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Microsoft: A Dip That Delights?


Microsoft's stock has shown a peculiar pattern the past few years of trading up one year and down the next. In 1999 it surged, in 2000 it staggered. In 2001 it climbed, and so far in 2002, it's stumbling once again -- from a high of $67 to the current $51. In fact, Microsoft (MSFT) isn't all that much above its late-2000 low of $43. To some investors, the see-saw pattern is a reflection of just how cyclical the technology sector has become. But to an increasing number of analysts, the recent slump is a buying opportunity.

"Microsoft is near a three-year low due to the tech sell-off, which I consider something of a gift," says Banc of America Securities analyst Bob Austrian, who initiated coverage on Apr. 30 with a buy rating. With a price-earnings ratio of 29, Microsoft is trading at roughly the same multiple as the market, "yet it's much better positioned than your average software stock, or your average stock in general," he says.

At current levels, Patrick Adams, president of Choice Investment Management, sees Microsoft as a fairly low-risk investment. He considers its current legal tangles a "nonevent" for the long term. Given its impeccable balance sheet, $40 billion cash hoard, and lock on the PC software business, Micosoft "has such a great franchise that it can't help but be successful," he says.

SLOWING ENGINE. Its shares have been dragged down along with the rest of the tech sector by fears that the slump in information-technology spending -- especially sales of business software -- will continue for years, not months. Even if tech spending picks up in 2002's second half as most analysts expect, there's no debating the fact that the PC market -- Microsoft's growth engine in the '90s -- is mature.

Wall Street has been betting on Gates & Co.'s push into industrial-strength operating systems for corporate servers to be its next source of growth. But with businesses remaining remarkably stingy with IT budgets, growth on the enterprise side hasn't been stellar.

Even weak growth is impressive in today's tech climate

Microsoft's third-quarter earnings report, issued Apr.18, was muddy. While the company hinted at an imminent uptick in PC sales and posted strong gains in deferred revenues (from long-term licensing deals that are paid over time), its Xbox sales disappointed the market, and it lowered its guidance for the current quarter and next fiscal year, which ends in June, 2003. Next year, analysts expect 13% growth in revenues, to $32 billion, but only 5% growth in profits as the sales mix shifts to lower-margin businesses.

That explains the recent slide in Microsoft's shares. But it's worth pointing out that in the current tech environment, even weak growth is darn good. Merrill Lynch projects Microsoft's 2003 fiscal year operating earnings will come in at $13.6 billion ($1.92 a share) vs. $12.6 billion ($1.84 a share) in fiscal 2002. Austrian points out that Microsoft's sales to corporations grew 15% in the recent quarter even as most business software companies posted steep declines.

CONFLICTING TRENDS. "It hasn't been gangbusters, but it's a profitable area, and it has been growing," he says of Microsoft's sales to companies. Underscoring the conflicting trends, on Apr. 19 Merrill Lynch analyst Christopher Shilakes raised his rating on the stock to buy even as he cut his earnings forecasts.

Given the middling near-term outlook, the best argument for buying Microsoft now may be the innovations it will introduce later. Indeed, it's generating free cash flow of about $800 million a month and pouring cash into research and development.

"Microsoft has become in many ways like a utility with a really big venture-capital fund," says Brendan Barnicle, an analyst with Pacific Crest Securities. Its dominance of the PC software business is the utility part, while its new investments are comparable to venture capital. "The stock gives investors a way to play the cutting edge of technology while still having the security of earnings," Barnicle says.

"BIT OF VISION." Banc of America's Austrian is enthusiastic about Microsoft because of its role in what he calls the "nascent market for intelligent devices." He estimates that the market for all current electronic equipment, including handheld computers, cell phones, DVD players, and set-top boxes, is $200 billion a year -- roughly equal to the PC market. Microsoft is aggressively entering those markets with many kinds of software -- operating systems, applications, and development tools. "Everything from cell phones to video cameras to VCRs is becoming more PC-like daily," observes Austrian.

True, Microsoft's vision for bringing to market a new generation of "smart display devices" (wireless tablet PCs and the like) as well as its dot-Net framework for creating new kinds of linked Web applications are amorphous and immature. "You have to put a little bit of vision to work, or wait until Christmas this year or next to really see it unfold before your eyes," says Austrian.

So maybe investors who don't think Microsoft has the talent or the muscle to deliver on its vision for the wireless and Web-enabled future should pass on the stock. Because without a strategy for growth, Microsoft will become a clumsy giant, fighting to protect its traditional markets and battling its way into businesses where competition is already tough.

For investors who think the New Economy is napping -- not dead -- and still consider the Net and e-commerce the wave of the future, the current lull could be an opportunity. Microsoft has the financial strength to fund innovation at a time when few technology leaders can. The stock may have further to fall if the IT slump endures. Yet it remains an article of faith on Wall Street that buying Microsoft on the dips is one of the safest bets around. By Amey Stone in New York


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