Microsoft Faces Slumping Margins

Microsoft teased investors last week with hints of stronger-than-expected revenue growth and then delivered earnings of $0.01 per share in the fourth quarter. Although pro forma income was in-line with expectations, operating margins are still falling. Microsoft may have simply run out of high-margin growth businesses as profitable as its operating system and business application suite software offerings have been.

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By Todd N. Lebor (TMF TeeTime)
July 20, 2001

Well, the good news is that Microsoft (Nasdaq: MSFT), the planet's biggest software maker, is still profitable. The bad news is that it only earned a penny in its fourth quarter! One measly penny per share. I guess when you have 5.6 billion shares outstanding, a penny still amounts to something -- $66 million, actually. Net income per share, excluding an enormous charge related to stock investments, was $0.43, in-line with analyst expectations.

But after last week's pre-announcement that revenues were going to be better than expected and the good news on the anti-trust front, investors may have been looking for more. Revenues came in at $6.58 billion, a 13% bump from last year, and on the high side of the company's original guidance of $6.3 to $6.5 billion.

The big hit against those revenues is a $3.9 billion charge for write-downs related to stock investments, primarily downtrodden cable and telecommunications companies. Microsoft has been an aggressive investor in these areas to make sure it is not left in the dark as other tech giants like AOL Time Warner (NYSE: AOL) divvy up the world's communication lines. Its investments in companies like Comcast (Nasdaq: CMCSA) and AT&T (NYSE: T) were more strategic than greedy, and Microsoft has spread its cash around over the past few years with very long-term goals in mind.

But the door swings both ways. It's no secret that Microsoft's investment portfolio has helped it manage earnings in the past. When times were good, Microsoft used to come in a "magic penny" over consensus estimates like clockwork. Now it's not so simple, and the investments are hurting its GAAP (generally accepted accounting principles) earnings.

That said, the cash-cow software business still produced an impressive $3.48 billion in cash flow from operations, which helped Microsoft increase its cash and short-term investments from $30 billion last quarter to $31.6 billion at fiscal year end. Gates & Co. managed to do this even as they spent $1.7 billion repurchasing 23.6 million shares during the quarter. With a lack of investment options that can produce returns on invested capital equal to or better than its core software applications, buying back shares is a good investment for Microsoft.

Don't get me wrong: There isn't an executive on the planet who wouldn't kill to have the returns or margins of Microsoft. Its dominance, business model, and the dynamics of its industry have all helped create a model of profitability. Over the past 10-year period (from fiscal 1992 to fiscal 2001), the Redmond-based company has produced net income of $38.9 billion on revenues of $121.6 billion. That's a 32% average profit margin for a decade!

But those days are numbered, and there's nowhere to go but down from here. It appears Microsoft will remain a model of profitability for some time to come, but the question is "How profitable?" Operating margins are under attack. Over the past eight quarters, operating margins have fallen a full 10 percentage points, culminating in the most recent quarter's 41.8%.

            Operating Margin (%)

------------------------------------------ 2001 2000 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 41.8 46.8 48.8 48.2 44.0 48.4 48.0 51.8

The problem is that Microsoft already dominates the operating system market and PC growth is slowing. It also already owns the business application suite arena. As these businesses grew, so did Microsoft's margins. Now that these markets are saturated, Softy is seeking new areas of growth, and therein lies the problem. Very few other industries offer the lofty margins Microsoft and its investors have gotten used to.

Microsoft is developing new initiatives -- like the Xbox video game machine -- for revenue growth, but near term, its foray into the gaming industry will only hurt profitability. Gaming consoles have low margins and gross margins on the Xbox are expected to be zero. Combine that with a $500 million marketing campaign and the company will lose money on this new venture until royalties from software developers start rolling in. Merrill Lynch estimates the Xbox could generate $1 billion in operating income by 2006, but unless the Xbox is the only gaming console on the planet, it won't have the margins of software.

Once again, the question remains: "How profitable will Microsoft be?" The answer simply is: Not as profitable as it once was. Investors should prepare for a less profitable, less dominant Microsoft. But while it is no longer the undisputed king of corporations, it's still the king.

Todd Lebor has jumped out of an airplane twice, can ride a unicycle, and passed the CPA exam on the first try, but can't get a date. At the time of publication, he owned shares of Microsoft. Todd's other holdings can be found online along with the Fool's complete disclosure policy.

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