The Rating Outlook is Stable. The ratings and Outlook are supported by Microsoft’s: i) leading market share in all of its core software segments, ii) superior balance sheet with exceptional financial flexibility, particularly for acquisitions; iii) industry-leading liquidity supported by a considerable cash position and consistent free cash flow; and iv) unparalleled financial performance and operating profile, complemented by a sizable recurring revenue base. Over the intermediate term, Fitch believes there are no significant competitive threats that could materially affect the company’s dominant market share position in its core operating systems businesses.
As of June 30, 2008, Microsoft’s total liquidity was strong at $23.7 billion of cash and investments, consisting of approximately $10.3 billion of cash and cash equivalents, and $13.3 billion of short-term investments, which are invested in highly liquid, fixed-income securities. Fitch believes a significant portion of Microsoft’s cash flow is generated outside the U.S. and will represent an increasing percentage of the total cash position due to stronger growth in international markets and continued funding of share repurchases and dividends with U.S.-based cash. The company also has $6.5 billion of long-term investments, consisting of primarily public and highly liquid equity securities. Liquidity is further supported by Microsoft’s industry-leading annual free cash flow of approximately $12 billion-$14 billion and a $2.0 billion revolving credit facility maturing March 22, 2009 that serves as a back-up to the CP program. Fitch anticipates that free cash flow will continue to be utilized primarily for share repurchases and acquisitions. Microsoft has authority to repurchase $40 billion of shares prior to its expiration on Sept. 30, 2013. Fitch gains further confidence in Microsoft’s liquidity profile from the company’s historical practice to maintain a significant net cash position.
As of June 30, 2008, Microsoft had negligible outstanding debt as the company has historically relied on its free cash flow to fund share repurchases, cash dividends and modest acquisition activity. However, similar to other large technology companies with significant operations and cash balances overseas, Fitch expects Microsoft may issue long-term debt in the near term to replenish its U.S.-based cash balances in order to continue funding stock repurchases, cash dividends, or acquisitions without repatriating offshore cash subject to incremental taxes. The company’s board of directors has authorized debt financings of up to $6 billion. Fitch believes the company has financial flexibility to issue significantly more debt over the intermediate term, particularly to deal with cash location issues, as the company maintains its net cash position commitment.
Over the past several years, Microsoft has continually exhibited strong top-line growth and superior profitability. Since fiscal year 2002, annual revenue growth has increased in the mid-teens percent range, resulting in a six-year compound annual growth rate (CAGR) of 13.4%. Additionally, profitability remains robust, with EBITDA margins in the mid 40% range (excluding legal charges), and the company converts over 20% of its revenue into free cash flow. Microsoft’s best-in-class operating and financial performance is driven largely by its leading position in the consumer, small business and enterprise computing markets, led by its Windows and Vista operating systems for personal computers (PCs – approximately 90% market share) and servers (approximately 70% market share).
Although Fitch believes the company has no near term competitive or financial risks, longer-term rating concerns consist of: i) new software models that could challenge Microsoft’s highly profitable license model, including open-source software, software as a service (SaaS) or advertising-supported software; ii) gross margin pressures attributable to investments in and stronger growth of emerging markets subject to lower average selling prices (ASP); iii) substantially lower operating margins for the two non-software business segments, which represent approximately 20% of total revenues; and iv) further legal and/or regulatory actions that could impede the company’s course of business. Fitch expects higher international growth and the ongoing expansion into adjacent businesses will continue to pressure the company’s margins, but are unlikely to materially affect the company’s free cash flow.
Despite the superior financial and operating profile, the company’s strong margins have compressed moderately in recent years due to pricing pressures from higher-growth overseas markets and the growth of lower-margin online and entertainment segments, which in aggregate account for 20% of total revenue and are significantly less profitable than the core software licensing divisions. Emerging markets are approximately 14% of total revenues and growing 35% annually (compared to 10%-15% for mature markets), driven mostly by solid demand for PCs. These markets are characterized by lower price points and thus the growth may negatively affect operating margins. This is exacerbated by piracy, which, while adversely affecting U.S. revenue, has a more significant impact on revenue from outside the U.S., particularly in countries where laws are less protective of intellectual property rights.
Over the past decade Microsoft has been subject to various lawsuits alleging monopolistic practices and unfair competition, largely due to the ubiquity of its operating systems and the company’s decision to include additional software, primarily Internet Explorer, with the core operating system. While the settlements and fees that Microsoft paid in relation to these legal issues were large, Fitch views them as manageable considering the company’s significant free cash flow. The company was able to achieve solid revenue and profit growth during this time and Fitch believes future legal and regulatory interference will not have meaningful financial impact.
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