Online Extra: Microsoft: A Retuned Cash Machine

The question now: Is the software giant's stock becoming too rich? The surprising answer: Maybe not

Microsoft (MSFT ) shareholders can't complain this year. The stock fell 62% in 2000, mostly because of the Justice Dept.'s move to split up the company and because of its ties to the slowing PC business. But so far in 2001, it's up nearly 60% -- having emerged as a safe harbor in the tech storm.

Not only did it manage to increase sales to $6.47 billion, up 14% over the same quarter last year, but investors have all but ruled out the chances that it will be split up. The software giant produced $4 billion in free cash flow from operations in its recent quarter and now has more than $30 billion in cash and short-term investments, making it the picture of financial strength. Microsoft's recent strong quarter proved to investors that its PC-related businesses are still a cash cow, while also showing that its newer, faster-growth units are gaining traction.

NOT INSPIRING. Indeed, the news out of Microsoft has been so good lately that the stock's only major flaw is that it's starting to look rather pricey relative to its moderate earnings growth. Analysts expect 10% to 15% earnings growth long term. That's great for a tech business in the current environment but not that inspiring given that Microsoft trades at about 35 times estimates for fiscal 2002 earnings. (The S&P 500 has a forward p-e of 21).

Microsoft's revenues should grow faster than its earnings. But as the high-margin PC-related businesses make up a smaller percentage of sales, its profit margins are slipping. "We prefer to focus on absolute operating income and absolute profit growth," CFO John Connors told analysts during the conference call following the Apr. 19 earnings release.

Investors who thought the stock was undervalued early in the year now say it's priced just about right. "I think it has recovered nicely from an undervalued situation," says Michael J. Davey, technology analyst at Investec Ernst & Co. Merrill Lynch analyst Henry Blodget wrote in an Apr. 20 report that he sees "potential for modest revenue acceleration and strong performance vs. other IT bellwethers," but long term, he believes that "valuation remains an issue."

That's no reason to sell, but it makes buying now a tougher call. The stock might not have much further to rise and may fall on bad news. Indeed, on Apr. 27, it dropped $2, or about 3%, on rumors that its new consumer operating system, Windows XP, could be delayed until later this year.

TOO-MODEST PROJECTION? That said, a strong bull case can still be made for buying Microsoft now. Many investors believe the company will surprise Wall Street with faster growth next year. "While the stock is definitely beginning to look a little expensive here based on current projected earnings, I think projected earnings could be understated," says David Brady, portfolio manager at Stein Roe Funds. "Actual earnings could be as much as 10% greater over the next four quarters than what we're currently seeing."

When you subtract the $47 billion in cash and equity investments from Microsoft's $370 billion market cap, the stock is trading only at about 20 times pretax earnings, says Jeffrey Van Harte, portfolio manager at Transamerica Premier Funds. "That's not a bad number to pay for a company that's growing 10% to 15% and has an absolute dominant share of the computer operating system and applications business," he says.

The real wild card for its PC business is whether its new business operating system, Windows 2000, and consumer system Windows XP will be dramatic enough improvements to spark an upgrade cycle. Brady thinks companies will start spending on upgrades in the next three to six months, and it will really pick up in 9 to 12 months. Van Harte calls both XP and 2000 "major catalysts for growth."

Microsoft is cautious. During the recent conference call with analysts, CFO Connors was optimistic about business spending but conceded a lot would depend on the economy. Given that Microsoft hasn't finished Windows XP and expects only high single-digit PC unit growth worldwide, he said it was "premature" to comment on the new operating systems' effect on the upgrade cycle.

LONG-TERM STAR. Even if the PC business doesn't rebound significantly, Microsoft fans point to the success of its software products for computer servers, handheld devices, and video games. Davey says he's newly impressed with the software giant's Internet portal/ISP, MSN, which managed to add 1 million subscribers in the recent quarter and posted double-digit advertising revenue growth despite a slump in that industry. It also has a new deal with Qwest Communications (QWST ) to offer high-speed Internet access to MSN subscribers that makes Davey think that MSN could be a strong second to America Online.

Brady thinks Xbox, the gaming console, and Windows XP will create excitement, even if they don't add much to earnings right away. Investors are also likely to react positively if the company settles the case with the Justice Dept., as some investors hope. Near term, Microsoft will trade along with the Nasdaq, which may not be out of the woods yet. But long term, Microsoft is a financial powerhouse with a flock of growth opportunities. For patient investors in it for the long haul, any dips could be a buying opportunity.

By Amey Stone

Edited by Douglas Harbrecht

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