The Microsoft Corporation

Running head: THE MICROSOFT CORPORATION COMPANY ANALYSIS

The Microsoft Corporation Company Analysis Arman Kanooni Capella University OM7040 Fundamentals of Financial Management Professor: Dr. Dennis Huber Mars 20, 2006

The Microsoft Corporation

Abstract

A group of investors has approached us for advice on an investment in the Microsoft Corporation. The investors want detailed research on the company, including its financial strengths and weaknesses, position in the market, and potential for growth. They want us to analyze the data we collect and make recommendations as to whether they should invest in the company. We will provide sound analysis and data to support our recommendation.

The Microsoft Corporation Introduction

Microsoft Corporations headquarter is in Redmond, Washington and started mainly as a software development company creating operating systems for personal computers (PCs) and office productivity software for PCs. Today this company is developing and supporting many software products for various computing devices worldwide. MSFT (2006) identified seven major product segments within the Microsoft Corporation: 1) Clients, 2) Servers and Tools, 3) Information Worker, 4) Microsoft Business Solutions, 5) MSN, 6) Mobile and Embedded Devices, 7) Home and Entertainment. The Microsoft technical innovations and its leadership in consumer markets and corporate markets make them a redoubtable competitor in this information age. In this paper, a financial analysis of the Microsoft Corporation is conducted based on the publicly available financial data for the last five years and a recommendation will be made for an investment strategy based on Microsofts track record. The reader should not judge the future gain or loss based on the past performance, since it is impossible to predict the future. Thus, please use your common sense to adjust the financial decision based on market conditions and other factors beyond the control of this study. Company Profile Index Membership This company is member of New York Stock Exchange (NYX). Sector of activity and Industry Based on MSFT (2006), the Microsoft Corporation is operating in the technology sector and is active in application software industry. Number of divisions and employees

The Microsoft Corporation The Microsoft (2006) has seven divisions and 61,000 employees. There are 39,000 employees in the United States and 22,000 all over the world. There are 24,000 individuals in research and development, 18,000 in sales and marketing, 12,000 in product support and consulting services, 2,000 in manufacturing and distribution, and 5,000 in general and administration. Business Summary Segment Revenue The following table 1 shows the segment revenue for the MSFT (2006) for last 3 years. Table 1 Microsofts Segment Revenue ((In millions) Segment Revenue Client Server & Tools Information Worker MS Business Solutions MSN Mobile Embedded Devices Home & Entertainment Reconciling amount Consolidated 2,779 (508) 32,187 2,870 344 36,835 14% 3% 3,211 325 39,788 8% 12% 2003 10,304 6,786 9,636 641 2,396 153 2004 % 2004 vs. 2003 11,283 8,007 10,895 753 2,444 239 10% 18% 13% 17% 2% 56% 2005 % 2005 vs. 2004 12,048 9,143 11,523 793 2,411 334 7% 14% 6% 5% -1% 40%

The consolidated revenue was up by 14% in 2004, but the growth was a bit slower at 8% in 2005. As far as the revenue by segment of activity is concerned, there were remarkable

The Microsoft Corporation revenue growths for the mobile and embedded devices with 40% increase, the server and tools

with an increase of 14%, and the home and entertainment segment with 12% increase compare to 2004. In opposite side, the Internet service provider MSN lost some revenue in 2005 by 1%. Graph 1 Plot of Microsofts Segment Revenue
14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 (2,000) Client Information Worker MSN Home & Entertainment 2003

2003 2004 2005

Client 2003 2004 2005 10,304 11,283 12,048

Server & Tools 6,786 8,007 9,143

Informati Microsoft on Business Worker Solutions 9,636 10,895 11,523 641 753 793

MSN 2,396 2,444 2,411

Mobile Home & Reconcili Embedde Entertain ng d Devices ment amount 153 239 334 2,779 2,870 3,211 (508) 344 325

Finally, in 2005 over all consolidated revenue is increasing by 8% compare to 2004, but still lower compare the 2004s revenue increase of 14%.

Net Operating Income/Loss The net operating income or loss for last 3 years is shown in the following table 2: Table 2 Microsofts Net Operation Income/Loss (In millions)

The Microsoft Corporation 2003 2004 % 2004 vs. 2003 Client Server & Tools Information Worker MS Business Solutions MSN Mobile Embedded Devices Home & Entertainment Reconciling amount Consolidated 8,306.00 1,879.00 7,500.00 (143.00) (384.00) (162.00) (938.00) 8,975.00 2,302.00 8,112.00 (115.00) 383.00 (98.00) (894.00) 8% 23% 8% 20% 200% 40% 5% 9,396.00 2,888.00 8,616.00 (163.00) 469.00 (19.00) (359.00) (6,267.00) -5% 14,561.00 61% 2005 % 2005 vs. 2004 5% 25% 6% -42% 22% 81% 60%

(6,513.00) (9,631.00) 9,545.00 9,034.00

Graph 2 Microsofts Net Operation Income/Loss

10,000.00 5,000.00 0.00 (5,000.00) (10,000.00) Client Information Worker MSN Home & Entertainment 2003 2005 2003 2004 2005

In term of net operation income or loss, there are mixed results. The client and Information Worker segments are strong and the net operation income is increasing each year at

The Microsoft Corporation

average rate of 7%. The server and tool segment is strong with 24% average growth. The MSN segment is strongest with 200% increase in 2004 and 22% in 2005. In the negative side, one can observe the net operating losses continues from 2003, 2004 to 2005 in Microsoft Business Solution, Mobile Embedded Devices, and Home and Entertainment. Stock price movements The table 3 shows the snapshot of MSFT as of March 2nd, 2006. (Big Charts, 2006). Table 3 Microsofts Stock Price Movements Last: 26.97 Change: -0.17 Percent Change: -0.63% Open: 27.02 Yield: 1.33 High: 27.1001 P/E Ratio: 22.48 Low: 26.90 Volume: 41,856,388

52 Week Range: 23.82 to 28.38

Graph 3 MSFTs stock price movements for last five years.

The Microsoft Corporation You can observe a dramatic stock devaluation of Microsoft in 2002. This corresponds with the overall US economic slowdown, the aftermath of September 11th, 2001 terrorist attacks and the loss of investors confidence in the high technology sectors and the dot com companies. Dividend payments Based on statement of cash flows (Exhibit 6), the Microsoft Corporation didnt pay any dividends for 2001 and 2002. But they paid the amount of $857 million, $1,729 million, and $36,112 million respectively for 2003, 2004, and 2005. Financial Statements Income Statement Exhibit 1 provides the Microsoft Corporations income statements from 2001 to 2005. Revenues are shown at the top of income statement, after which operating expenses, interest

costs, and taxes are subtracted to obtain the net income available to common shareholders, which are referred to as net income. The revenue grown has been accelerating at a rate of 13% per year on average. This seems to be a normative growth rate based on five years of data. This growth is significantly lower than the 10 year average growth of 23% (Yahoo, 2006). However, it is still solid growth. Earning per share (EPS) or the bottom line shows $1.13 per share in 2005, up from $0.76 in 2004, and it is up from $0.70 in 2003. Dividends per share (DPS) indicate that in 2001 and 2002, Microsoft didnt pay any dividends to shareholders. In year 2003 the DPS was $0.08. It doubled in 2004 to $0.16 and jump to $3.33 for 2005. Book value per share (BVPS) for the year 2001 was $4.43 and the average market value per share was $33.20. Therefore the market value per share versus book value per share ratio was around 7.50 times. This ratio was 5.25 times in 2002, 4.54 times in 2003, 3.82 times in 2004,

The Microsoft Corporation

and 5.87 times in 2005. This indicates that Microsoft achieved high rates of return on their assets causing their market values to be well above of their book values. For the past five years, research and development expenses are around 17% of revenue in 2001, 15% in 2002, 20% in 2003, 21% in 2004, and 16% in 2005. General and administrative expenses are growing from 3% of revenue in 2001 to 5% in 2002, 8% in 2003, 14% in 2004, and 10% in 2005. The large increase in 2004 is attributable to legal expenses of $1.92 billion to settle the Sun Microsystems case, a $605 million fine imposed by the European Commission, and $280 million of stock-based compensation. The cost of revenue was 14% of revenue in 2001, 18% in 2002, 19% in 2003, 18% in 2004, and 16% in 2005. The sales and marketing was 19% of revenue in 2001, 19% in 2002, 23% in 2003, 23% in 2004, and 22% in 2005. The most current growth rates per percent of Microsoft compared to the industry and the S&P 500 (MSN Money Central, 2006) is shown in the table 4. Table 4. Growth Rates % Growth Rates % Sales (Qtr vs year ago qtr) Net Income (YTD vs YTD) Net Income (Qtr vs year ago qtr) Sales (5-Year Annual Avg.) Net Income (5-Year Annual Avg.) Dividends (5-Year Annual Avg.) Company 9.40 13.40 5.50 11.07 7.99 NA Industry 1.80 36.90 -8.90 2.77 12.25 NA S&P 500 10.70 17.70 20.00 5.12 15.23 7.96

The Microsoft Corporation Balance Sheet The balance sheet statement is presented in Exhibit 3 which shows the Microsoft Corporations assets from 2001 to 2005. The assets are listed in order of their liquidity. 1. Cash versus other assets. The cash and short term investments were $31.6 billion in

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2001, $38.6 billion in 2002, $49 billion in 2003, $60.5 billion in 2004, and $37.7 billion in 2005. There is a general trend of growing cash from 2001 up to 2004. In 2001, the cash and short term investments represented 53.7% of total current assets, 57.1% in 2002, 60% in 2003, and 64.2% in 2004. But, this trend came to a decline in 2005 with cash representing 53.3% of total current assets. The net total receivables were $3.6 billion in 2001, $5.129 billion in 2002, $5.196 billion in 2003, $5.89 billion in 2004, and $7.18 billion in 2005. The percentage of total receivables compare to the total current assets is 6.2% in 2001, 7.6% in 2002, 6.4% in 2003, 6.2% in 2004, and 10.1% in 2005. 2. Liabilities versus stockholders equity. The claims against the total current assets are represented by the total liabilities providing the net worth as indicated in table 5. Table 5 Microsofts Net Worth Year Total current assets Minus Total Liabilities Net Worth 2001 $39,210 $11,541 $27,699 2002 $48,576 $15,466 $33,110 2003 $58,973 $16,820 $42,153 2004 $70,566 $19,543 $51,023 2005 $48,737 $22,700 $26,037

Cash Flow The cash flow statement is presented in Exhibit6. Cash flow from operations increased from $14.626 billion in 2004 to $16.605 billion in 2005.

The Microsoft Corporation Cash flow from financing is negative and went up by $39 billion in 2005. This due primary to $36.112 paid dividends to the shareholders. Cash flow from investing was very positive in 2005. It went from ($3.345) billion to

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$15,027 billion. The increase in cash flow from financing is attributable to a shift in duration of investment held. Long-term maturities were exchanged for more liquid investments. Financial Ratios Analysis The purpose of this section is to evaluate and interpret the results, especially with respect to the financial statements. Liquidity Ratios Brigham & Houston (2004) argue that liquidity shows how a firm can meet its short-term obligations using assets that could be converted into cash in a short period of time. These liquid assets are listed in the balance sheet as current assets. They are used to meet current liabilities. Now, the question is how much liquidity a firm must have? To answer this question, one has to consider the role of the operating cycle. This is the time it takes to invest in firms products and services to the time when investment generates cash. The net operating cycle is the duration of time it takes to convert an investment of cash in inventory and back into cash. So, the number of days a firm holds its fund in inventory is calculated by the following formula: The inventory turnover ratio of the Microsoft Corporation for last five years is shown in the table 6. There is a remarkable improvement from 2001 to 2002 going from 41.63 days to 7.71 days. In 2004, the inventory turnover increased to 15.95 days, but the trend reverses itself in 2005 and stayed at 12.63 days. The industrys inventory turnover ratio is 28.4 and 8.4 for S&P 500. So, Microsoft is performing well compare to the industry, but still could improve even better compared to S&P 500. Table 6 Microsofts Inventory Turnover Ratio

The Microsoft Corporation Inventory Turnover Number of day 2001 41.63 2002 2003 7.71 2004 2005 Industry S&P 500 28.4 8.4

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9.47 15.95 12.63

The same kind of logic could be applied to the account receivables to determine the number of days between sales to the time it is collected in cash. The longer the operating cycle, the more current assets are needed to cover current liabilities. Thus, it is important to know how long it takes to convert inventories and account receivables into cash. The following table 7 shows the Microsofts number of days it takes to collect account receivables. One can notice that in 2001 it took Microsoft 52.97 days to collect receivables and in 2002 it went up to 66 days. By 2003, there is an improvement of 7 days staying at 58.92 days. In 2004, there isnt any significant change, but by the year 2005, it went up by 7 days and stayed at 65.87 days. Table 7 Microsofts Average Collection Period Number of Days receivables Number of days 2001 2002 2003 2004 2005 65.87

52.97 66.00

58.92 58.36

Measures of liquidity Brigham & Houston (2004) explained that liquidity ratios provide a measure of firms ability to generate cash to meet its immediate needs. There are three liquidity rations: 1. The current ratio is the ratio of current assets to current liabilities indicating a firms ability to satisfy its current liabilities with its current assets. The latest Microsofts current ratio is 2.89. The industrys current ratio is 2.3, and S&P500 is 1.4. This is well beyond the Industry and S&P 500. Table 8 Microsofts Current Ratio

The Microsoft Corporation 2001 2002 Current Ratio 4.24 3.81 2003 4.22 2004 4.71 2005 Industry S&P 500 2.89 2.3 1.4

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2. The quick ratio is the ratio of quick assets to current liabilities indicating a firms ability to satisfy its current liabilities with its current assets. The quick ratio is 2.86 and above the Industry of 2.1 and S&P 500 of 1.0. Table 9 Microsofts Quick Ratio 2001 Quick Ratio 4.23 2002 2003 3.76 4.17 2004 4.69 2005 2.86 Industry S&P 500 2.1 1.0

3. The net working capital to sales ratio is the ratio of net working capital to sales indicating a firms liquid assets relative to its need for liquidity. Table 10 Microsofts Net Working Capital to Sales Ratio 2001 Net Working Capital to Sales 1.18 2002 1.26 2003 1.40 2004 1.51 2005 0.80

The larger the liquidity ratios are, the better the firms position to meet its immediate financial obligations. The Microsofts liquidity ratios are showing increasing liquidity from 2001 to 2004, but it is weakening in 2005. Profitability Ratios Brigham & Houston (2004) defined that the profitability ratios compare components of income with sales. There are three ratios to consider: 1) gross profit margin, 2) operating profit margin, 3) net profit margin, 4) return on total assets, 5) return on common equity.

The Microsoft Corporation

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1. The gross profit margin is the ratio of gross income to sales. This ratio shows how much of every dollar of sales is left after costs of good sold. 2. The operating profit margin is the ratio of operating profit to sales. This is a ratio that represents how much of each dollar of sales is left over operating expenses. 3. The net profit margin is the ratio of net income to sales and indicates how much of each dollar of sales is left over after all expenses. 4. The ratio of net income to total assets measures the return on total assets (ROA) after interest and taxes. 5. The bottom line accounting ratio is the ratio of net income to common equity, which measures the return on common equity (ROE). Table 11 Microsofts Profitability Ratios Profitability Ratios Gross profit Operating profit margin Net profit margin ROA ROE 46.33% 29.04% 12.49% 15.53% 41.99% 29.65% 24.53% 36.60% 27.60% 23.40% 22.17% 30.80% 11.57% 9.21% 8.66% 17.30% 32.5% 23.5% 13.9% 22.6% 12.4% 8.5% 2.9% 16.3% 2001 86.34% 2002 2003 2004 2005 Industry 82.6% S&P 500 47.3%

81.70% 81.18% 81.77% 84.42%

15.00% 11.60% 10.92% 25.47%

Table 11 shows the Microsofts profitability ratios compared to the Industry and the S&P 500. Indeed, the Microsoft Corporation is profitable and leads not only the rivals, but also S&P 500. Activity Ratios Brigham & Houston (2004) showed that the activity ratios are measures of how well assets are used.

The Microsoft Corporation

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1. Accounts receivable turnover is the ratio of net credit sales to account receivable. This ratio indicates how many times in the period credit sales have been created and collected on. 2. Total asset turnover is the ratio of sales to total assets. This ratio indicates the extent that the investment in total assets results in sales. There is some room for improvement in term of account receivable turnover. In year 2005, this ratio was at 5.54 for Microsoft compare to the industry rate of 5.2. In other hand, the total asset turnover is better than the industry but above the S&P 500. Table 12 Microsofts Activity Ratios Activity Ratios Account receivable turnover Total Asset Turnover 2001 2002 2003 6.89 0.43 5.53 0.42 6.19 0.39 2004 6.25 0.39 2005 Industry 5.54 0.56 5.2 0.6 S&P 500 7.5 0.3

Financial Leverage Ratios A firm uses equity or debt to finance its assets. If the firm decides to use debt, then this introduces the financial risk to its operations, since the firm is legally obligated to pay interest and to repay the principal as promised. If the firm decides to use equity financing, then it doesnt legally obligate the firm to pay anything except it might have to pay the dividends which are at the discretion of the board of directors. Brigham & Houston (2004) argue that financial leverage ratios are used to assess how much financial risk the company has taken on. There are two types of financial leverage ratios: component percentages and coverage ratios. Component-percentage financial leverage ratios 1. The total debt to assets ratio indicates the proportion of assets that are financed with debt. 2. The long-term debt to assets ratio shows the proportion of the firms assets that are financed with long-term debt. Microsoft doesnt have long term debt.

The Microsoft Corporation

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3. The debt to equity ratio indicates the relative uses of debt and equity as sources of capital to finance the firms assets, evaluated using book values of the capital sources. Table 13 Microsofts Financial Leverage Ratios 2001 Total debt to assets ratio Total debt to equity ratio 2002 2003 2004 2005

19.62% 22.86% 20.58% 20.71% 32.06% 24.41% 29.64% 25.91% 26.12% 47.18%

Coverage financial leverage ratios Brigham & Houston (2004) defined that the times-interest-coverage ratio compares the earnings available to meet the interest obligation with the interest obligation. Table 14 Microsofts Coverage Financial Leverage Ratios Coverage financial leverage Times-interest-coverage 2001 -60.10 2002 -30.00 2003 6.33 2004 2.86 2005 7.04

Shareholder Ratios Brigham & Houston (2004) argued that shareholder ratios demonstrate the overall results of business operations so they can be compared in terms of a share of stock. There are two numbers of earnings per share reported by companies: basic and diluted. Basic earnings per share are calculated using reported earnings and the average number of share outstanding. Diluted earnings per share are computed assuming that all potentially dilutive securities are issued. The table 15 shows both the basic and diluted earnings per share ratio. Table 15 Microsofts EPS Earnings Per Share 2001 2002 2003 2004 2005

The Microsoft Corporation Basic Diluted $0.69 $0.66 $0.72 $0.70 $0.76 $1.13 $0.70 $0.69 $0.75 $1.12

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The difference between the basic and diluted earnings per share could be attributed to the use of stock options in compensation programs. Price-earnings ratio Brigham & Houston (2004) stated that the price-earnings ratio (P/E or PE ratio) is the ratio of the price per share of common stock to the earnings per share of common stock. Table 16 Microsofts P/E Ratio 2001 2002 Price/Earnings Ratio 97 71 2003 2004 40 36 2005 Industry 23 27.3 S&P 500 18.4

P/E is used to analyze the companys ability to generate cash flows in the future. The following table (MSFT, 2006) is a snapshot of top application software companies by market cap as of March 4th, 2006. Table 17 Snapshot of top application software companies Company Microsoft Corp. Oracle Corp. SAP AG Adobe Systems Inc. CA INC. Intuit Inc. Symbol MSFT ORCL SAP ADBE CA INTU Price 26.9 12.8 52.1 39.1 27 48.6 Change -0.15% -0.08% 0.85% 0.62% 0.07% 0.35% Market Cap 278.28B 66.02B 64.54B 23.42B 15.59B 8.60B P/E 22.26 23.25 35.93 32.9 76.27 21.31

The Microsoft Corporation Financial Analysis and Benchmarking

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Based on the income statement analysis from Exhibit 2, the Microsofts revenue has been growing at a rate of 13% on average every year. In this highly competitive market segment, this growth rate is solid. In fiscal year 2005, the Microsoft Corporation invested 16% of its revenue in research and development (Exhibit 3). This amount was 21% in 2004, 20% in 2003, 15% in 2002, and 17% in 2001. General and Administrative expenses show a steady increase from 3% in 2001, 5% in 2002, 8% in 2003, and all of sudden 14% in 2004! This is due to legal expenses of $1.92 billion to settle the Sun Microsystems case, a $605 million fine imposed by the European Commission, and $280 million of stock-based compensation (CNN, 2006). In 2005, General and Administrative expenses were reduced to 10%. Based on Microsofts Balance Sheet (Exhibit 4), the company has $37.751 billion in cash and short-term investments. Microsoft doesnt have long term debt, but they do have short-term loans and liabilities. The fiscal year 2005, the value of Microsofts current liabilities was $22.7 billion. Although, there is an increase in short-term liabilities in 2005, Microsofts has 1.66 times the cash necessary to payoff its short-term debt without tapping to its account receivables and other assets. The working capital can be known by subtracting the current assets of $48,737 billion from the current liabilities at $22,700 billion. Therefore, the working capital is $26,037 billion. Based in Balance Sheet (Exhibit 4) there are 10,710 billion shares outstanding in 2005. So, the working capital per share is $2.41. MSN Money Central (2006) lists the Microsoft stock around $27.00.

The Microsoft Corporation In fiscal year 2005, the current ratio was 2.89 compare to 4.71 in 2004. One can see continual improvement efficiency. Specially, the Microsoft using its cash to launch new operation system named Vista and planned to be released for consumer market in 2007.

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In term of quick ratio as of year 2005, Microsoft has $2.86 in current assets for every $1 in liabilities. This is a good financial position. But, the quick ratio has deteriorated in year 2004 from 4.69 to 2.86 in year 2005. Direct Competition Comparison Microsoft is in direct competition with many high technology companies. This is due to the vast products and services that Microsoft is developing for many segments of activities. MSFT (2006) indicated in table 18 some of the major direct competitors of Microsoft. Table 18 Microsofts Direct Competition Microsoft Market Cap: Employees: Quarterly Revenue Growth: Revenue: Gross Margin: EBITDA: Operational Margins: Net Income: EPS: P/E: PEG (5 yr expected): 289.43B 61,000 6.00% 40.34B 85.01% 17.95B 42.19% 12.87B 1.184 22.96 1.67 Google 137.80B 3,021 95.90% 5.25B 57.15% 2.24B 33.93% 1.30B 4.514 103.29 2.67 IBM 131.37B 348,052 -7.80% 94.38B 39.17% 18.48B 14.14% 8.57B 5.160 16.12 1.48 Oracle 64.58B 49,872 19.40% 12.89B 76.83% 5.01B 33.62% 2.88B 0.550 22.75 1.38

The Microsoft Corporation P/S: 7.16 26.10 1.40 5.01

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Microsoft is ranked number one in term of sales and its net income is the highest. The future financial growth seems to be strong. Microsoft is subject to fierce competition not only from its arch commercial rivals such as IBM, Oracle, Sun Microsystems, but also from noncommercial software developers. These companies are developing open source software at nominal cost and earn their revenue by providing software customization or service support. A good example of this open source software is the operating system Linux. Another example is Open Office which can be used to replace Microsoft Office Productivity Suites. Microsofts own success has become a handicap, since many hackers are focusing their attentions to break into Microsoft software products causing security issues. Microsoft is using its intellectual capital as a competitive advantage to respond to these threats. The introduction of new generation of 64 bits operating system called Windows Vista is scheduled to be offered to the public for the fiscal year 2007 (Microsoft 2006). Foley (2006) reported that on February 2006, Microsoft has invited hundreds of Technology Adoption Partners to come to the Redmond for the beta testing of Windows Vista. Microsoft is releasing in 2006 major updates of several products including new version of its database management system called SQL Server, an integrated software development environment called Visual Studio, and a middle ware called Biz Talk Server. Microsoft is preparing to introduce new wave of products, code named Office 12, to be released during the first half of fiscal year 2007 (Microsoft 2006). Microsoft Business Solutions has already released a major product upgrade for Microsoft CRM version 3.0 to address the needs of small and mid-size firms to manage their customers

The Microsoft Corporation relationship and marketing efforts. Other enhancements include products such as Microsoft Axapta, Microsoft Great Plains, Microsoft Navision and Microsoft Solomon (Microsoft 2006). In 2006, Microsoft Mobile and Embedded Devices division expects to release added

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functionality to the Windows Mobile 5.0 platform through the Microsoft Enterprise Feature Pack and the Extended Service Pack 2. (Microsoft, 2006, p.10) Microsoft Xbox went through a major upgrade in May 2005 and it will be introduced in the first half of 2006 in European Market (Microsoft 2006). Recommendations Microsofts current stock pricing levels appears slightly undervalued compare to its peers. It is recommended, based on current data and future expectations for growth, to buy this stock or at least to hold for future upside. But, it is important to notice that Microsoft is no longer the prototypical growth stock. The shares are 47% below their all-time-high reached in the year 1999. This year stock price is around $27 and profits are continuing to grow. The yearahead earnings are $1.43 per share. The balance sheet includes $4 per share in cash. There is expectation of 13% earnings growth this year. In term of new products offering, Microsoft is marketing its Xbox 360 game player in US and Europe, the Windows Vista and new Microsoft Office products are in beta release and will be ready for mass market in 2007. Business Week (2005) listed the Microsoft Corporation brand as number two in its top 100 brands just behind Coca Cola. This brand recognition is due to the Microsoft Corporation management philosophy which is centered on the innovation and forward looking business strategy by designing new products and services using their strong market position on Windows platforms. Their competitive advantage is a source of litigation by other software development companies and ongoing governments scrutiny in United States and European Union. But, Microsoft is fighting back and tried to settle most of these litigations out of the court. This has a direct impact on their

The Microsoft Corporation

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net income and profitability. With the anticipated release of Windows Vista in 2007, we could expect higher earnings momentum. Conclusion Microsoft carries a positive rating. Based on ratio analysis and benchmarking with its competitors, the current valuation of stock seems undervalued. There is a potential for future growth, thus holding on Microsoft stock is very attractive in any portfolio. A target price of $29 per share is reasonable and we highly recommend buying it.

The Microsoft Corporation

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References Big Charts (2006). Microsoft Corporation Stock Price Movements form 2001 to 2005. Retrieved March 2, 2005, From http://bigcharts.marketwatch.com/intchart/frames/frames.asp?symb=msft&time=&freq= Brigham, E. F., & Houston, J. F. (2004). Fundamentals of Financial Management (4th ed.) Mason: Thomson. Business Week (2005). The 100 top brands. Business Week, 8/1/2005, 3945, p. 90-94. CNN (2006). Microsoft Stock Quote Report. Retrieved February 4, 2006 from http://money.cnn.com/quote/quote.html?symb=MSFT. Foley, M. J. (2006). Vista coming into focus. Retrieved February 4, 2006 from http://www.eweek.com/article2/0,1759,1928056,00.asp. MSFT (2006). Retrieved February 4, 2006 from http://finance.yahoo.com/q?s=MSFT. Microsoft (2006). 2005 Microsoft Annual Report, retrieved February 28, 2006 from http://www.microsoft.com/msft/ar.mspx. MSN Money Central (2006). MSFT Chart, Retrieved February 4, 2006 from http://moneycentral.msn.com/investor/charts/chartdl.asp?Symbol=MSFT.

The Microsoft Corporation Exhibit 1- Microsoft Corporation Income Statement (In million except per share data) INCOME STATEMENT Revenue Operating Expenses: Cost of revenue Research & development Sales & marketing General & administrative Total Operating Expenses Operating Income Investment income/ (loss) and other Income before income and taxes Provision for income taxes Income before accounting change Effect of accounting change Net Income Earning per share: Basic Diluted Weighted average shares outstanding: Basic Diluted Dividends per share Book value per share Cash flow per share 2001 $25,296 $3,455 $4,379 $4,885 $857 $13,576 $11,720 ($195) $11,525 $3,804 $7,721 ($375) $7,346 2002 $28,365 $5,191 $4,307 $5,407 $1,550 $16,455 $11,910 ($397) $11,513 $3,684 $7,829 $0 $7,829 2003 $32,187 $6,059 $6,595 $7,562 $2,426 $22,642 $9,545 $1,509 $11,054 $3,523 $7,531 $0 $7,531 2004 $36,835 $6,716 $7,779 $8,309 $4,997

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2005 $39,788 $6,200 $6,184 $8,677 $4,166

$27,801 $25,227 $9,034 $14,561 $3,162 $12,196 $4,028 $8,168 $0 $8,168 $2,067 $16,628 $4,374 $12,254 $0 $12,254

$0.69 $0.66

$0.72 $0.70

$0.70 $0.69

$0.76 $0.75

$1.13 $1.12

10,683 11,148 $0 $4.43 $0.83

10,811 11,106 $0 $4.83 $0.82

10,723 10,882 $0.08 $6.05 $0.83

10,803 10,894 $0.16 $6.93 $0.87

10,839 10,906 $3.33 $4.44 $1.21

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Exhibit 2 Microsoft Corporation Income Statement Percentage of Change INCOME STATEMENT Revenue Operating Expenses: Cost of revenue Research & development Sales & marketing General & administrative Total Operating Expenses Operating Income Investment income/ (loss) and other Income before income and taxes Provision for income taxes Income before accounting change Effect of accounting change Net Income Earning per share: Basic Diluted Weighted average shares outstanding: Basic Diluted 6.17% -3.96% 7.80% 33.34% 10.84% From From From From Average 2001 to 2002 to 2003 to 2004 to 2002 2003 2004 2005 10.82% 11.87% 12.62% 7.42% 10.68% 33.44% -1.67% 9.65% 44.71% 17.50% 1.60% 50.88% -0.10% -3.26% 1.38% 14.33% 34.69% 28.50% 36.11% 27.33% -24.78% 126.31% -4.15% -4.57% -3.96% 9.78% 15.22% 8.99% 51.45% 18.56% -5.66% 52.28% 9.36% 12.54% 7.80% -8.32% -25.79% 4.24% -19.95% -10.20% 37.96% -52.98% 26.65% 7.91% 33.34% 12.31% 5.61% 12.85% 28.08% 13.29% 2.28% 44.12% 7.94% 3.16% 9.64%

4.17% 5.71%

-2.86% -1.45%

7.89% 8.00%

32.74% 33.04%

10.49% 11.33%

1.18% -0.38%

-0.82% -2.06%

0.74% 0.11%

0.33% 0.11%

0.36% -0.55%

The Microsoft Corporation Exhibit 3 Microsoft Corporation Common Size Income Statement INCOME STATEMENT Revenue Operating Expenses: Cost of revenue Research and development Sales & marketing General & administrative Total Operating Expenses Operating Income Investment income /(loss) and other Income before income and taxes Provision for income taxes Income before accounting change Effect of accounting change Net Income 2001 100% 14% 17% 19% 3% 54% 46% -1% 46% 15% 31% -1% 29% 2002 100% 18% 15% 19% 5% 58% 42% -1% 41% 13% 28% 0% 28% 2003 100% 19% 20% 23% 8% 70% 30% 5% 34% 11% 23% 0% 23% 2004 100% 18% 21% 23% 14% 75% 25% 9% 33% 11% 22% 0% 22% 2005 100% 16% 16% 22% 10% 63% 37% 5% 42% 11% 31% 0% 31%

26

The Microsoft Corporation Exhibit 4 Microsoft Corporation Balance Sheet (In millions) BALANCE SHEET Current Assets: Cash and Short Term Investments Total Receivables, Net Total Inventory Other Current Assets, Total Total Current Assets Property/Plant/Equipment, Total - Net Goodwill, Net Intangibles, Net Long Term Investments Other Long Term Assets, Total Total Assets Current Liabilities: Accounts Payable Accrued Expenses Other Current Liabilities Total Current Liabilities Deferred Expenses Other Liabilities, Total Total Liabilities Common Stock, Total Retained Earnings (Accumulated Deficit) Total Equity Total Liabs. & Stockholders' Equity Total common Share Outstanding 2001 $31,600 $3,671 $83 $3,856 $39,210 $2,309 $1,511 $401 $14,361 $1,038 $58,830 2001 $1,188 $742 $7,324 $9,254 $409 $1,878 $11,541 $28,390 $18,899 $47,289 $58,830 10,766 2002 $38,652 $5,129 $673 $4,122 $48,576 $2,268 $1,426 $243 $14,191 $942 $67,646 2002 $1,208 $1,145 $10,391 $12,744 $398 $2,324 $15,466 $31,647 $20,533 $52,180 $67,646 10,718 2003 $49,048 $5,196 $640 $4,089 $58,973 $2,223 $3,128 $384 $13,692 $3,332 $81,732 2003 $1,573 $1,416 $10,985 $13,974 N/A $2,846 $16,820 $49,234 $15,678 $64,912 $81,732 10,771 2004 $60,592 $5,890 $421 $3,663 $70,566 $2,326 $3,115 $569 $12,210 $5,582 $94,368 2004 $1,717 $1,339 $11,913 $14,969 N/A $4,574 $19,543 $56,396

27

2005 $37,751 $7,180 $491 $3,315 $48,737 $2,346 $3,309 $499 $11,004 $4,920 $70,815 2005 $2,086 $1,662 $13,129 $16,877 N/A $5,823 $22,700 $60,413

$18,429 ($12,298) $74,825 $94,368 10,862 $48,115 $70,815 10,710

The Microsoft Corporation Exhibit 5 Microsoft Corporation Balance Sheet (Percent of Assets) BALANCE SHEET Current Assets: Cash and Short Term Investments Total Receivables, Net Total Inventory Other Current Assets, Total Total Current Assets Property/Plant/Equipment Total - Net Goodwill, Net Intangibles, Net Long Term Investments Other Long Term Assets, Total Total Assets Current Liabilities: Accounts Payable Accrued Expenses Other Current Liabilities Total Current Liabilities Deferred Expenses Other Liabilities, Total Total Liabilities Common Stock, Total Retained Earnings (Accumulated Deficit) Total Equity Total Liabs. & Stockholders' Equity 2001 2002 2003 2004 2005

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53.7% 6.2% 0.1% 6.6% 66.6% 3.9% 2.6% 0.7% 24.4% 1.8% 100.0% 2001 2.0% 1.3% 12.4% 15.7% 0.7% 3.2% 19.6% 48.3% 32.1% 80.4% 100.0%

57.1% 7.6% 1.0% 6.1% 71.8% 3.4% 2.1% 0.4% 21.0% 1.4% 100.0% 2002 1.8% 1.7% 15.4% 18.8% 0.6% 3.4% 22.9% 46.8% 30.4% 77.1% 100.0%

60.0% 6.4% 0.8% 5.0% 72.2% 2.7% 3.8% 0.5% 16.8% 4.1%

64.2% 6.2% 0.4% 3.9% 74.8% 2.5% 3.3% 0.6% 12.9% 5.9%

53.3% 10.1% 0.7% 4.7% 68.8% 3.3% 4.7% 0.7% 15.5% 6.9%

100.0% 100.0% 100.0% 2003 1.9% 1.7% 13.4% 17.1% N/A 3.5% 20.6% 60.2% 19.2% 79.4% 2004 1.8% 1.4% 12.6% 15.9% N/A 4.8% 20.7% 59.8% 19.5% 79.3% 2005 2.9% 2.3% 18.5% 23.8% N/A 8.2% 32.1% 85.3% -17.4% 67.9%

100.0% 100.0% 100.0%

The Microsoft Corporation Exhibit 6 Microsoft Corporation Statement of Cash Flows (In millions) CASH FLOW FROM OPERATING ACTIVITIES Net Profit After Taxes Cumulative effect of accounting change, net of tax Depreciation Stock-based compensation Net recognized (gains)/losses on investments Stock option income tax benefits Deferred income taxes Unearned revenue Recognition of unearned revenue Account receivable Other current assets Other long-term assets Other current liabilities Other long-term liabilities Net Cash Flow from Operations Financing Common stock issued Common stock repurchased Repurchase of put warrants Common stock cash dividends Other Net cash used for financing Investing Additions to property and equipment Acquisitions of companies, net of cash required Purchase of investments Maturities of investments Sales of investments Net cash used for investing Net change in cash and equivalents

29

2001 $7,346 $375 $1,536 $0 $2,221 $2,066 ($420) $6,970 ($6,369) ($418) ($482) ($330) $774 $153 $13,422

2002 $7,829 $0 $1,084 $2,424 $1,596 ($416) $11,152 ($8,929) ($1,623) ($264) ($9) $1,449 $216 $14,509

2003 $7,531 $0 $1,393 $3,749 $380 $1,365 ($894) $12,519 ($11,292) $187 $412 ($28) $35 $440 $15,797

2004 $8,168 $0 $1,186 $5,734 ($1,296) $1,100 ($1,479) $11,777 ($12,527) ($687) $478 $34 $2,063 $75 $14,626

2005 $12,254 $0 $855 $2,448 ($527) $668 ($179) $13,831 ($12,919) ($1,243) ($245) $21 $396 $1,245 $16,605

1,620 ($6,074) ($1,367) $0 $235 ($5,586)

1,497 ($6,069) $0 $0 $0 ($4,572)

2,120 ($6,486) $0 ($857) 0 ($5,223)

2,748 ($3,383) $0 ($1,729) 0 ($2,364)

3,109 ($8,057) $0 ($36,112) ($18) ($41,078)

($1,103) $0 ($66,346) $5,867 $52,848 ($8,734) ($898)

($770) $0 ($89,386) $8,654 $70,657 ($10,845) ($908)

($891) ($1,063) ($91,869) $9,205 $77,123 ($7,495) $3,079

($1,109) ($4) ($95,005) $5,561 $87,215 ($3,342) $8,920

($812) ($207) ($68,045) $29,153 $54,938 $15,027 ($9,446)

The Microsoft Corporation

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Effect of exchange rates on cash and equivalents Cash and equivalents, beginning of period Cash and equivalents, end of period

($26) 4846 $3,922

$2 3922 $3,016

$61 2217 $5,357

$27 5357 $14,304

($7) 14304 $4,851

Exhibit 7 Microsoft Corporation Ratio Analysis 2001 4.24 4.23 41.63 52.97 0.43 0.20 0.04 -60.10 86.34% 46.33% 29.04% 12.49% 15.53% $0.68 6.21 2002 3.81 3.76 7.71 66.00 0.42 0.23 0.04 -30.00 81.70% 41.99% 27.60% 11.57% 15.00% $0.73 5.22 2003 4.22 4.17 9.47 58.92 0.39 0.21 0.04 6.33 81.18% 29.65% 23.40% 9.21% 11.60% $0.70 6.04 2004 4.71 4.69 15.95 58.36 0.39 0.21 0.06 2.86 81.77% 24.53% 22.17% 8.66% 10.92% $0.75 6.27 2005 2.89 2.86 12.63 65.87 0.56 0.32 0.12 7.04 84.42% 36.60% 30.80% 17.30% 25.47% $1.14 2.52

Current Ratio Quick Ratio Inventory Turnover Average Collection Period Total Asset Turnover Debt Ratio Debt-to-Equity Times Interest Earned Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Total Assets (ROA) Return on Equity (ROE) Earnings Per Share Price/Earnings Ratio