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Unanswered Questions at Microsoft

We like Microsoft's sales growth, and can even forgive its rising operating expenses that caused a decline in operating income. Microsoft's Windows 2000 is selling crisply, and Windows Me is gaining traction as well. But we still don't know what to think of this company's Internet strategy, or how to assess the threat from Linux.

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By Richard McCaffery (TMF Gibson)
October 20, 2000

Windows software maker Microsoft (Nasdaq: MSFT) reported much better results in the first quarter than it did in the fourth quarter; and better results than analysts expected, as sales jumped nearly 8% to $5.8 billion.

Customer acceptance of Microsoft's flagship platform, Windows 2000, spurred sales, while growth of Windows Me, the consumer version of the do-everything operating system, also contributed to strong growth.

On the conference call, Microsoft was guarded about economic conditions worldwide, but guided investors to expect year-over-year Q2 revenue growth in the low teens, as well as operating and earnings-per-share growth that should track revenue growth.

It's worth tempering some of the excitement, however, since Microsoft beat estimates on the strength of its investment income, which added $1.1 billion to the bottom line. Again, these results are much better than last quarter's, when revenue grew less than 1% and operating profits plunged 13.1%, but folks should put the success in perspective.

Let's roll out some of the numbers we've been tracking lately:

               Q2 2000   Q2 1999    Growth 
Revenue         $5,800    $5,384     7.7%
Operating inc.  $2,777    $2,789    (0.43)
Flow Ratio       0.72      0.37      96%

Revenue growth is a big improvement over Q4, but it's not exactly unexpected. Who didn't expect sales to pick up once Microsoft shook the bugs out of Windows 2000, and corporations had a chance to get it in the budget queue?

Operating income decreased, which is disappointing, but fell as the result of higher operating expenses, mainly in research and development and sales and marketing. Microsoft's operating margins fell to 47.9% from 51.8% a year ago, and margins may very well shrink as the company faces tougher competition from Linux and the Internet. But I don't view what's happening here as a sea change. We'll watch next quarter to see if sales gains flow through to the operating line and boost profits as management said they should.

We've talked a lot about Microsoft's Foolish Flow Ratio recently, a metric that gives us a sense of how well the company is managing working capital, including critical items such as accounts receivable. This has been an anchor for Microsoft lately -- its Flow Ratio has increased for the last eight quarters.

Though it's still well below the 1.25 level we require in the Rule Maker, Microsoft's ratio has doubled in the last year and its accounts receivable are up 44% year-over-year. It's not what we like to see, since sales grew just 7% over the same period. Nevertheless, the company is rolling out new products, which could account for some of the flux, and a Flow Ratio less than 1 means its creditors basically fund its working capital needs.

A big chunk of the increase in the Flow Ratio comes from deferred income taxes and other items that aren't nearly as troubling from a cash management point of view as receivables. Also, receivables decreased sequentially, and management has kept days sales outstanding at roughly 50 days for the last four quarters.

I'm pleased with Microsoft's results this quarter. It's worth pointing out, however, that these numbers -- other than Windows 2000 sales -- don't tell us anything about the important issues facing the company, the issues that will decide whether Microsoft remains at the center of the technology industry or becomes an aging giant on the sidelines. Analysts are focused on PC demand in the coming quarters, since it's a useful gauge of short-term expectations. We're not. Over the long term, the number of PCs in use will grow. We're interested in following up on these issues:

• What the heck is Microsoft's "bet the company" initiative, .Net? I vaguely understand it's a software platform that would allow Microsoft's applications to function on any device, but I have no idea whether there is an actual product that can do this or what incentive customers truly have to implement it. At this point, I wouldn't pay a dime for a piece of those future cash flows, yet it's an important part of the company's strategy.
  
  
• What kind of threat does the Windows server platform face from Linux? With Linux growing hand-over-fist in the corporate server environment, it's clearly a threat, but how should the long-term investor assess it? Feel free to post your thoughts on the Rule Maker Strategy board. Is Linux a long-term threat on the desktop as well?

I'll be writing a follow-up column that tries to put some perspective on these issues in the coming weeks. Meanwhile, investors looking for more information should check out research analyst John Del Vecchio's recent Motley Fool Research on Microsoft.