Growth may be slowing, but MS magic kicks stock into life

And maybe the Street just needs something to feel good about...

Analysis There were some curious inconsistencies in the presentation of Microsoft's Q1 results this week. The income statement showed Q1 2001 income of $2.206 billion compared with $2.191 billion a year earlier - a very modest increase of just $15 million, or less than one per cent. But the press release claimed an 18 per cent increase because of an accounting change (SFAS 133) that Microsoft had to adopt because it is now required that all derivatives be recognised as assets or liabilities - and measured at fair value. Microsoft was not doing this, so took a hit of $375 million.

In essence, Microsoft is presenting its results in the new format while ignoring that format for marketing purposes. But perhaps the PRs are just a little bit slow.

Revenue was up 8 per cent and income up 18 per cent in Q1, compared with the year-earlier quarter. Desktop software came in at $4.02 billion compared with $3.88 billion a year ago, while desktop apps were down to $2.14 compared with $2.21 billion. Enterprise software and services tipped the scale at $1.04 billion, compared with a pro-forma $0.95 billion, showing that Microsoft's products are still appealing primarily to consumers and small business.

During the year, Microsoft repurchased $1.7 billion of its stock, which was quite a lot considering that it was prevented from doing so for nearly half the year - but the low price made this attractive. On the expenses side, operating costs rose 14 per cent to more than $3 billion (the Caldera settlement seems to have been partly responsible), while operating income was flat. Microsoft's cash and short-term securities amounted to $24.7 billion at 30 September, up from $23.8 billion at 30 June.

Windows Effect somewhat inflated

CFO John Connors attributed the success of the quarter to brisk sales of Windows 2000 Professional and Windows Me, but the evidence did not support this: the success was mostly with Microsoft's investments. Microsoft calls its investment income "revenue", which is normally done only when the income is closely linked to the core business - but in Microsoft's case, this income is mostly from areas where Microsoft has said it will not be competing, such as cable. An astonishing 44 per cent of Q1 total income - $1.13 billion - came from investments, as a result of a 51 per cent increase compared with a year earlier. Clearly Microsoft has morphed into being a highly successful investment banker, especially in view of how much it makes from stock options.

Sun meanwhile has certainly thrashed Microsoft in the enterprise sector, with an 85 per cent leap in its profits and a 60 per cent increase in sales. Even this was constrained by Sun's ability to manufacture fast enough for the demand. So much for Unix being on its last legs. Microsoft didn't give any breakdown in Windows 2000 client versus server sales, so one might presume that Windows 2000 server sales are in fact disappointing. The only yardstick that Microsoft offers is what it calls its "expectations", but since it does not publish these, the data cannot be taken very seriously.

One Connors comment that didn't quite square was when he said that European results were soft because of a weak Euro - he attributed $100 million to this after currency hedging. But how could this be when Microsoft's OEM contracts (from which it gets most of its revenue) are in dollars, while its major licensing deals are individually negotiated and probably include an allowance for the declining Euro? Packaged software is no longer particularly significant as a percentage of the whole.

The guidance that Connors gave financial analysts for the remaining three quarters was that, barring the unexpected on the world stage, growth would be in the "mid-teens". This is a far cry from the 25-30 per cent growth seen in earlier years, and marks the beginning of a new era where Microsoft's monopolies have matured and are even beginning to decline - as was seen with Office.

The analysts wobble, then buy

Not all financial analysts were wild about the results. Doug Cook of Prudential cut his 12-month target for Microsoft's share price from $90 to $65, which may have been a little unwise. There are signs that Wall Street wants Microsoft to be back in favour now, for several reasons: its shares are cheap and could provide some easy profits if the price were run up; it is a component of the index, and unless Microsoft does well, that will be held back; and finally, the financial community hasn't been doing so well in recent weeks and needs a boost.

Even the second biggest ever increase in the NASDAQ composite index on 13 October did not result in even a "dead cat" bounce for Microsoft's share price, but this changed dramatically yesterday when the third biggest NASDAQ increase of 7.8 per cent was propelled by the good that Wall Street chose to see in Microsoft's results, so that its shares went up $10.125 to $61.875. This is still half of what it was in December, but it was a remarkable improvement - especially after the humiliation of dropping below $50 earlier in the week. The key to the sustainability of a rally will be if the big mutual funds start buying back into Microsoft, instead of dumping it as they have been, but since they only have to report their holdings every three months, we shall have to wait and see. ®

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