ALEXANDRIA, VA (Jan. 19, 2000) -- As reported in this morning's Fool Breakfast News, last night Microsoft (Nasdaq: MSFT) turned in fiscal Q2 earnings that beat the expectations of the Wise -- and by a wide margin at that. But investors weren't happy. The stock went straight south from the get-go and ended down more than 7%. What gives? I have a few ideas to offer that may lend insight -- and more than the lame "cautionary outlook" nonsense that has been cluttering the newswires today.

But before we do that, I want to put Microsoft through the paces of our 10 RM investment criteria. In many ways, Microsoft represents the quintessential Rule Maker by exemplifying such qualities as industry dominance, strong business growth, lotsa cash, and zilch in debt. It wasn't by accident that Microsoft was this portfolio's first buy. Normally, we walk through these 10 criteria whenever we review a company's investment potential, but today I want to try something different. I'm going to run -- and I mean fly -- through these 10 qualities that essentially define Rule Makerhood. My goal here is to prove that analyzing a company from a Rule Maker perspective is -- believe it or not -- pretty dern simple.

Ready, get set, go!
  1. Dominant Brand. Windows runs an estimated 90% of all personal computers.
  2. Repeat-purchase Business. First I had MS Works, then Word 95, now Word 97, soon-to-have Word 2000... and Microsoft anticipates a future of "software as a service," whereby software would be purchased on a subscription basis.
  3. Convenience. Most of Microsoft's business is through organizational licenses (such as The Motley Fool's use of Windows NT throughout our 250+ Fools here at HQ) and OEM deals with PC manufacturers (such as the pre-loaded Microsoft software on Dell, Gateway, etc.). For most of us, purchasing from Microsoft is inevitable.
  4. Expanding Possibilities. The Internet is making available immense quantities of data. But it takes software to convert raw data into meaningful information. Software is Microsoft's bread and butter, so the future looks golden.
  5. Your Familiarity & Interest. In its relatively short 26-year corporate life, Microsoft has grown to become the most highly valued enterprise on the planet -- worth more than $600 billion. Wealth creation of that magnitude is certainly of interest to this Fool.

Pause. We need a quick change of equipment to proceed with the second half of this event. If you haven't already downloaded our Rule Maker Essentials spreadsheet, click over to our RM Spreadsheets page. With that tool, we can figure out criteria 6-10 even faster than 1-5. We'll wait for you, if you need to get the spreadsheet fired up. Ready? Unpause.

Using the financial data in yesterday's earnings release, we need the following items (only nine total), listed in $ millions:

Microsoft Fiscal Q2 Income Statement:
Sales                  6,112
Prior Year Sales       5,195
Cost of Goods Sold       756
Net Income             2,436

Microsoft Fiscal Q2 Balance Sheet:
Cash & Equivs.        17,843
Current Assets        22,020
Current Liabilities   10,504
Short-term Debt            0
Long-term Debt             0

OK, with those numbers plugged into your spreadsheet, the number crunching is a piece of cake. I'll add just a touch of commentary to spice things up a bit.

  1. Sales Growth > 10%. Sales grew 17.7% on the strength of Office 2000, despite weakness in the Windows platform as companies await Windows 2000's launch on February 17.
  2. Gross Margins > 50%. Mass-produced software is a very "lightweight" product, thus it's no surprise Microsoft had gross margins of 87.6% in Q2.
  3. Net Margins > 7%. Microsoft blows this one out of the water with a net margin of 39.9%.
  4. Cash-to-Debt > 1.5. No debt of any kind (not even the convertible preferred securities that Microsoft carried for the past several years) makes this one a breeze. If you include Microsoft's equity investments, the company now has a war chest of $37.6 billion. That staggering figure is unparalleled in the corporate world.
  5. Flow Ratio

    The final tally is a perfect score for this quintessential Rule Maker.

    At the beginning of this column, I said I'd offer some ideas as to Microsoft's stock decline today. I think Microsoft's increasing flow ratio could be part of the problem. Here's a look at Microsoft's flowie history for the past two years:

    12/99    0.40
     9/99    0.37
     6/99    0.34
     3/99    0.29
    12/98    0.34
     9/98    0.27
     6/98    0.34
     3/98    0.29
    12/97    0.34
     9/97    0.31

    As you can see, the direction of Microsoft's flowie has turned eerily upward in the past few quarters. The root problem appears to be receivables. Accounts receivable have been growing faster than sales for more than a year now. As I've explained in the past, a rising flow ratio causes operating cash flow to suffer. Take it one step further, and you can see that a rising flow ratio directly impacts (negatively) free cash flow. That's not good, folks.

    At this point, this matter isn't of grave concern. But it is something to keep our eye on in future quarters.

    Another factor that might have weighed on the stock today was the heavy dose -- $773 million -- of investment income that was included in Microsoft's bottom line. Three months ago, Microsoft's guidance called for about $400 million in investment income, so this number came in much higher than expected. At $773 million, investment income made up nearly 32% of this quarter's net income. Most investors would prefer to see Microsoft making its profits from software sales rather than stock trading.

    Between the rising flow ratio and the higher-than-expected investment income, I think the flow ratio is of much greater concern. Let's keep our eye on those receivables in the quarters ahead. To get the Microsoft earnings from the horse's mouth, including the earnings release and conference call replay, head over to the Microsoft Investor Relations website.

    On a final note, for some Foolish lessons learned the hard way, check out our special on When Fools Were fools -- Fools share their worst investing blunders and the lessons they learned.

    Have a Foolish night!