Dont underestimate Microsofts Potential


  Recent Price
  P/E Ratio
  Shares (millions)
  Long-Term Debt as % of Capital
  52-Week Price Range
$36.72 - $17.50

Microsoft ($20; NASDAQ: MSFT) shares haven’t done much in recent years, but the company’s size, market power, and far-reaching business model still separate it from the crowd.

The software giant generates 25% of sales from recurring contracts, which offer some defense against revenue erosion in a downturn. A strong cash position also allows the company to invest in new markets and make acquisitions during periods of economic weakness. While the company is cutting back this year, spending on research, capital projects, and acquisitions should still be substantial.

In October, Microsoft adjusted profit guidance for fiscal 2009 ending June to reflect a mild to severe recession. Microsoft’s idea of a worst-case scenario, earnings of $2.00 per share, still represents 7% growth — and at 10 times that estimate, plenty of bad news seems baked into the shares. Cash flow tumbled in the September quarter, but Wall Street expects flat per-share cash flows for the year ending June. The stock seems poised for a bounce given even a small dose of good news. Microsoft is a Buy and a Long-Term Buy.

Targeting new markets
Microsoft expects three of its five business segments to post double-digit revenue gains in fiscal 2009. While the company is best known for the Windows operating system (27% of fiscal 2008 revenue) and Office suite of business software (31%), much of its future growth is likely to come from the Internet (5%) and server-and-tools segments (22%).

Revenue from servers and tools should climb at least 14% in the December quarter, marking the unit’s 26th consecutive quarter of double-digit growth. Though the economic slump has made technology buyers more frugal, Microsoft can count on recurring sales from customers who purchase software by subscription, while others will still buy when upgrades hit the market.

Key to Microsoft’s future growth is competition with Google ($325; NASDAQ: GOOG), the Internet’s top search engine. Rumors abound that Microsoft will acquire the search business of troubled Yahoo ($13; NASDAQ: YHOO). Such a deal would immediately boost Microsoft’s search operations, but the company also has other options.

Earlier this year, Microsoft struck deals to distribute its search toolbar on Sun Microsystems ($4; NASDAQ: JAVA) software and Hewlett-Packard ($36; NYSE: HPQ) computers. The company is also working on a deal with Verizon Wireless — outbidding Google in the process — for its first major partnership in the market for Internet searches on mobile phones.

The software company began paying a dividend in 2003, and the regular payout has risen in each of the last four years. Despite making at least 16 acquisitions and spending more than $12 billion on stock repurchases in the current calendar year, Microsoft held $20.72 billion in cash and short-term investments at the end of September. At $2.26 per share, cash represents 11% of Microsoft’s stock-market value. Excluding cash holdings, the company trades at nine times expected fiscal 2009 earnings. An annual report for Microsoft Corp. is available at One Microsoft Way, Redmond, WA 98052; (425) 882-8080;

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