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Microsoft's (MSFT) stock has languished for five years, but it might finally be a good time to buy into the world's largest software company. My argument in favor of Microsoft concerns their immediate future (2006 and 2007) more than their long-term prospects. In regard to their long-term prospects, you've probably read about the disruptive threats including the strength of the open source movement, the impact of Google (GOOG), and the tendency of globalization to push down prices by activating low-cost, high-skill programmers.

Long-term trends in software bode for greater industry fragmentation; i.e., more players but fewer gorillas. I think the headline threat is web services, which is the technical moniker for platforms that enables more collaboration, participation and on-demand functionality. In the future world of web services where the operating system is sort of invisible, it's not clear how Microsoft will dominate. The company's long-term problem is summarized nicely by Robin Miller (editor-in-chief for the Open Source Technology Group): the barriers to entry in software have fallen so low that "the age of the software monopoly is over."

But I admit to liking their near-term prospects. Aside from the lingering taste of legal problems and concerns about their sheer size, Microsoft's vast product portfolio reflects a company that still cares about innovation. They actively invest in the industry's most important trends. And boy do they spend money. Here is a chart of dollars invested in research and development (R&D) by software companies:


In the last four years, Microsoft cumulatively invested $25 billion in R&D. But here is the statistic that really makes an impression: over this time, their R&D spending averaged 17% of revenues. In percentage terms, according to my estimates, they were more devoted to research than about 2/3rds of their software peers.

Still, critics say, they horde too much cash. And let's concede that point. Microsoft holds a staggering $40 billion in cash. The quick ratio is one measure of liquidity. The quick ratio equals "cash plus near cash" (i.e., cash plus marketable securities plus accounts receivable divided by current liabilities). Microsoft's quick ratio is 2.9x. That's too high, as the average software company's quick ratio is 1.7x. The good news is that they are doing something about this – this problem that we'd all like to have. Over the last five quarters, they repurchased about $11 billion in stock. Their buyback program is ahead of schedule and in December, they increased their quarterly dividend. The company is currently paying out most of their operational cash flow in dividends and share repurchases! Below is a chart that compares historical net income to both operational cash flow (CFO) and free cash flow (CFO minus investments).


While the hockey stick in 2005 for free cash flow is an outlier-due to investment proceeds-the fundamental cash flow trend is healthy.

The best thing about Microsoft is the underlying strength of their business units. I think the individual parts may be "greater than the whole." Here is a chart of revenue and operating income for each of the reporting segments (you can click on the button to switch back and forth):


The two largest units are Client and Information Worker. These sell, respectively, Windows and Office. Sometime around the end of 2006, we will see new releases of each of these core products (i.e., Vista and code-named Office 12). For the moment, forget the question of whether we will see "features or just a facelift." Windows ships on 90+% of personal computers; performance of the Client business tracks PC sales. And sales of PCs have been surprisingly buoyant due to emerging economies and brisk notebook sales. Global unit growth in PC sales is somewhere around 15%. Price deflation works against this, of course. But still, Microsoft projects 6% to 7% revenue growth for this unit next year. Information Worker will probably see similar top-line growth. And the next upgrade to Office will move this widely deployed productivity tool closer towards it theoretical potential as an enterprise portal. I don't know if Microsoft can transform MS Excel into a gateway for business intelligence, but nobody has a better toehold on this opportunity.

Server and Tools sells SQL Server and sales for this product grew 15% last year. Growth may taper off next year but will still see double digits. In Business Solutions, Microsoft has already entered the customer relationship management (CRM) market in addition to other "vertical industry" applications like accounting. They forecast 11 to 13% growth in this segment, next year.

I am less optimistic about MSN. The business was flat because a +20% increase in advertising revenue was wiped out by a ~30% decline in internet access. And of course, Microsoft's paid search is getting trounced by Google.


Finally, with trailing 12-month trailing sales in excess of $3 billion, only at Microsoft is Home and Entertainment a small business. But this segment is growing at 50+%. You already know about the Xbox 360, but this is just part of a broader strategy by Microsoft to increase their penetration into households. If a media PC somehow displaces (in degrees) television as the household hub, then Microsoft will be well-positioned to surround this hub with other tools and applications. Devices like smartphones can connect to this hub and these "edge devices" can run applications sold by the Mobile & Embedded Devices segment. This segment is small, too, and it is not the category leader. In the market for smartphone operating systems (OS), Symbian outsells Microsoft. But it is very early in this game. According to PC Magazine, 22 million smartphones units were sold in 2004 and this jumped to over 50 million is 2005! For many users, Windows and Office are standards and Microsoft has a natural advantage in serving familiar applications to these new mobile devices.

Next year could be eventful for Microsoft shareholders. Soon, 4th quarter results (Dec 31st ends their second fiscal quarter) will be announced and Xbox will continue to attract attention with 200+ titles in development. The quarterly dividend of $0.09 complements ongoing share buybacks. We will see new releases of the two flagship product sets. Finally, look for strength especially in SQL Server, the new business applications, mobile applications and the home entertainment initiatives.

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