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Microsoft Isn't Past Its Prime

By Joseph Radigan Since the beginning of the year, Microsoft's (MSFT

; recent price: $25) stock has fallen about 5%. On May 12 the software giant showed off its Xbox 360, a new video game console scheduled for release in late November, before the start of the holiday shopping season.

The new version of the Xbox demonstrates Microsoft's continued commitment to diversifying its revenue stream, according to Jonathan Rudy, systems software analyst for Standard & Poor's. Microsoft's home/entertainment division now accounts for about 10% of its total annual revenues.

While the decline in Microsoft's stock price this year is not as large as the nearly 10% drop that has hit the information-technology sector, it repeats a pattern that has plagued the issue since the tech bubble burst.

ATTRACTIVE OPPORTUNITY. The stock has fallen in the first quarter for five of the past six calendar years. Although in both 2003 and 2004 it recovered somewhat in the second and third quarters, it has essentially traded within a band from $24 to $30 since 2002.

This uneven performance is a far cry from the 1980s and 1990s, when Microsoft's shares regularly jumped 30%, 40%, or more each year. The company went public in March, 1986, at $21. Adjusting for nine stock splits, the initial offering price was 10¢ per share, and the shares peaked at nearly $60 in December, 1999. The stock lost more than half its value in the aftermath of the tech bubble and has yet to recover fully.

The contrast between Microsoft's first 13 years as a public company and the past five years is so sharp that investors can be forgiven for thinking they missed their shot. But we at Standard & Poor's believe the software giant offers an attractive opportunity, and we strongly advise purchase of the shares.

STRONG FUNDAMENTALS. "There is still plenty of growth here," says Rudy, who has a 5-STARS (strong buy) ranking for Microsoft. "This is a company that invests in its business for the long haul." One indication of this recurring investment is the approximately $1.5 billion Microsoft spends each quarter on research and development.

Part of the stock's appeal can be credited to Microsoft's still-strong fundamentals. Rudy projects revenue growth of 8% in fiscal year 2005 (ending June) to about $39.8 billion, and estimates earnings will rise to $1.31 per share on an operating basis, compared with 75¢ (including legal charges) in fiscal 2004.

For fiscal 2006, he projects 11% revenue growth, fueled by the new version of the Xbox video game console and other new products that are likely to reach the market. He also believes long-term growth will be aided by the company's continued dominance of the personal computer market with its Windows operating system and Office application software.

FUTURE BOOSTS. Microsoft's stock has much more going for it. Since the outfit initiated a dividend in 2003, the stock now can be viewed as a total return investment and not just a vehicle for capital appreciation.

Shareholders were amply rewarded last December when Microsoft paid a special dividend of $3 per share, for a total of $32 billion. Last year the company also announced a $30 billion share repurchase program over four years.

Microsoft's indicated dividend of 32¢ per share translates to a yield of 1.3%, below the 1.9% average for the S&P 500-stock index. However, as we see it, the company has more than enough cash to give it the flexibility to boost payouts in the future.

With about 10.9 billion shares outstanding and a quarterly distribution of 8¢ per share, Microsoft is returning about $870 million to its shareholders each quarter. Even so, it added $3.1 billion in cash to its balance sheet in its most recent quarter.

CASH IS KING. Finally, Microsoft's estimated payout ratio for fiscal 2005 is 24%, vs. an estimated 29% for the S&P 500 for calendar 2005. This is a measure of the percentage of a company's earnings paid in dividends, and a lower number generally indicates a company's ability to raise its cash payments to shareholders.

Microsoft also continues to generate monthly free cash flow of about $1 billion. At the end of the March quarter the company had $37.6 billion in cash and short-term investments on its balance sheet.

"When you have that much cash, you have the flexibility to invest in the business, pay a special dividend, and buy back $30 billion of your stock," Rudy says.

AN EYE ON LINUX. Rudy also rates Microsoft highly in terms of corporate governance. S&P's 12-month target price of $33 is based primarily on

discounted cash flow analysis and implies a 30% appreciation from the current price, which alone is enough reason to like the stock.

Rudy notes that risks to his opinion and target price include a highly competitive software industry and developments in a quickly changing technology landscape, such as more rapid adoption of the Linux operating system, which he currently anticipates.

Microsoft is a component of several broad-market and technology-specific exchange traded funds (ETFs), including the iShares Goldman Sachs Software Index Fund (IGV). As of May 6, Microsoft accounted for 9.2% of this ETF's portfolio. Radigan is senior editor of Standard & Poor's weekly investing newsletter, The Outlook

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