RULE MAKER PORTFOLIO

<THE RULE MAKER PORTFOLIO>

Microsoft: Cash and Opportunity

by Matt Richey (TMF Verve)

ALEXANDRIA, VA (August 24, 1999) -- This morning's Wall Street Journal broke word that Microsoft (Nasdaq: MSFT) has lured Silicon Graphics CEO Richard Belluzzo to take charge of the company's Internet businesses. Even though Microsoft hasn't officially verified the story, the market greeted the news with optimism, sending the software giant's shares northward to the tune of more than 6%.

The 45-year-old Belluzzo is reportedly a highly talented executive with expertise in finance and operations, as well as a track record of success at Hewlett-Packard prior to his move to SGI in 1998. Most likely, the market was also excited to hear that Microsoft has supposedly dropped the idea of a tracking stock for its Internet operations, and will instead seek to spin-off certain businesses, such as the MSN.com portal and Expedia.com travel services site. If you ask me, this makes a heckuva lot more sense than one of those incomprehensible tracking stocks.

Microsoft's Internet properties don't get much attention compared to the company's big revenue drivers like Windows and Office, but the company has actually amassed quite an impressive array of Web businesses. In addition to the sites mentioned above, Microsoft also owns free Webmail provider Hotmail.com and a stake in the #1 news site MSNBC.com. According to Media Metrix, Microsoft owns five of the top-50 Web domain names and, in total, has the #3 position for all Web properties. And don't forget the WebTV business.

Compared to Microsoft's total fiscal 1999 revenues of $19.7 billion, the $2.4 billion from the "Consumer, Commerce, and Other" division -- which includes the above Web ventures, plus consumer hardware and the Microsoft Press -- looks relatively insignificant. But compared to Yahoo!'s (Nasdaq: YHOO) trailing 12-month revenues of $390 million, Microsoft's Internet businesses look huge! Further, if these businesses were spun off, they could undoubtedly compete more aggressively outside the shadow of the government's trustbusters. That would spell trouble for our Yahoo! position, but the market would likely grant a tremendous value to the spun-off BabySofts.

Today's news is an interesting development in the Microsoft story, but I'm much more interested in focusing on how the company was able to incubate great little businesses like Expedia (which -- by the way -- is the only way I book flights these days). The question for Rule Maker investors is, "What allows this company to continue to innovate and expand its business?" Obviously, there's no single answer. It helps that Microsoft is at the epicenter of many emerging technologies. Young, talented management is also a big part of the equation. But, the one factor that I think really gives Microsoft a substantial advantage over the competition is its tremendous financial resources, namely free cash flow.

Here's where we pick up with yesterday's article on the Statement of Cash Flows. As we saw, income statement "profits" don't necessarily translate into cash on the balance sheet. (If that sentence doesn't register, go back and read yesterday's article. The rest of today's report builds off that information.) The cash flow statement is where you can find out if a business is actually generating real cash profits, or what is commonly called "free cash flow."

Free cash flow may sound complicated, but it's not. Using the statement of cash flows, the simple calculation is as follows:

Net Cash from Operations minus Capital Expenditures

In the case of Microsoft, we see a company that is actually generating free cash flow in excess of its reported net income. In other words, Microsoft's income statement understates the company's true profitability. Using the company's most recent cash flow statement, let's together (that means you, too!) calculate the free cash flow for the first nine months of fiscal 1999. Here's how it works:

  ($ millions)
  Net Cash from Operations                       $7,419
- Additions to Property, Plant, & Equipment (PP&E) (291)
= Free Cash Flow                                 $7,128

If that makes sense, groovy. But if not, the hang-up is probably related to a question about what qualifies as a capital expenditure. As mentioned yesterday, capital expenditures are investments to build the business. Examples include buying equipment, computers, warehouses, etc. For the most part, capital expenditures are summed up in the line item labeled, "Additions to Property, Plant, & Equipment." Investments in other businesses, such as the cash portion of Microsoft's acquisition of WebTV, are technically a capital expenditure, but for the purposes of calculating ongoing free cash flow, such "one-time" acquisitions do not have to be included.

Items that do not qualify as "cap ex" are putting liquid cash into U.S. Treasury bills, or moving T-bills to an investment in common stock. Such movements of cash are included in the investing activities section of the cash flow statement, but they are distinctly different from capital expenditures. For all practical purposes, the "Net Cash Used for Investments" line item is of little use.

So, Microsoft generated more than $7 billion of free cash in the first nine months of fiscal 1999. Free cash for the full fiscal year will likely approach $10 billion, which is quite a bit higher than the $7.8 billion in reported net income. That means that in a single year, Microsoft has created $10 BILLION that it could hypothetically issue as a gigantic dividend to shareholders. Fortunately, Microsoft instead chooses to use this cash as an offensive weapon to expand its business. Lately, the company has made strategic investments in AT&T and Nextel, among others.

Just last week, Microsoft made its 31st strategic investment of calendar 1999 alone. This one is a $126 million investment in Globo Cabo, a Brazilian cable television operator. According to the press release, "The Globo and Microsoft alliance is intended to foster the creation, delivery and operation of a set of joint services for PCs and advanced digital set-top boxes for Brazilian consumers."

I don't have any particular insight on the Globo deal, but I'm heartily impressed with Microsoft's strategy of planting seed money around the globe. Eventually, some of those investments will yield entirely new businesses in the same way that Microsoft's early investments in the Internet are now producing a crop of businesses that could prove tremendously valuable if spun off to shareholders.

In essence, Microsoft's free cash flow forms the basis for expanding possibilities as far as the eye can see. That's why Microsoft gets my vote once again for our next $500 monthly investment.

If you want to continue the discussion about Microsoft or free cash flow, click over to any of the three Rule Maker message boards, which are linked below.


 




Rule Maker Portfolio

8/24/99 Closing Numbers
 Ticker   Company   Dly Pr Chg   Price 
AXP   AMER EXPRESS                  1/2    $147.88
CHV   CHEVRON CORP                  Unch.    $95.94
CSCO   CISCO SYSTEMS                 5/8    $66.38
DPH   DELPHI AUTOMOTIVE SYSTEMS    -9/16    $18.13
EK   EASTMAN KODAK                 11/16    $75.44
GM   GENL MOTORS                   3/16    $64.56
GPS   GAP INC                       -1/8    $41.63
INTC   INTEL CORP                    3/16    $83.13
KO   COCA-COLA CO                  7/16    $59.25
MSFT   MICROSOFT CORP                3/4    $92.19
PFE   PFIZER, INC                   7/16    $39.06
SGP   SCHERING-PLOUGH               3/8    $54.56
TROW   T.ROWE PRICE ASSOC            -7/16    $33.25
XON   EXXON CORP                    -1 3/16    $81.63
YHOO   YAHOO INC                     13/16    $152.94

  Day Week Month Year
To Date
Since
1/5/98
Annualized
Rule Maker 1.09% 4.08% 6.43% 16.70% 47.16% 26.71%
S&P 500 .24% 2.01% 2.62% 10.92% 39.55% 22.66%
S&P 500(DA) .24% 1.99% 2.58% 11.41% 41.32% 23.61%
S&P 500(DCA) n/a n/a n/a n/a 26.18% 15.32%
NASDAQ 1.21% 3.93% 4.32% 25.52% 72.66% 39.75%

 Trade Date   # Shares   Ticker   Cost/Share   Price   LT % Val Chg 
  6/23/98   68 CSCO     28.784   $66.38   130.60%
  2/3/98   54 MSFT     45.135   $92.19   104.25%
  5/1/98   82 GPS     22.708   $41.63   83.31%
  2/13/98   52 INTC     46.928   $83.13   77.13%
  2/3/98   66 PFE     27.433   $39.06   42.39%
  5/26/98   18 AXP     104.067   $147.88   42.10%
  3/12/98   20 XON     64.335   $81.63   26.87%
  2/17/99   16 YHOO     126.309   $152.94   21.08%
  3/12/98   20 EK     63.148   $75.44   19.46%
  3/12/98   15 CHV     83.343   $95.94   15.11%
  8/21/98   44 SGP     47.993   $54.56   13.69%
  3/12/98   17 GM     60.400   $64.56   6.89%
  3/12/98   11 DPH     17.190   $18.13   5.44%
  2/3/98   56 TROW     33.673   $33.25   -1.26%
  2/27/98   27 KO     69.107   $59.25   -14.26%

 Trade Date   # Shares   Ticker   Cost   Value   LT $ Val Ch 
  6/23/98   68 CSCO     $1,957.28   $4,513.50   $2,556.22
  2/3/98   54 MSFT     $2,437.28   $4,978.13   $2,540.85
  2/13/98   52 INTC     $2,440.28   $4,322.50   $1,882.22
  5/1/98   82 GPS     $1,862.06   $3,413.25   $1,551.19
  5/26/98   18 AXP     $1,873.20   $2,661.75   $788.55
  2/3/98   66 PFE     $1,810.58   $2,578.13   $767.55
  2/17/99   16 YHOO     $2,020.95   $2,447.00   $426.05
  3/12/98   20 XON     $1,286.70   $1,632.50   $345.80
  8/21/98   44 SGP     $2,111.70   $2,400.75   $289.05
  3/12/98   20 EK     $1,262.95   $1,508.75   $245.80
  3/12/98   15 CHV     $1,250.14   $1,439.06   $188.93
  3/12/98   17 GM     $1,026.80   $1,097.56   $70.76
  3/12/98   11 DPH     $189.09   $199.38   $10.29
  2/3/98   56 TROW     $1,885.70   $1,862.00   ($23.70)
  2/27/98   27 KO     $1,865.89   $1,599.75   ($266.14)
  Cash: $100.80  
  Total: $36,754.80  


Notes
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.