Last week three of the biggest tech companies in the world reported quarterly earnings. Many expected Microsoft Corporation (NASDAQ:MSFT) to report dismal earnings as the PC market suffers a rapid deterioration, but the company managed to grow both revenue and earnings. Google Inc (NASDAQ:GOOG) reported even faster growth, and the stock of both companies surged. International Business Machines Corp. (NYSE:IBM), however, wasn’t so lucky. The company reported declining revenue and profit, causing the stock to severely slump. What do these earnings mean for these three companies?
Microsoft: not as bad as expected
Going into earnings many people were expecting bad news from Microsoft. Windows 8, the recently released update of the Windows operating system, has thus far been unable to reverse a decline in demand for PCs. But Microsoft Corporation (NASDAQ:MSFT) was able to grow revenue by 18% year-over-year, or 8% adjusting for pre-sales. EPS grew by 20%, or 8% using the non-GAAP adjusted numbers.
On the adjusted basis sales for the Windows division were flat year-over-year, not great news but not terrible news either. Windows 8 has been slow to gain market share as consumers are not quite sold on the new operating system.
Businesses are notoriously slow to upgrade operating systems, with many still using Windows XP. However, on April 8, 2014 Microsoft will officially end support for Windows XP, meaning no more security updates and other support. This may be what gets many businesses to upgrade, either to Windows 7 or to Windows 8. Windows 8 market share has risen slower than its predecessor, but its important to remember that Windows 7 followed Windows Vista, which had a litany of problems and was universally despised. In contrast, Windows 8 follows an extremely popular operating system, giving much less incentive to upgrade immediately.
The server and tools division was the real stand out, with 11% revenue growth year-over-year. This division is about the same size as the Windows division, so this double-digit growth has a real impact on the company’s results.
Microsoft’s net cash position has grown to about $60 billion, or $7.15 per share. In terms of free cash flow the company has recorded $20.4 billion in the first nine months of its fiscal year, about $2 billion behind last year’s pace. If that gap remains, free cash flow for the full year, which ends in June, should be about $27 billion, or $3.20 per share. Backing out the cash Microsoft currently trades at an adjusted P/FCF ratio of just 7.45 even after the post-earnings run up.
A simple discounted cash flow calculation assuming 6% growth for the next 10 years and 3% growth after that yields a fair value range of $40 – $52 per share, using a discount rate of 12% and 15% to define the range. Microsoft Corporation (NASDAQ:MSFT) remains severely undervalued, by as much as 40%, and I believe that the pessimism surrounding the company is largely unfounded.
Google: big growth, big bets
Google Inc (NASDAQ:GOOG) grew its year-over-year revenue by 31% to $14 billion in the first quarter. Operating income grew by just 2.6% while net income grew by a much larger 15.8%. This discrepancy seems to be due to a much lower tax rate compared to a year ago, 7.9% compared to 18.5%.
Google still derives much of its revenue from advertising but is making some big, expensive bets which could pay off in the future. Google Fiber is the fiber-based internet service which Google first introduced in Kansas City and has now announced launches in Austin, TX and Provo, UT. The service will offer speeds of 1 Gbps, much faster than the standard 10 Mbps speeds offered by other ISPs. This puts Google into competition with companies like Verizon Communications Inc. (NYSE:VZ), AT&T Inc. (NYSE:T), and Time Warner Inc (NYSE:TWX), among others.
Another big project is the self-driving car. Last year the cars collectively passed the 300,000 mile mark, and so far the only accidents have been the result of human error. How long it takes for the self-driving car to become a consumer product is a big question, as legal issues and regulations will likely hold back the technology.
The most recent project announced by the company is Google Glass, a wearable computer in the form of eyeglasses. Google Glass, if successful, could mark a shift in the way people use computers. The smart phone and tablet shifted us towards a more mobile experience away from the traditional PC, and Glass could shift us yet again away from those devices. Of course, this is all a big “if.”
In terms of the financials, Google Inc (NASDAQ:GOOG) has a $45 billion pile of net cash. This works out to $133 per share, 16.7% of the total market capitalization. The free cash flow in 2012 was $13.3 billion, or $41.30 per share. Backing out the cash the stock trades at an adjusted P/FCF ratio of 16.2. With capital expenditures on the rise free cash flow may be pressured in the near future, so the forward ratio is probably a bit higher.
Valuing Google is difficult because they have so many projects which could be huge. Using a 12% discount rate Google Inc (NASDAQ:GOOG) must grow FCF at an annual rate of about 8% over the next decade for the stock to be fairly valued today. Although this doesn’t seem unreasonable, Q1 saw a much slower rise if the effect of the tax rate is removed. So it really comes down to the success of the large investments made in these projects.
IBM: weakness and opportunity
IBM is Warren Buffett’s latest big stock investment, having bought over $10 billion worth by late 2011. IBM stock reached a high of $215 recently, well above the average purchase price of Buffett, but after the most recent earnings report has plummeted to around $190 per share.
What caused this huge drop? Revenue fell 5%, net income fell 1%, and EPS grew 3% driven mainly by share buybacks. Hardware sales were down 17% year-over-year, causing much of the decline. Now there’s talk of IBM selling its low-end server division to Lenovo, the buyer of its PC division back in 2004. Selling its PC division proved prescient, and IBM has generally been good at shedding its low-margin businesses to focus on its high-margin businesses.
At the same time as all of this IBM reiterated its full year EPS estimate of at least $15.53. That would represent 8% growth from 2012, at least partially driven by share buybacks. IBM had reduced its share count by 16% since 2008, spending a total of $60 billion during that time on share buybacks.
IBM has quite a bit of debt, $17.1 billion after counting the cash, and another $20 billion in pension obligations. The debt levels have been largely flat since 2008, with the cash flow funding most of the buyback efforts. IBM only paid $459 million in interest in 2012, a very low rate given the amount of debt.
If earnings do indeed come in at $15.53 this year the forward P/E ratio is about 12.1 after the decline in the stock price. With a $15 billion free cash flow each year IBM can buy back about 7% of the company annually, providing a boost to the per-share numbers.
One disappointing quarter doesn’t mean much in the grand scheme of things. Paying 12 times forward earnings for a company like IBM is an opportunity which doesn’t come around all that often. Even while facing weakness in demand buybacks can drive growth going forward. If you’ve been wanting to buy IBM, now is the time.
The article Big Tech, Big Earnings, Big Opportunity originally appeared on Fool.com.
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