Markets & Finance

Microsoft: Scoring All Over the Ballpark


By Jonathan Rudy Despite the drubbing technology stocks have taken over the past three years -- the recent rally notwithstanding -- and the oft-delayed hopes for a recovery in information technology spending, Microsoft (MSFT) is the sector's one company that has steadily moved ahead, in our view. It wrapped up its fourth quarter of fiscal year 2003 (ended June 30) with a solid 11% growth in revenues and about 10% earnings growth, excluding one-time charges.

Revenues of $8.07 billion were better than our estimate of $7.91 billion. However, operating earnings per share of 23 cents was 1 cent below our estimate of 24 cents, mainly due to higher-than-expected marketing costs for upcoming products. Another drag on operating earnings: Microsoft settled its lawsuit with AOL Time Warner (AOL), which resulted in an aftertax charge of 5 cents per share, resulting in reported EPS of 18 cents. Nevertheless, we at S&P increased our fiscal year 2004 operating EPS estimate to $1.10, from $1.06, following this earnings release.

TAKING SHARE. Revenues from Europe, the Mideast, and Africa were up 43% year-over-year, to $1.7 billion during the quarter, helped by favorable foreign-exchange rates. (On a constant-currency basis, revenues would have increased 27% year-over-year.) Revenues from Japan and the Asia-Pacific region increased 7% year-over-year, to $835 million, also benefiting from favorable exchange rates.

In the product groups, we were particularly impressed with the 17% growth in Microsoft's server-platforms segment, to $1.9 billion for the quarter. Microsoft continues to take market share in this highly competitive enterprise market. Client revenues, primarily coming from the Windows operating system, and information-worker revenues, coming mostly from Microsoft Office, were up 4% and 8% year-over-year, respectively. Microsoft's MSN Internet service segment grew revenue 25% year-over-year, and Home and Entertainment, which includes the Xbox video console, was up 8% year-over-year.

While it wasn't a spectacular quarter, we believe that Microsoft showed another period of solid execution and progress on the legal front. It managed to increase revenue in all of its business units despite the challenging global economic environment during the past couple of years.

NO MORE OPTIONS. With the AOL Time Warner lawsuit settled, the primary outstanding legal disputes are with Sun Microsystems (SUNW) and the European Union. While it's difficult to predict an outcome for either situation, we believe that a monetary resolution, which may cost $1 billion or even $2 billion, will be the most likely scenario. Still, with more than $49 billion in short-term cash and investments, Microsoft has more than ample funds to resolve these two disputes.

On the corporate-governance front, Microsoft announced in July that it will no longer grant stock options and will issue restricted stock instead. The software maker will also begin expensing all equity compensation in the quarter ending Sept. 30. This is clearly a step forward for corporate governance for the whole industry, in our opinion, and we also believe that this plan clearly aligns the interest of Microsoft employees with long-term stockholders.

Though Microsoft is typically conservative when issuing its outlook, its forecast for fiscal year 2004 was better than we had expected -- especially considering its mid-single-digit forecast for PC unit-shipment growth. Excluding the impact of expensing equity compensation, which Microsoft will now include in its earnings releases, the software giant raised its forecast above the consensus estimate to $34.2 billion to $34.9 billion in revenues, and operating EPS in the range of $1.09 to $1.11. Our fiscal year 2004 EPS estimate is currently $1.10, and our revenue forecast is $34.6 billion.

FOLLOW THE LEADER. While Microsoft will clearly benefit from any increase in overall PC demand, it should also benefit from a recent product release and an upcoming one. Windows Server 2003 should provide a further boost to Microsoft's growing Server Platforms group. And in October, 2003, Microsoft will release its latest version of the Office application suite. Office 2003 should provide a spark for Microsoft's Information Worker segment.

In its fiscal year ended June 30, Microsoft generated about $14 billion in free cash flow -- defined as cash flow from operations minus additions to plant, property, and equipment, and acquisitions of companies. Based primarily on our discounted cash-flow analysis, we would recommend that investors continue to buy shares of this software-market and corporate-governance leader. Microsoft shares, which closed at $26.24 on Aug. 21, are trading at a notable discount to our target price of $32. Analyst Rudy follows software stocks for Standard & Poor's


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