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Microsoft Corp.
MSFT Stock Performance

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By JrByrdmann
September 14, 2005

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Since the "reason for another loss to Linux" thread has wandered hopelessly off the original purpose, and as I said earlier, here is the new thread for discussing where we think the STOCK PRICE and RETURN ON INVESTMENT FOR SHAREHOLDERS is likely to go in the future.

As we begin, I will state the obvious from looking at charts.

MSFT did not experience the extreme drop in the bursting of the tech bubble that most of its competitors were hit with. Rather than a quick 90%+ drop in price, MSFT took a year to drop about 70% off of the all time high. Because of their strong financials, the stock rebounded somewhat, but has been trading in an ever-narrowing range centered around $27 for the last four years. Why is this?

Microsoft management made, IMO, a smart move in changing their internal structures and reward systems to employees and shareholders to reflect the fact that they were not going to be able to remain on a fast growth track forever. The options program became a restricted stock grant program, and direct payments to shareholders in the form of dividends were started. The market saw these moves and realized the premium being paid for future earnings was too high and began adjusting portfolios accordingly (moving them from the "growth" category to the "growth and income" category. Other companies making this transition have seen large stock price drops, so why did the bottom not fall out of Microsoft's price (e.g., Cisco, AOL/TWX, HPQ)?

Microsoft's profits were still increasing while all this was going on, so the P/E ratio came into line with its "growth and income" peers, which allowed the stock price to stay fairly level. Some of the new markets have grown to profitability and the mature markets continued growth (albeit at a slowing pace).

The mature markets (Servers, Desktop OS, Office) represent a steady market stream. Even if all the existing users stay on the steady upgrade treadmill, the actual growth in profits will be limited. There is some room for growth as the overall market and economy expands (i.e., companies grow and need more licenses), but these wells are tapped and another bonanza in these areas is not likely. Maintaining the upgrade treadmill (i.e., providing compelling improvements to the products to encourage upgrades) is mandatory just to maintain the existing profit stream, so where will the growth come from?

Let's look at some growth areas:

Customer Resource Management - this market is beginning to take off as business IT spending is slowly returning to normal levels, CRM is one area where it is easy to show a return on investment. Integrating the Great Plains purchase with their Exchange/Outlook line could make this a huge growth area in the future.

XBox - The original is bordering on profitable even though it came out after the PS2 and has been fighting its way into a new market. The new version has a head start on the PS3, and has the additional income stream with the XBox Live market (which Sony still hasn't hit yet). Where they face an uphill battle is in the Asian market (which is HUGE for games and where Microsoft is going up against the "home team").

Digital Music - Apple's iPod and iTunes jumped to an early lead, and so far the offerings from Microsoft have not been able to chip into this area to any significant degree. In addition, there is the question of how much profit is available on the software side of this market? To date, Microsoft has shown no sign of building their own digital music player so all they stand to get is a small payment for the software from the various manufacturers trying to compete with the iPod. They run into the same problem in selling the songs since there are so many competitors already in the marketplace the potential for profits is limited.

PDA/Cellphone/portable devices - While the Microsoft devices in the PDA market have captured a big chunk of the market, there is still the question of how much income Microsoft actually receives from these markets since they are not making the devices, but just licensing the software to run on them?

Home entertainment - There have been many attempts to enter the market that TiVo has captured, but it seems that the devices never actually reach the end users and the products quietly disappear into the lab until the next label and test market. Media Center sounds like a nifty idea, but the general public seems to like keeping the computer and the television systems separate (at least for now).

Looking short-term, Microsoft is flirting with my buy-point. I predict a run-up in the stock price through the end of the year as the XBox 360 hits store shelves and becomes this year's "Cabbage Patch Doll". This will be followed by a drop in the price in December/January, as people take the profits from this run-up. Looking at the last 4 years, the lows have hit in March/April and August/September with the highs in October/November. While I am not advocating market timing, I do think there is a right price and a wrong price to buy into Microsoft right now.

Looking long-term, I think most of the conversion volatility has taken place with this stock and they are probably ready to return to a reasonably steady growth path (10-15% annual appreciation in stock price). The catalyst to jump-start this stock price growth would be another 50% to 100% increase in the regular dividend. This shows management's confidence that they can maintain the existing profitability level. I don't think another one-time dividend would have the same effect (much as the last one fell flat).

Steve


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