RULE MAKER PORTFOLIO

Rule Maker Portfolio
Mighty Microsoft

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (October 20, 1999) -- Last night, Microsoft (Nasdaq: MSFT) reported yet another solid quarter of estimate-crushing results. Not too astonishing anymore, is it? Heck, this is the information company of the information age. Even so, I continue to be amazed by this unbridled wealth-creation machine that we call Microsoft.

Before getting into the quarter's results, let's step back and look at the core economics of this business:

                      (in billions)
Cash & Equity Investment    $33.8 
Total Assets                 39.7 
Non-cash Assets               5.9 
Okay, so we're talking about a company that has nearly $40 billion in total assets, but the vast majority of that sum is made up of liquid cash and equity investments. Essentially, Microsoft -- the most highly valued commercial enterprise on earth at more than $500 billion -- runs its business on a base of operating assets worth less than $6 billion. That's $6 billion worth of land, buildings, networked computers, and loans to customers. That's it. From that relatively meager base, Microsoft generates the following results:
                (in billions)
12-month Revenue     $ 20.9 
12-month Net Income     8.3 
How many other companies do you know of that generate more in profits every year than their entire base of invested capital. That's wealth creation at its finest.

With that overview in place, let's look at what events transpired during the quarter. I'll start with the good news -- since the good outweighs the bad by 10-to-1.

Sales grew 28% to $5.4 billion. Excellent PC unit demand led to strong sales of Office 2000 and Windows NT Server. Units of Windows NT Workstation now make up 27% off all high-performance 32-bit operating systems. That's about the same as a quarter ago, but up from 18% of the 32-bit market a year ago. The SQL Server database software also experienced a strong quarter. Version 7 of SQL Server was released during the December quarter last year, and is now a major platform for Internet companies, including Dell.com, Nordstrom.com, Nasdaq.com, Monster.com, and AskJeeves.com. In addition, the SQL Server software is making strong inroads into Oracle's entrenched database position. As a percentage of Oracle's database revenue, SQL Server now equals 35%, up from 23% for all of last year.

As always, all of those sales were very high-margin sales. Gross margin for the quarter increased to 86.8%, up from 84.5% a year ago. Moving to the bottom-line, net margins came in at a stellar 40.7%, up slightly from the 40.0% result a year ago. The low material costs of Microsoft's intellectual property products makes for extraordinary profitability.

And that profitability carried over to the balance sheet where liquid cash and investments increased to $18.9 billion, up from $17.2 billion last quarter. With no debt and only $980 million in preferred stock, the cash-to-debt ratio rings in at a solid 19.3 -- far ahead of our 1.5 minimum standard. And as I mentioned at the top, counting the additional $14.9 billion in long-term equity investments, Microsoft has a total war chest of $33.8 billion -- staggering! That kind of firepower ensures the company's ability to buy whatever technology it needs to maintain its dominant position.

Well, before waxing on and on about more good news, let's look quickly at the one disappointing metric -- the flow ratio. Microsoft registered a flowie of 0.37, which on its own is admirably below our high-end threshold of 1.25. But, this quarter's result is up significantly from the 0.27 showing a year ago. The culprit is accounts receivable, which are up 91% from last year's level. It's never good to see receivables outpacing sales, but I wouldn't consider it a cause for concern at this point. Microsoft's receivables seem to fluctuate erratically at times, and this quarter's level is actually down a notch from last quarter. Nevertheless, we'll of course keep an eye on this going forward.

All in all, Microsoft is off to a great start during the first quarter of its fiscal year 2000. CFO Greg Maffei was much more positive than in past conference calls. Maffei enthused, "You have to feel good and optimistic about the periods ahead." In the quarter ahead, Maffei expects a sequential revenue increase of $750 million -- which would translate to 18% year-over-year revenue growth -- due to a holiday increase in PC purchases, rising demand for Office 2000, and a likely increase in corporate IT spending. The CFO even admitted that the Q2 Street consensus of $0.39 seemed a little low, and it deserved an increase of about 3 cents. Looking out to Q3 and Q4 in the first half of calendar 2000, Maffei offered his more typical conservatism and advised that those earnings estimates not be raised.

Looking out farther into the future, Maffei offered the following words in a speech earlier this month:

"If you look at what Microsoft believes, we're really moving into a new era, a third era of the Internet in which programmability is going to massively enhance the usefulness to the average consumer and the average business. It's going to take across the multiplicity of devices and a multiplicity of connectivity methods. Whether it be DSL and cable for broadband narrow band dial up or wireless. To manage all of that multiplicity of connectivity and devices and to do that programmability, great software will be more important and more critical than ever. You're going to strain the ability of software companies to manage that opportunity but it's going to be an enormous revenue upside potential."

It doesn't take a genius to realize that the information business is booming. Exponential growth in information demands ever more software to manage information -- and increasingly this information needs to be available anywhere and on any device. Microsoft is front and center in this on-going revolution. It's not a stretch to imagine that Microsoft's next decade may be more prosperous than the last.

For the full story on Microsoft's quarter, click into the excellent Microsoft Investor Relations homepage. Also, I've posted my conference call notes and Microsoft's Q1 Ranker on the RM Companies board. Microsoft's Rule Maker ranking hit an all-time high -- for any company -- of 56 out of 61 possible points.

Have a great evening! Phil will be back tomorrow with a full report on the earnings from our pharmaceutical Rule Makers, Pfizer and Schering-Plough.

Fool on!


 




Rule Maker Portfolio

10/20/99 Closing Numbers
Ticker Company Dly Pr Chg Price
AXPAMER EXPRESS7/8$144.75
CHVCHEVRON CORP1/8$92.00
CSCOCISCO SYSTEMS9/16$69.94
DPHDELPHI AUTOMOTIVE SYSTEMS-1/2$14.94
EKEASTMAN KODAK-9/16$69.88
GMGENL MOTORS3/8$65.13
GPSGAP INC1/4$34.69
INTCINTEL CORP13/16$69.94
KOCOCA-COLA CO-1/16$52.75
MSFTMICROSOFT CORP15/16$92.25
PFEPFIZER, INC9/16$41.50
SGPSCHERING-PLOUGH9/16$47.56
TROWT.ROWE PRICE ASSOC-1/8$28.50
XONEXXON CORP1/16$76.50
YHOOYAHOO INC1/4$180.13

  Day Week Month Year
To Date
Since
2/2/98
Annualized
Rule Maker 4.05% 4.76% 3.14% 11.61% 39.50% 21.44%
S&P 500 2.23% 3.37% .52% 4.90% 31.54% 17.34%
S&P 500(DA) 2.23% 3.37% .52% 5.48% 33.31% 18.26%
S&P 500(DCA) n/a n/a n/a n/a 18.49% 10.40%
NASDAQ 3.72% 2.06% 1.53% 27.16% 72.17% 37.30%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
6/23/9875CSCO32.865$69.94112.80%
2/3/9859MSFT49.352$92.2586.92%
5/1/9882GPS22.708$34.6952.75%
2/3/9866PFE27.433$41.5051.28%
2/13/9852INTC46.928$69.9449.03%
2/17/9916YHOO126.309$180.1342.61%
5/26/9818AXP104.067$144.7539.09%
3/12/9820XON64.335$76.5018.91%
3/12/9820EK63.148$69.8810.65%
3/12/9815CHV83.343$92.0010.39%
3/12/9817GM60.399$65.137.83%
8/21/9844SGP47.993$47.56-0.90%
3/12/9811DPH17.202$14.94-13.16%
2/3/9856TROW33.673$28.50-15.36%
2/27/9827KO69.107$52.75-23.67%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
6/23/9875CSCO$2,464.86$5,245.31$2,780.45
2/3/9859MSFT$2,911.79$5,442.75$2,530.96
2/13/9852INTC$2,440.28$3,636.75$1,196.47
5/1/9882GPS$1,862.06$2,844.38$982.31
2/3/9866PFE$1,810.58$2,739.00$928.43
2/17/9916YHOO$2,020.95$2,882.00$861.05
5/26/9818AXP$1,873.20$2,605.50$732.30
3/12/9820XON$1,286.70$1,530.00$243.30
3/12/9820EK$1,262.95$1,397.50$134.55
3/12/9815CHV$1,250.14$1,380.00$129.86
3/12/9817GM$1,026.78$1,107.13$80.35
8/21/9844SGP$2,111.70$2,092.75($18.95)
3/12/9811DPH$189.22$164.31($24.91)
2/3/9856TROW$1,885.70$1,596.00($289.70)
2/27/9827KO$1,865.89$1,424.25($441.64)
  Cash: $181.37  
  Total: $36,269.00  


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.