From Barrons Aug 28.
Microsoft's Best Engineering
May Be Financial
By Mark Veverka
Microsoft is world-renowned for its deep bench of engineering talent, most
notably its competent cadre of computer nerds. But some portfolio managers
are saying it's high time the green eyeshades in Redmond got recognition in
equal measure for crafty engineering of the company's income statement.
In the wake of its quarterly earnings report last month, most of the wires and
other financial scribes dutifully noted that the company's investment income
helped prop up profits during what was an otherwise flat quarter. Quarterly
earnings were up 10% on an only modest gain in revenues. No doubt, the fact
that personal computer sales are slowing and reports that sales of Windows
2000 have yet to set the world ablaze weren't lost on many.
But at the same time, few brokerage analysts, if any, have actually gone so far
as to state the obvious: Operating earnings are shrinking and perhaps Microsoft
should no longer be expected to perform as a high-octane growth stock. True,
some have downgraded their recommendations, most notably, Rick Sherlund of
Goldman Sachs, who is widely viewed as the axe on the shares.
But he and others still seem to frame their arguments in the context of the old
Microsoft, the juggernaut software stock that saw no bounds. Lawsuit or no
lawsuit, expecting Microsoft to perform as well in the era of the wireless
Internet as it did in the PC's heyday is unrealistic, at best.
To be even more caustic about it, maybe it's time to look at Microsoft as two
distinct companies. No, not in the way that Judge Jackson has decreed, but as a
software developer and as an investment company. After all, as one New York
hedge-fund analyst points out, investment income and other non-operating
profits accounted for 31% of Microsoft's pre-tax earnings for the second
quarter. That means nearly a third of Microsoft's $3.65 billion quarterly pre-tax
profit, or $1.13 billion, was generated by things other than software sales and
services.
Certainly, most investment boutiques would be thrilled to rack up a quarterly
return of that caliber, and Microsoft has progressively come to rely on its
financial engineers to pick up the slack. In fact, the company's dependence on
stock-market bets and venture-capital stakes have risen steadily over the last
eight quarters or so. Looking back to the June quarter of 1998, for example, one
finds only 10% of pretax earnings coming from sources other than operations,
compared with 31% in this year's June quarter.
Considering that analysts have yet to see evidence that Microsoft's new
computer operating system, Windows 2000, will deliver stellar revenues on a
par with its predecessors -- and that investment returns going forward aren't
likely to be as robust as they have been in the past -- the prospects for earnings
growth are less than rosy. Toss the disruption, paralysis and uncertainty of the
antitrust case into the mix, and the total revenue outlook starts to look downright
mortifying.
"As their clout decreases, and their monopoly power decreases, their leverage
over these upstart tech companies will diminish," says our hedge-fund source,
who asked not to be identified.
Put another way, Microsoft may still be overvalued at $71 a share. With
earnings projected to grow 11% to $1.88 a share in the fiscal year ending next
June, and 13% to $2.12 in fiscal 2002, Microsoft may no longer deserve the
pricey multiple it carried as the dominant technology stock for more than a
decade.
"This is a company that is growing at low teens at best. You're basically paying
a multiple of about 40 times [projected] earnings for a company whose
prospects are for annual earnings growth of 10%-13%," the bearish hedge-fund
analyst asserts.
Taking it a step further, if one wanted to peg a multiple to the non-cash and
investment portion of the business, the value of the software part of the
company would seem even more expensive, the analyst says. At the end of the
second quarter, cash and short-term investments were worth about $4.30 a
share, and equity and other investments were worth about $4.80 a share (when
assessed at 1.5 times book value), totaling $9.10 a share. Thus, when
non-operational value is subtracted from the stock price of say $71, the
operational part of Microsoft would be worth about $62 a share. That would
peg the P/E of the software and technology part of the company at 46 times
projected 2001 noninvestment operational earnings of $1.30 a share, the analyst
argues.
What's more, Microsoft is padding its profits by steadily decreasing the
effective tax rate on its books. The tax rate is expected to fall to about 33%
during fiscal 2001, nearly a four-percentage-point drop from the June quarter
two years ago. And each percentage-point drop adds another penny or two to
earnings per share. Says the hedge-fund analyst: "It's only a matter of time
before all of this catches up with them." |
