Microsoft's Midlife Crisis

Despite its admirers' optimistic predictions, the truth can no longer be denied: The Colossus of Redmond isn't a growth company

By Alex Salkever

So Microsoft is making a big change in the way it does its books and runs its business. While the markets remained calm after CEO Steve Ballmer dropped the July 8 bomb that the software giant will scrap stock options in favor of compensating its employees with restricted stock, I suspect some rough days are ahead for the Colossus of Redmond, as the realization strikes investors that even Gates & Co., believe the outfit's glory days are over.

This much seems clear: The move won't provide much boost for the stock for the rest of the year, and it could well result in a short-term loss in value. So far, shares have stayed within a narrow band -- between $27.75 and $26.75. But remember that Microsoft (MSFT ) shares had risen 13.5% since the March earnings preannouncement. Now everyone on the Street knows that profits going forward could fall by 15% to 30% as Microsoft starts to treat the issuance of restricted stock as a balance-sheet expense, subtracted directly from the income line. Nothing in those numbers will make investors' hearts race.


  With Ballmer's announcement, Microsoft finally has acknowledged what it has long been loath to admit -- it's no longer a growth company. And the markets will react by treating its shares as they would any other staid industry giant: awarding them a lower price multiple because future sales aren't expected to shoot out the lights.

Yes, most analysts and investment strategists give Ballmer a thumbs-up for the move. They feel that cleaning out stock options will make Microsoft's performance more transparent and better align the interests of shareholders with those of employees. And over the long run, Microsoft's price could rise if stock compensation provides stronger incentives to employees to improve output (see BW Online, 7/10/03, "This May Be the End of the Options Era"). "If I were an investor I would be elated," says Albert Meyer, principal of Second Opinion Research. Still, investors should expect share declines -- or at best, for the stock to hold steady -- for at least the next two quarters.

Just look at the numbers: Microsoft generated $12.1 billion -- 88% -- of its operating income over the last three quarters from two franchises: Microsoft Office and the Windows desktop operating system. Redmond's server-software unit is the only other profitable business line, and that contributes less than one-eighth the revenues of the first two combined. Both the Office and Windows lines are closely tied to the PC sales, and the PC replacement cycle continues to lengthen. Translation? Microsoft has cash cows that produce billions each quarter. But that herd grazes on the legacy PC market. Microsoft needs new cows if it's to grow.


  Which helps explain why it has sought to shift most of its corporate customers to a subscription model, under which they pay for annual software plans or multiyear packages. Redmond doesn't break out what percentage of it revenues come from consumers as opposed to business customers, but the new model is clearly aimed at providing more regular earnings streams to please investors. Wall Street and giant pension funds have clung to Microsoft throughout the tech downturn, attracted by its regular revenues. But this strategy also underscores how little it can do to expand the overall PC market and, by extension, Microsoft's core markets. These days, its strategy is more akin to that of an insurance company than a tech dynamo.

So if it walks and talks like a mature company, shouldn't it cost the same as its counterparts in the S&P 500? By those standards, Microsoft shares look pricey right now. Thomson Financial First Call estimates that its price-earnings ratio for forward earnings in 2003 stands at 25.9. That compares to a forward p-e of 17.3 for conglomerate General Electric (GE ) and 21.7 for consumer-products dynamo Proctor & Gamble (PG ). Microsoft will need a heck of a PC rebound to justify its current p-e.

Then there are the laws of supply and demand. While Microsoft no longer will be diluting its share pool with massive stock options, most analysts figure it will also slow down or halt a share-buyback plan, in part because they anticipate Redmond will begin a more aggressive dividend payout schedule. Mighty Microsoft will no longer be supporting its own shares by taking millions of them off the table each year. On net, that could mean "less long-term price appreciation," figures Melanie Hollands, president of hedge fund Koala Capital and a longtime Microsoft bear.


  Finally, there's the compensation issue. With its employees receiving restricted stock shares in lieu of options, Microsoft will probably have to pay out more cash in salaries to keep its prized talent. That means wages at Microsoft will probably go up, cutting into bottom-line profitability. While this won't have an impact on overall revenue, it could crimp cash flow, since wages typically represent a big chunk of expenses. More cash for employees means less for shareholders, who'll be buying or holding Microsoft stock in anticipation of dividends.

Why assume these risks? At least one prominent Microsoft watcher, Portland (Ore.) money manager Bill Parish, sees a temporary-inconvenience, permanent-improvement strategy. "They're positioning themselves for a significant drop in their stock price, at which time they'll be able to buy back options at a reduced rate. [Then] they can also issue shares at a greatly reduced price to employees," says Parish.

Microsoft has declined to elaborate on to its new options policy. Surely, Ballmer would disagree with Parish's notion. But Koala's Hollands and others agree that much thought and planning seems to have gone into the announcement's timing -- and if the switch to stock from options is well executed, it could leave Microsoft with a significantly stronger foundation going forward.


  Some analysts think the market had priced in Microsoft's big shift before the announcement. And the bulls still run with the notion that a surprisingly strong tech rebound is still on tap this year and next. Standard & Poors analyst Jonathan Rudy has a 5 STARS rating on Microsoft, the highest issued by S&P.

Merrill Lynch software analyst Jason Maynard also has a buy rating and a stock-price target of $30. He believes Microsoft stands to benefit from the end of the cyclical software slump and that the market is underestimating the demand for software in the near future. His rationale: "Have you ever called a telecom company and not have them ask you to repeat information, so they can enter it into multiple screens?" Banks and telecoms account for more than one-third of all tech spending, and Maynard is sure they'll be buying.

He may be correct. But whether banks and telecoms feel the need to buy more PCs remains an open question. Further, Maynard's price target of $30 for a stock trading at around $27 and change isn't aggressive -- and it's certainly a far cry from the turbocharged appreciation rates of Microsoft's heyday.

The true test will come in the final three months of 2003, when Microsoft comes out with the hard numbers reflecting its new stock-as-compensation policy. Until then, investors may want to think long and hard before purchasing shares in Mister Softie.

Salkever is technology editor for BusinessWeek Online

Edited by Douglas Harbrecht

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