RULE MAKER PORTFOLIO

<THE RULE MAKER PORTFOLIO>

Mucho Cashola at Microsoft

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (July 20, 1999) -- Most techies hate the company's products and the U.S. government is a monkey on its back, but Microsoft (Nasdaq: MSFT) continues to shame its naysayers with unprecedented financial success. After the bell yesterday, the company turned in another set of sparkling financial results with earnings coming in well ahead of estimates. Revenue and net income soared, gross and net margins expanded significantly, cash continued to outgrow debt, and working capital management remained solid.

Microsoft's so-called "conservative" guidance in projecting future results is almost laughable. Back in April when the company announced its third quarter earnings, CFO Greg Maffei told conference call listeners to expect sequential revenue growth "in excess of $500 million." In actuality, Q4 revenue was $1,500 million ahead of the Q3 number. Oops, what's a comma and a couple of zeros among friends? Also on the April conference call, Maffei predicted Q4 year-over-year revenue growth in "the mid 20s" and earnings per share growth (EPS) of 40%. The actual numbers were 39% and 60%, respectively. In effect, Maffei low-balled estimates by 50%. I'm all for genuine conservatism in financial projections, but this is a bit extreme.

Even with Microsoft's well-known track record of squelching analyst enthusiasm with dire projections of slowing growth, the following Reuters headline appeared today:

"Microsoft Slips After Slow-Growth Warning"

No matter how Microsoft tries to frame its results, there's nothing "slow growth" about this company. While revenue growth will certainly slow down at some point, that day doesn't appear to be anytime soon. Let's look at how the software giant fared on our five Rule Maker financial criteria.

Sales Growth was very strong. Compared to the comparable quarter last year, Q4 revenue increased 39% due to strong growth across all business divisions and sales channels. Last quarter, Greg Maffei predicted that "Office 2000 should be a big winner." Bingo. Strong sales of Office 2000 and SQL Server 7.0 led to 48% growth in the Productivity Applications and Developer unit. Elsewhere, the Windows platform revenues grew a robust 32% thanks to higher PC shipments and continued momentum of Windows NT Workstation. Even as it nears the end of its product life cycle, NT Workstation has doubled its installed base in the past year and is now being pre-installed on nearly 30% of business PCs.

Gross Margins were 88.4%, up from 83.8% a year ago. The company attributes the improvement to its ongoing business model shift from selling shrink-wrapped packages to selling organizational licenses and subscriptions. The licensing model is not only more efficient than packaged sales, but also reduces the risk of product returns. Based on this materially reduced risk for obsolete inventory, Microsoft reduced its estimate of channel returns by $250 million, and thus increased its revenue by the same amount. In essence, Microsoft boosted revenue by reducing an accounting reserve for inventory obsolescence. This legitimate move had the impact of boosting gross margins.

Net Margins were 38.2%, versus 32.7% in the year-ago period. For a mature company like Microsoft to expand net margins by 5.5 percentage points is simply amazing. This level of profitability is already well beyond our net margin benchmark of 7%, but it could increase further in the quarters and years ahead. In Q4, the company booked a $217 million one-time charge for a change in compensation expense related to the employee stock option plan. In addition, Q4 profitability was subdued by increased non-recurring legal expenses. Over the years, Microsoft has relentlessly improved its efficiency, driving net margins higher and higher. Obviously, this trend can't go on forever, and the company is now saying that it will not see further margin expansion, but we'll see about that.

The Ratio of Cash-to-Debt improved as cash poured into the company's coffers, while debt held steady at $980 million. This "debt" comes in the form of preferred stock, which is not exactly debt but not exactly equity. It's somewhere in-between, but because of its required regular dividends, I classify it as a form of debt. All told, cash now stands at 17.6 times debt, up from a ratio of 14.2 a year ago. Microsoft's business is producing a nifty combo of strong cash inflows from operations and low cash outflows for capital expenditures. Together, this combination is creating the holy grail of finance -- free cash flow, which shows up in the rising ratio of cash-to-debt.

The Flow Ratio remained steady versus the year-ago period. Compared to our benchmark of 1.25, Microsoft's Flowie of 0.34 leaves little room for improvement and draws no complaints from me. Accounts receivable, one of the nasty current assets, increased by nearly 54% year-over-year, but that increase was due to higher volumes of packaged product shipments in preparation for the Office 2000 launch. Unearned revenue, one of our favorite current liabilities, increased quite nicely by 45%, or $1.2 billion year-over-year. This account represents cash that Microsoft has already received for licensed software sales, but is accounted for as revenue "ratably" over multiple periods based on the life cycle of the product.

I'm already past deadline on this one. I'll post a more comprehensive conference call summary in the next 24 hours. In summary, Microsoft's fourth quarter financial results were outstanding. With the #2 global brand (according to Interbrand), young but proven management, and wide-open opportunity, this Rule Maker's throne looks secure.

07/20/99 Close
Stock Change    Bid
AXP   -5 3/8    133.81
CHV   -1 13/16   93.31
CSCO  -2 11/16   62.25
EK    +  1/8     73.25
GM    -1 13/16   66.50
GPS   -2 11/16   47.00
INTC  -2 5/8     64.94
KO    -  1/4     62.94
MSFT  -5 1/16    93.31
PFE   -1         36.00
SGP   -1 7/16    52.63
TROW  +  15/32   35.47
XON   -  7/8     77.94
YHOO  -7 3/8    142.13


                  Day     Month  Year    History
        R-MAKER  -3.27%  -0.97%  12.64%  42.53%
        S&P:     -2.17%   0.32%  12.61%  39.27%
        NASDAQ:  -3.47%   1.73%  24.60%  65.30%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     93.31   138.44%
   6/23/98   68 Cisco Syst    29.21     62.25   113.15%
    5/1/98 82.5 Gap Inc.      22.91     47.00   105.12%
   2/13/98   44 Intel         42.34     64.94    53.38%
    2/3/98   66 Pfizer        27.43     36.00    31.23%
   5/26/98   18 AmExpress    104.07    133.81    28.58%
   2/17/99   16 Yahoo Inc.   126.31    142.13    12.52%
   8/21/98   44 Schering-P    47.99     52.63     9.65%
    2/6/98   56 T. Rowe Pr    33.67     35.47     5.33%
   2/27/98   27 Coca-Cola     69.11     62.94    -8.93%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     77.94    21.14%
   3/12/98   20 Eastman Ko    63.15     73.25    16.00%
   3/12/98   15 Chevron       83.34     93.31    11.96%
   3/12/98   17 General Mo    72.41     66.50    -8.16%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4479.00  $2600.55
   6/23/98   68 Cisco Syst  1985.95   4233.00  $2247.05
    5/1/98 82.5 Gap Inc.    1890.33   3877.50  $1987.17
   2/13/98   44 Intel       1862.83   2857.25   $994.42
    2/3/98   66 Pfizer      1810.58   2376.00   $565.42
   5/26/98   18 AmExpress   1873.20   2408.63   $535.43
   2/17/99   16 Yahoo Inc.  2020.95   2274.00   $253.05
   8/21/98   44 Schering-P   2111.7   2315.50   $203.80
    2/6/98   56 T. Rowe Pr  1885.70   1986.25   $100.55
   2/27/98   27 Coca-Cola   1865.89   1699.31  -$166.58

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1558.75   $272.05
   3/12/98   20 Eastman Ko  1262.95   1465.00   $202.05
   3/12/98   15 Chevron     1250.14   1399.69   $149.55
   3/12/98   17 General Mo  1230.89   1130.50  -$100.39

                              CASH    $232.29
                             TOTAL  $34292.67


Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.

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