Microsoft's Winning Numbers

The software giant just had a great quarter and looks to be unstoppable. S&P's only concern: The stock's valuation may be high

By Jonathan Rudy

Name the date when a software company reported quarterly revenue growth of 26% over the prior year. And for good measure, earnings per share topped the consensus estimate of Wall Street analysts by a wide margin. 1998? 1999?

How about 2002? Yes, at a time of unprecedented misery in the industry, one company, Microsoft (MSFT ), was able to post these impressive results -- so reminiscent of the late 1990s' go-go days, when even small tech startups could crank out such numbers. Despite a very challenging global economic environment, the software giant posted big jumps in revenue and earnings for its fiscal first quarter ended Sept. 30. The numbers took most observers by surprise.

Yet, while it was an impressive quarter, investors didn't get ahead of themselves. After strong gains immediately following the earnings release on Oct. 17, Microsoft's share price retreated to about the same level it was just prior to the announcement. That's because part of the results' strength can be tied to some one-time events that will make this kind of performance difficult to duplicate in the future.


  Indeed, on Oct. 21, at a conference in Australia, Microsoft CEO Steve Ballmer sought to curb any excessive enthusiasm about the company's quarterly performance by saying conditions remained challenging globally for the information-technology market.

The primary one-off factor driving Microsoft's spectacular quarter was its switch to a new multiyear licensing agreement for Windows, Office, and server products, from the typical upfront, one-time arrangement. The deadline for existing customers to sign up for this pricing structure was July 31, so they had an incentive to do business with Microsoft before the deadline. The goal of the new licensing scheme is to lock customers into longer term, annuity-type contracts that provide a much steadier revenue stream.

In addition, two other events contributed to Microsoft's upside surprise: It underestimated licenses sold by computer makers such as Hewlett-Packard (HPQ ) and Dell (DELL ), and it realized a benefit from foreign currency exchange of approximately $135 million.


  These one-time factors aside, though, underlying trends in Microsoft's other businesses remain positive. Revenues in its Client segment, which represents approximately 37% of total revenues, rose 33%, primarily due to strong sales of Windows XP, the latest release of the dominant operating system.

Microsoft's server-platform sales, which account for about 20% of total revenues, were up 14%. This performance was even more impressive when compared to many competitors' double-digit percentage declines during the same quarter. Microsoft continues to take market share in the enterprise segment across the board.

Microsoft's Information Worker segment -- mainly consisting of the Office software suite -- accounted for about 29% of total revenues and increased 26% during the quarter. Office XP also benefited from the shift to the new multiyear contracts.


  The outlook is promising for Redmond's existing businesses, and at S&P, we anticipate that each of these divisions will grow at a percentage rate in the low teens for the remainder of the fiscal year. Microsoft is in the enviable position of having new growth opportunities in other businesses: Business Solutions, the MSN Internet service, the CE/Mobility division, and Home/Entertainment, which includes the Xbox video-game console. These units are small in comparison to Microsoft's Windows and Office businesses, but they demonstrate the giant's focus on diversifying its revenue stream.

Microsoft has made particular strides with MSN, highlighted by the Oct. 24 launch of its newest version, MSN 8, which overshadowed the previous week's debut of AOL 8.0. Microsoft has taken its blueprint of continuously improving its products in order to wipe out the competition to the ISP market. AOL's lead over MSN should narrow considerably over the coming years, as AOL will be hard-pressed to meet the research and marketing muscle that Microsoft can throw behind its products.

With solid results in a difficult environment, a balance sheet that now has over $40 billion in cash and short-term investments, and no debt, Microsoft continues to do what it does best: execute its business plan. So we aren't particularly worried about its underlying business.


  S&P's primary concern with Microsoft shares is valuation. While trading low compared to historical p-e levels, the shares are still at 27 times our fiscal 2003 EPS estimate of $1.93, and over 9 times estimated revenues -- a significant premium to its peer group. The market has clearly priced in the notion that Microsoft will continue to execute at the same high level.

And we have one other concern. With its entry into new product areas such as video-game consoles, profit margins (now 40%-plus net) will likely come under pressure.

Nevertheless, it's hard to bet against Gates & Co. With its existing businesses on a solid footing and promising new products and services in the pipeline, we believe that this cash-generating machine will continue to outperform the market over the next 6 to 12 months. That's why we have a rating of 4 STARS (accumulate) on Microsoft stock.

Analyst Rudy follows software stocks for Standard & Poor's

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