Microsoft: Same as it ever was

The No. 1 software company should post decent results, but can shares break out of a 3-year rut?

April 27, 2005: 12:43 PM EDT
By Paul R. La Monica, CNN/Money senior writer

 
NEW YORK (CNN/Money) – If you succumbed to a Rip Van Winkle-like sleep in say, the middle of 2002, and just woke up today, you're probably scratching your head about what's different on the tech landscape.

MCI has suddenly become one of the most desired companies in telecom. eBay isn't the hottest Internet stock anymore. And Carly Fiorina is looking for a new job.

But fear not. Microsoft (Research) is still the most boring tech stock on the planet.

Even so, that's not to say that Microsoft -- the company -- hasn't undergone a major transformation.

After all, since the beginning of 2003, the company has begun to pay a dividend and announced a sizable stock buyback program; it has stopped giving stock options to employees; and it has made a few notable acquisitions in security software and settled many outstanding legal cases.

Still, shares have been stuck below $30 for more than three years and with fiscal third quarter results due on Thursday, it doesn't appear that the company will regain its sizzle just yet.

Wall Street does Windows
Analysts expect net income, on a GAAP basis, of 28 cents a share, according to Thomson/First Call, up sharply from profits of 12 cents a share in the same period last year.

But excluding the cost of restricted stock grants to employees and legal settlement charges, analysts are predicting pro-forma earnings of 32 cents a share, a 6 percent drop from the 34 cents per share pro-forma profit Microsoft reported a year ago.

Sales are forecast to come in at $9.8 billion, up just 7 percent from last year. For the full fiscal year, which ends in June, analysts are forecasting a revenue increase of 8 percent.

Yet, many analysts think Microsoft's stock appears to be a compelling value play, with shares trading at just 17.5 times fiscal 2006 pro-forma earnings estimates. If you subtract the company's $34.5 billion in cash, Microsoft has a P/E of 15. Plus, Microsoft's dividend yield is a solid 1.3 percent.

Wall Street is nearly unanimous in its praise for the stock, with 29 of the 32 analysts following Microsoft rating it at least a "buy." So why have shares barely budged?

Waiting for Longhorn is the hardest part
The company's problem, in part, stems from a belief that there's little reason for enthusiasm until the long-awaited update of the Windows operating system, Longhorn, comes out next year.

David Hilal, an analyst with Friedman Billings Ramsey, thinks that investors are ignoring other positive signs.

"Will the third-quarter report be a catalyst to jump start the stock? I'm not convinced of that," Hilal said. "But there are a handful of pretty interesting products coming out later this year that will tide people over until Longhorn."

Hilal cites three potential sales boosts: a new version of Windows that will be compatible with computers running on 64-bit microprocessors, the company's latest SQL Server database offering and the Xbox 2 game console.

Brendan Barnicle, an analyst with Pacific Crest Securities, added that some investors may be underestimating the impact of healthy demand for computers in the first quarter.

Dell (Research) and Hewlett-Packard (Research) both reported decent gains in PC shipments in the first quarter, according to data from tech research firm Gartner. And last week, Intel (Research), the biggest supplier of chips used in computers, reported better than expected first-quarter results.

Jamie Friedman, an analyst with Fulcrum Global Partners, said that Microsoft's Internet division, MSN, could also wind up posting stronger than expected results.

The company recently relaunched its MSN search engine to become more competitive with Yahoo! (Research) and Google (Research), which both reported extremely strong first quarter results last week. MSN is still a small part of the overall business though, accounting for about 5 percent of total sales in the second quarter.

Stuck in neutral
But despite all the good news on the horizon, shares could continue to flounder. Legal concerns haven't completely faded away, which could serve as an overhang on the stock.

The European Union, which issued a record fine against Microsoft last year for antitrust violations, said on Wednesday that it was not satisfied with steps Microsoft has taken to address competitive concerns.

And that Microsoft has been such a sluggish performer could in itself be a problem. It appears that some institutional investors are waiting for firm evidence of stronger growth before getting back into the stock. In other words, Microsoft won't head much higher until it starts heading higher.

"The stock price is just stuck. Microsoft is probably as safe a play as you can have in tech but I would like to see it break out and move before buying it again," said Craig Hodges, co-manager of the Hodges Fund, a Dallas-based mutual fund that does not own shares of Microsoft.

Barnicle agrees that investors need to be patient. Analysts expect fiscal 2006 sales to be up 9 percent from this year and he thinks the company could eventually guide Wall Street to a revenue growth rate in the double digits.

But until that happens, investors are likely to keep waiting on the sidelines. "Microsoft is not going to pop back up above $30 overnight but it's a good opportunity to buy," Barnicle said.