The new issue of Businessweek came out today, and the cover story is “Steve Ballmer Reboots.” The article addresses how Microsoft has fared in the three years since Bill Gates retired.  While the article is required reading for anyone thinking about buying MSFT stock, here at Turnkey Analyst, we suggest you supplement this kind of qualitative input, with some unbiased quantitative input.  We therefore ran MSFT through our powerful, academically rigorous screening and evaluation systems, in order to help you make some quantitative judgments about the stock that are unclouded by the many behavioral financial biases that afflict all of us.

Microsoft develops and markets a wide range of software, services and hardware products that enhance the way people live and work.  Its products include operating systems for personal computers, servers, phones and other devices, and it also provides various consulting and support services.  MSFT is based in Redmond, Washington, and it does business in more than 100 countries.  Let’s now take a look at our composite Fundamental Factor quantitative scores for a starting reference point before moving into the details.

MSFT generates a Quality Measures score of 82%,  and a Pricing Measures score of 76%, which combine for an aggregate Turnkey score of 79%.  So it would appear that MSFT is a high quality company trading a fairly cheap price.  Before getting into the factors that make up these scores, let’s see how MSFT fares within our various screening methods, in order to see if these are telling us anything.

Reviewing our Turnkey Quantitative Measures, there is one item that stands out: MSFT scores in the 96th percentile for our Magic Score screen.  Screening cognoscenti will recognize this screen as the one popularized by Joel Greenblatt in his “The Little Book That Beats the Market.”  Just for kicks I went to the Magic Formula web site, and ran their screen for the top 50 magic formula stocks with a market capitalization of above $50 million.  Sure enough, MSFT appeared on the list.  Although our chosen universe is slightly smaller, with stocks above $250 million, it’s still nice to know that our results are consistent with Mr. Greenblatt’s.

Unfortunately, MSFT does not particularly distinguish itself on any of our other long screens, although it scored in the 77th percentile for F Score, which indicates lower than average risk of financial distress, which is good.  Our Long Term E/P and Profit and Value screens are not giving the company especially high marks, so we would not be a buyer on the basis of either of these screens.  On the bright side, MSFT does not score especially poorly on our accounting-based short screens: it is in the 39th percentile for our Percent Accruals screen, and in the 88th percentile for our Goodwill Gone Bad.  So there are no obvious accounting-based short signals to investigate.  Our Asset Growth screen, another short screen, is showing MSFT in the 29th percentile, so that is not insanely bad, but certainly not great.  With these short screens we are looking for very low output (<20%), which would be a red flag, but we are not seeing that in this case.

Turnkey’s Economic Moat score for MSFT is an impressive 88%; this score is higher than for several other equity names we have reviewed recently that have exceptional economic moats, including Apple, Coca Cola, and Johnson & Johnson.  Normalized (8 yr average) returns on assets and on capital are stratospheric, at 19.6% and 29.2% respectively, both good for the 98th percentile; normalized cash from operations – capex / assets is 134%, which is within top 1.5% of all firms in our universe.  These stellar returns on capital investments and on operating assets indicate MSFT is a highly efficient generator of cash.  Note how in the graph, above right, that operating cash flow shows an upward trajectory, even as capex appears relatively flat.  Our computed value for MSFT’s margin strength is 31%, which is in the 83rd percentile.  The graph above left shows fairly stable margins, although there may be a downward trend.  Not surprisingly, the company has not lost money in any of the past 8 years.  It would seem MSFT’s high economic moat value is driven by its strong cash flows which are accompanied by a comparatively low relative rate of investment.  And this makes sense based on MSFT’s quasi monopoly position in its industry.

While precise figures are hard to come by, the various versions of MSFT’s Windows operating system (7, Vista, XP) combine for on the order of an 80% market share of new computers sold in the U.S.  Since Windows is the dominant operating system, the vast majority of business software is compatible with it, and a significant number of specialized business software applications are designed exclusively for it.  If you have an existing integrated business system or a critical piece of business software, the last thing you want to worry about whether these will function, and so one easy choice for an IT director is to choose the default operating system configuration that resolves that issue: Windows.  There are probably not many IT directors who have gotten fired for choosing Windows.

Additionally, MSFT’s Office franchise, which includes such applications as Word, Excel, PowerPoint, and the company’s Outlook information manager and email software, are fully interoperable, and have been a day-to-day part of people’s business lives for many years.  The idea of running these applications on other operating systems is daunting for many and so, as with the IT directors above, individuals will also often stick with what they know: Windows.  Thus, MSFT’s market share is largely self-sustaining, since necessary hardware upgrades are accompanied by high switching costs for the underlying operating system.  Yet all is not well in Redmond: Apple and Google pose multiple threats, such as through devices that move people away from PCs (iPhone, iPad, Android), as well as cloud computing.  And so while Windows will likely wither away, the economic moat created by its entrenched position in the market for computers will likely allow it to continue to generate significant cash flows for many years.

Our Turnkey Financial Health measures are giving a green light to MSFT.  The company scores 100% in Profitability, with almost $27.3 billion in cash flow from operations, and $23.5 billion in net income.  Ben Graham counseled that we look at long run average earnings figures to assess a company’s underlying earnings power, and MSFT’s normalized earnings figure of $17.7 billion is impressive by any measure.  Again we see MSFT’s strong returns on assets and capital.  MSFT is also a paragon of stability.  The quick ratio is approaching 3X, demonstrating ample liquidity.  MSFT scores well on our two measures of bankruptcy or financial distress, with the Altman Z of 4.9, which is comfortably above our cutoff of 3.0, and an F Score of 6.0, which as we discussed above puts the company in the top quartile of our universe.  Total debt / capital is 29%, below the 50% level at which we would want to look more carefully, and interest coverage is fine, with EBIT / interest of 79X.  In general MSFT is a highly profitable company with no significant risk of bankruptcy or financial distress.

Our shareholder yields output for MSFT looks encouraging, with an overall Valuation score of 76%.  Long-run cash flow yields look solid, with normalized (8 yr average) EBIT / TEV of 10.4%, and FCF / TEV of 10.0% placing the company in the 88th and 84th percentiles, respectively.  Normalized net income / market cap is also healthy at 6.6%, which is in the top quintile of our universe.  Current cash flow yields are also strong, with EBIT / TEV of 14.4%, which is in approximately the top decile, and FCF / TEV of 10.0%, which is in approximately the top quintile.  Net income / market cap of 10% is in the 85th percentile.  Book to market is low at 25.4%, but as discussed above, MSFT’s value is based on its ongoing cash flow, rather than on some notional liquidation value, so we can safely discount this figure.  In general, MSFT looks fairly cheap at these prices.

So overall what are the quantitative data telling us about an investment in MSFT?  Perhaps its most distinguishing feature is that MSFT is a cash cow, earning high current and normalized returns on capital and assets based on the wide defensive business moat that its Windows operating system provides.  While in the longer run, MSFT may face significant competitive pressures, it is unlikely to be dislodged from its strong defensible position in a dramatic way any time soon.  There are no obvious red flags from any of our short screens, and the company is hugely profitable and stable, so there is a low risk of financial distress.  The stock looks cheap here, and its strong magic score suggests that you are not overpaying for this very high quality business.  If you are looking for a safe bet in a high quality company in the technology space, MSFT would appear to fit the bill.