Financial Analysis of IT Companies - Research Paper Example

Company Overview Microsoft is the largest developer and manufacturer of software and applications for computers and other technological computing devices. The company was founded in 1975 by William (“Bill”) Gates and Paul Allen in a suburban garage. Their early corporate vision was to provide personal computing to the masses; “A computer in every desk and every home” which has morphed and grown to be a multinational multi-billion dollar software development giant in less than ten years after its creation. The company has matured and grown to be one of the world’s leading providers of software, computing services and hardware. Although the original focus of Microsoft was on PC development, it later changed its efforts towards the more profitable business side of software and application development. By 1981 Microsoft had created the highly successful MS-DOS operating system which it successfully licensed to IBM and came bundled with all their computers. In 1985 his new GUI (Graphic User Interface) Windows 1.0 operating system was unveiled which Gates viewed as the future of personal computing, but IBM executives did not share the same vision. Contrary to IBMs belief, Windows and its GUI interface became the de-facto standard for all personal computers in the future. Microsoft as a company soon achieved dramatic success and growth by becoming an operational system and personal productivity applications developer marketing giant (Windows, 2012). Operations Microsoft as a company is centered on its customer driven mission of “Enabling people and businesses throughout the world to realize their full potential by creating technology that transforms the way people work, play, and communicate.” The company is focused on developing, manufacturing, licensing and providing customer support to its varied software and hardware products. Some of the major software categories that Microsoft competes in are in operating systems, business solutions software applications, server applications, high-performance computing and software development tools, desktop and server management tools, video games, cloud-computing and online advertising. Microsoft also develops and markets hardware products for entertainment such as the Xbox 360 console and accessories, an interactive entertainment console and other Microsoft hardware. The company also provides solutions and product support services, consulting, training and certification to IT professionals and computer system developers and integrators. Microsofts company structure has a global reach, with corporate offices in over 100 countries worldwide (Globaldata, 2012). Operating Segments and Markets Microsoft has divided its operations into five discrete business segments. By dividing the company operations into operational segments it allows management to gauge the financial and operational performance of each business sub-division. Such segmentation also allows management to align division objectives, strategies and resource allocation with the development, marketing, sales objectives and servicing of each of their business operating segments. The five operating segments are: Windows and Windows Live Division – This segment deals with the development and marketing of the Windows Operating System, Internet Explorer, Windows Live and other PC software applications. The Windows operating system is used in over 90% of the computers worldwide. The main revenue driver of this division is the growth PC market, as over 75% of the revenue of this division comes from OEM sales of the windows operating system to PC manufacturers which come pre-installed with new computer systems. Server and Sever Tools- This business division develops and markets server software, software development tools and solutions to IT technology business and software developers. Server and Tools and also a broad range of product support and business enterprise consulting services for the development, deployment and support of Microsoft server and other business desktop solutions. Their cloud-based business server enterprise services provide a scalable operating system with computing data storage capabilities for their enterprise or web application customers. Online Services Division- Division that markets and develops software to simplify online search, online tasks and help connect advertisers with their target audience. Some of their products are Bing search engine, MSN, advertiser tools an ad-Center. Microsoft Business Division- This segment deals with development and marketing of Microsoft Office (Office, Office 365, SharePoint, Exchange and Lync) business solutions. These business Office solutions can be delivered either on the premises or cloud based. Entertainment and Devices Division- this segment is in charge of developing and marketing devices that connect and entertain people. They are in charge of the Xbox 360, Xbox 360 video games, Xbox Live, Kinect system and Windows Phone. As of June 30, 2012 Microsoft had approximately 94,000 full time employees on payroll; 55,000 in the U.S. and 39,000 internationally. The company distributes all its products through OEM agreements, distributors, retailers, licensing agreements and online (Live, 2012). Corporate Financial Vulnerability Microsoft is fundamentally a very solid company with excellent management and good shareholder performance, but like any technology company it is subject to market pressures of the software industry that is highly dynamic and competitive. The current global economic conditions have not affected Microsofts financial performance like many other of their competitors, but the company is subject to a myriad of industry systemic, regulatory and dynamic business related factors that can negatively affect the financial performance of the company at any time. Some of the intrinsic business related risks for Microsoft are (Shareholder, 2012): 1. The company faces intense competition in all of the markets it competes which could result in lower operating margin or revenues than whats expected. The size of its competitors vary from large multinational developers with significant R&D resources to small specialized software developers which can become a major threat due to their small, narrower product lines, giving them dynamic and flexible infrastructures. Since the entry barriers for this industry are generally low, due to easy and low cost marketing and distribution of new software through the online environment. The ability of Microsoft to stay above the competition lie in creating new innovative products and solutions that customers want and need. Many of the main software products offered by Microsoft compete in a market characterized by new ever changing and disruptive technologies which frequently introduce new products and services in response to the customers changing needs. 2. The trend towards investing more towards cloud based services and infrastructure. A growing part of the companys efforts have gone towards expanding the development and availability of cloud based software solutions and service strategies for the business and consumer level smart client service industry. The risks associated with the high level of competition and lack of consumer acceptance of new cloud based software and service models provide a significant level of added risks to Microsoft, especially in the short term. 3. The company makes significant investments in new products and software services which might prove to be unprofitable. Continued investment in research and development is a major expense for the company. As a company Microsoft makes significant expenditures in research and development of new products and updating their software to new versions play a vital role in their business expenses and their long term ability to continue to thrive in the marketplace. 4. Protecting against intellectual right infringement of their software. Protecting against piracy is very difficult. Although piracy is a problem in the U.S. that affects the market negatively, it is even more widespread internationally particularly in countries where intellectual property rights are not as protected under the law. 5. Adverse economic conditions can harm the overall financial performance of the company. Declines in business spending due to unfavorable economic conditions such as a recession can negatively affect the company due to decreased demand for PCs, servers and other computer hardware. Additionally consumer spending will get suppressed further eroding the sales of PCs and other computer electronics. Having plenty of operating cash flow and adverse interest rates will not affect the company as much as smaller corporations with less financial clout. 6. Because of the global nature of the business the volatility in foreign exchange rates can negatively impact earnings. Financial Performance and Stock Valuation As a company Microsoft has historically been considered a very good investment due to its excellent financial performance regardless of the highly volatile and competitive nature of the industry. The company has been performing extremely well financially with revenues increasing consecutively during the last three years, despite a decrease in revenues for 2009, which in managements opinion was caused by the global economic downturn at the time. Overall in 2012, Microsoft reported a 5% increase in operating revenues amounting to $73.7 billion dollars compared with $69.9 billion in 2011. The company attributed the increase in revenues from mainly an upswing in sales of its Microsoft Office Suite as well as its Server and Tools business software solutions. Some of this increase in revenues was offset by $540 million in deferred customer sales revenue, resulting from a Windows upgrade offer to their customer base. Unfortunately the operating income in 2012 decreased 24.8% ($21.76 billion) primarily due to a 13% increase in operational expenses mainly in the research & development department and in general and administrative functions. Microsoft regularly invests around 10% of its total revenues in R&D. The company had other unforeseen expenses coming from $6.4 billion impairment on goodwill charge on the online services division. In order to gauge the financial performance of the company we will perform a fundamental financial ratio analysis to better understand the true financial position of the company. By analyzing the most important solvency, profitability and financial leverage financial ratios we can better access the Microsofts current financial position. We will analyze the trend of a few financial indicators such as the current ratio, net working capital net margin, return on assets (ROA), return on equity (ROE), debt to equity and compare them with industry averages. In order to measure liquidity we will use the current ratio and net working capital. The current ratio (current assets / current liabilities) gauges the ability of a firm to satisfy current short term obligations as they are due. Current Ratio 2012 2011 2010 Microsoft 2.6 2.6 2.13 Industry Average 2.51 The company has demonstrated an upwards trend towards further improving their liquidity. Microsoft has a strong liquidity position and their current ratio is 3.5% higher compared with the industry average in 2011. Being the #1 software company in the world has brought about many financial advantages to Microsoft. Their admirable net working capital position has increased considerably from $29.52 billion in 2010 to $52.39 billion in 2012, a 77% increase in only three years. The companys financial leverage can be measured by using the debt-to-equity ratio (Long-Term Debt/Stockholders Equity) which gauges the proportion of debt versus equity used to finance the companys operations. A lower ratio is better. Debt-to-Equity 2012 2011 2010 Microsoft .16 .21 .11 Industry Average .23 Microsoft’s lower debt-to-equity ratio allows Microsoft to be a lower risk exposure for lenders. For 2012 Microsoft has a 0.16 metric which is 43.75% lower than industry average in 2011. We will examine and compare Microsofts overall profitability by analyzing the return on assets and return on equity. ROA 2012 2011 2010 Microsoft 14.77% 23.77% 22.88% Industry Average 13.3% ROE 2012 2011 2010 Microsoft 27.51% 44.84% 43.76% Industry Average 23.96% Microsofts management has done a great job managing the asset base to generate the most profit. Even in 2012 with the added expenses the company managed to outpace the industry ROA average by 11%. The ROE demonstrates the companys management ability and effectiveness in asset management, operations and financial capital structure. Microsoft has done an excellent job of maximizing shareholder’s return as can be seen by the excellent returns in 2010 and 2011.Even in 2012 the companys ROE was great providing 14.7% above average returns. If we look at Microsoft overall as a company, its historical financial performance demonstrates a well managed multinational company with excellent financial condition and future performance. By analyzing some stock valuation ratios such as price to book and price to sales ratio we can better assess the value as a stock investment for the average investor. By looking at the from the income statement: Price to Sales 2012 2011 2010 Microsoft 3.2 3.1 3.7 Industry Average 3.6 A below market price to sales ratio indicates a stock whos price is undervalued and vice versa. We can see that Microsofts stock has a 3.2 which is 12.5% lower than industry average, likely pointing at an undervalued stock price in the case of Microsoft. Price to Book 2012 2011 2010 Microsoft 3.3 3.4 4.8 Industry Average 3.47 The companys price to book ratio also reinforces the notion that Microsofts stock price is slightly undervalued (Morningstar, 2012).Therefore we can conclude based on the fundamental financial ratio and stock valuation analysis that Microsoft as a stock investment seems like a very good option for the average investor particularly in the long term. References Globaldata.com (2012). Microsoft Corporation (MSFT) – Financial and Strategic SWOT Analysis Review. Retrieved December 12, 2012 from http://www.globaldata.com/ReportStore/GCI/Report.aspx?ID=Microsoft-Corporation-MSFT-Financial-and-Strategic-SWOT-Analysis-Review&ReportType=Company%20Report&TitleId=29&Title=Technology Live.com (2012). Microsoft Corporation 2012 Annual Report. Retrieved December 12, 2012 from http://view.officeapps.live.com/op/view.aspx?src=http://www.microsoft.com/investor/reports/ar12/docs/2012_Annual_Report.docx Microsoft.com (2012). A history of Windows. Retrieved December 12, 2012 from http://windows.microsoft.com/en-US/windows/history Morningstar.com (2012). Microsoft Corporation MSFT. Retrieved December 12, 2012 from http://financials.morningstar.com/ratios/r.html?t=MSFT®ion=USA&culture=en-us Shareholder.com (2012). Microsoft Corporation Form 10-K. Retrieved December 12, 2012 from http://apps.shareholder.com/sec/viewerContent.aspx?companyid=MSFT&docid=8733512 Read More