Cash Flow less debt acquired using a growth rate of 1.5%
each year for the next 10 years and then 3% growth forever after that period of time.

Year Growth FCF DFCF

2010 17,993.500
2011 3.00% 18,533.305 17,003.032
2012 3.00% 19,089.304 16,067.085
2013 3.00% 19,661.983 15,182.659
2014 3.00% 20,251.843 14,346.916
2015 3.00% 20,859.398 13,557.177
2016 3.00% 21,485.180 12,810.911
2017 3.00% 22,129.735 12,105.723
2018 3.00% 22,793.627 11,439.353
2019 3.00% 23,477.436 10,809.664
2020 3.00% 24,181.759 10,214.636
Perpetuity 3.00% 415,120.203 175,351.260
Total 308,888.417
Share Outstanding 8,650
Per Share Estimated Value 35.71
Discount/(Premium) to Current Price 47.38%

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Disclosure: This is NOT a buy or sell recommendation. This is for information purposes only
 Microsoft (MSFT) David Krauza

Aggressive Estimate
Average of previous four years of Free Cash Flow less debt acquired using a growth rate of 6.0%
each year for the next 10 years and then 3% growth forever after that period of time.

Year Growth FCF DFCF

2010 17,993.500
2011 6.00% 19,073.110 17,498.266
2012 6.00% 20,217.497 17,016.662
2013 6.00% 21,430.546 16,548.314
2014 6.00% 22,716.379 16,092.856
2015 6.00% 24,079.362 15,649.933
2016 6.00% 25,524.124 15,219.201
2017 6.00% 27,055.571 14,800.324
2018 6.00% 28,678.905 14,392.976
2019 6.00% 30,399.640 13,996.839
2020 6.00% 32,223.618 13,611.604
Perpetuity 3.00% 553,172.109 233,665.877
Total 388,492.852
Share Outstanding 8,650
Per Share Estimated Value 44.91
Discount/(Premium) to Current Price 85.35%

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Disclosure: This is NOT a buy or sell recommendation. This is for information purposes only