http://www.businessweek.com/stories/2001-10-24/microsofts-staying-power-on-the-street

Microsoft's Staying Power on the Street


By Amey Stone The launch of Windows XP, Microsoft's most significant upgrade of its personal computer operating system since Windows 95, is sure to create plenty of interest among investors, consumers, and corporate customers. Microsoft (MSFT) shares already have risen in recent weeks in anticipation of the Oct. 25 debut.

Investors got a taste of what's to come on Oct. 24, when Bill Gates "opened" the Nasdaq (since it's an electronic exchange, that just means he attended a ceremony at the Nasdaq MarketSite in New York City that morning). The reason? To celebrate 15 years of Microsoft's trading on the exchange -- and, of course, to hail XP's imminent arrival. "The company is going to have a lot of perceived good news coming out," says Michael Davey, technology analyst with Investec Ernst. "That's going to get people excited about its prospects."

Even if the excitement reaches fever pitch, XP isn't the main reason the stock has jumped from just $48 less than a month ago to its current $61 -- a 27% rise. Nor should it be. Investors are buying Microsoft because it's a good stock to own in turbulent times. The shares aren't cheap -- especially given their recent gains -- but with $36 billion in cash, the company is about as solid as you can get for a tech name these days. "I can sleep very well at night with Microsoft in our portfolio," says David Brady, portfolio manager at Stein Roe Mutual Funds.

"IT'S WONDERFUL." Microsoft's staying power makes it more than just a haven. Jeffrey Van Harte, who runs the Transamerica Premier Equity Fund, has increased his stake this year because he believes the company will ultimately use tough times to gain market share and enter new markets. "It's wonderful when you're in a downturn to have a balance sheet like this, because you can do things that other competitors couldn't do," he says.

Not only does Bill Gates have cash galore to spend on promoting XP but he can also easily afford the initial costs of entering the videogame market, which Microsoft will do on Nov. 15 with its launch of its Xbox gaming system.

Microsoft isn't immune to the problems facing the tech sector and the broader economy, however. Its latest earnings report, on Oct. 18, was far from pristine. The company absorbed a hefty $1.24 billion charge because of losses on its cable and telecom investments -- after taking nearly a $4 billion write-down of investments in its June quarter. It also said it wouldn't meet earlier revenue and earnings targets for its 2002 fiscal year.

The main point Stein Roe's Brady took from the quarterly report, though, is that Microsoft was able to increase its sales and operating earnings during a major downturn in the PC industry. In the difficult quarter ended Sept. 30, Microsoft managed a moderate 4% gain in operating earnings, to $2.9 billion (not counting the investment losses), and an impressive 6% increase in sales, to $6.1 billion.

MODEST RETREAT. Meanwhile, Microsoft's warning that it won't meet Wall Street's expectations for the remainder of 2002 surprised no one, given the weakening economy and the company's history of providing cautious future guidance. Analysts ratcheted back their estimates a bit for the December quarter and the rest of fiscal 2002, which ends in June, 2002 -- but didn't complain much about having to so.

"The reduction was modest under the circumstances," Merrill Lynch analyst Henry Blodget noted in his Oct. 19 report on the quarter, in which he cut Microsoft's full year per-share earnings target to $1.83, from $1.87. That's partly because many analysts believe that the company will be able to exceed its new targets. "I think they are set up quite nicely to grow and to beat investor expectations," says Brady.

That doesn't mean Microsoft will return to its blistering growth pace of the '90s any time soon. Even with some surprising strength in its other products, including server sales, Windows 2000 (the corporate-strength OS), and Internet service MSN, analysts are looking for at best 12% to 15% earnings growth, vs. 40% annual growth in the mid-1990s. That makes the stock, which has a price-earnings ratio of 31 based on projected earnings for the 2002 calendar year, look pretty pricey relative to its earnings growth rate, as well as the broader market.

BEING REALISTIC. Weak PC sales aren't going to help. Management itself noted in a conference call following the earnings announcement that the PC market is extremely weak. Microsoft now thinks PC unit growth will be flat or down slightly through next June, vs. an earlier hopes for about 5% growth in unit sales, according to Blodget.

In short, analysts are trying to be realistic about the outlook for XP, hoping that it will have a slow but steady adoption rate over the next year. "The days of people upgrading just because of some new operating system are pretty much behind us," says Investec's Davey. Still, he thinks XP is debuting at a time when many users who last upgraded their PC in advance of Y2K are ready for a new machine. The fact that PC prices are plummeting should also help to put a floor under demand for both computers and XP.

XP's impact on Microsoft's bottom line won't be significant at first, "but ultimately it will be," Van Harte says. "That isn't going to really happen until we get the consumer and the economy to come back, but we will see adoption rates that will surprise people."

For long-term investors, that could make the present a pretty good time to get in, even though better opportunities to buy Microsoft may arise if the market suffers more shocks. "The p-e ratio at this level is at the upper limit of what you want to pay," cautions Davey. He also urges investors to keep in mind that Microsoft is "going to be more of a stable growth stock than a tech high-flyer." For weary tech investors, even that may sound pretty good right now. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.

Questions or comments? Join in the discussion at our Ask Amey Stone interactive forum


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