New Year, New Rules: Mister Softee's Melting

A morose Microsoft (MSFT) will have little to toast at the New Year's Eve ball this year.

Tough Act to Follow Microsoft's impressive run-up

After a year of legal battles, talent flight, a weakening economy and a first-in-a-decade earnings warning, the software giant could use a cheery 2001. But it's unlikely to get one.

With its warning, the company already acknowledged that its expects a rougher-than-expected 2001. And in a conference call after the announcement, Chief Financial Officer John Connor indicated it could get worse. "This is our best effort and our best forecast for the moment," Connors said. "It's hard to predict the extent of the economic slowdown."

Investors have a little problem with that kind of uncertainty, and they've driven down Microsoft's stock 25% since the Dec. 14 warning. The stock is now down some 60% for the year, more even than the beaten-down Nasdaq Composite Index.

The Slowdown

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The biggest issue the company faces involves the much-discussed drop in PC sales, which threatens Microsoft's core business. Desktop software accounts for 70% of the company's revenue, which totaled $16.3 billion for fiscal 2000. The software maker charges customers like Dell (DELL) and Compaq (CPQ) licensing fees for products like Windows ME for consumers and Windows 2000 Professional and Office for corporate users.

The PC market is growing much slower in part because so many Americans already own the boxes. So it has become a replacement market, which grows slower than a market for new products. Then there's the economic slowdown, which is hitting PC makers across the board.

"They're a great company in what now is a lousy business. It's like having a monopoly on automobile engines when no one wants cars anymore," says Jeff Matthews, a fund manager at RAM Partners, which has no position in the stock.

Earlier this year, CFO Connors said Microsoft expected PC sales growth for the year in the low- to midteens on a percentage basis. During the company's recent conference call, he said it's more like 10%.

In Limbo Microsoft underperforming even the Nasdaq.

Corporate PC sales, in particular, are sagging more than most industry analysts expected. Intel's (INTC) Dec. 7 warning triggered a series of analyst downgrades of Microsoft because Intel had bemoaned "slower-than-expected PC sales in all segments and in all geographies."

And Connors said desktop applications like Office and Excel, used mostly by corporate customers, accounted for more of the issues than desktop operating systems like Windows.

"A good part of [the applications sales] softness clearly stems from poor corporate demand for Office -- something we've been fearing for several quarters now," SG Cowen analyst Drew Brosseau wrote in a Dec. 15 report. The Office applications product line accounts for 33% of Microsoft's 2001 projected revenue. (Brosseau rates the stock a neutral, and his firm hasn't done underwriting for Microsoft.)

"Desktop applications will likely remain sluggish and will likely decline again in the second quarter, perhaps by as much as 10% or more. The prospects for any rebound in March and June seem limited," he added.

Dramatic Irony

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Click here to see 2001: New Year, New Rules stories from earlier this week.

Ironically, until last week's warning, company watchers were mostly preoccupied with Windows 2000. Connors said Windows 2000 sales are in line with expectations, but they clearly aren't good enough to make up for the other problems.

Smaller segments of Microsoft's business look like they will have a less-than-dazzling new year as well.

There were big hopes for its consumer software, services and devices division, comprised largely of its MSN Internet business. The business is small, bringing in just 8% of overall revenue in the quarter ended Sept. 30. But it grew faster than most of segments, 31% over last year's fiscal first quarter.

But last week, the company said subscription and advertising revenue was weaker than expected. Aside from the tough advertising climate, Microsoft's strategy may be somewhat off base here, according to many company watchers. The software colossus wants MSN to push the sales of its other products, but with all the TV ads and rebates the company is paying for, MSN actually costs money.

Next year, Microsoft also will take a $500 million step into the video game area, marketing its new Xbox game console, due out in the fall. But it will hit stiff competition against Sony's (SNE) PlayStation and isn't expected to start contributing revenue until the second half of fiscal 2002.

Re-engineering the Enterprise

All this leaves Microsoft looking to its enterprise segment for much of its growth, as evidenced by Thursday's acquisition of Great Plains Software (GPSI), a deal that puts Microsoft squarely in Oracle's (ORCL) turf.

"Microsoft's success depends on its ability to transition itself from a desktop software company to an enterprise solution vendor," wrote Merrill Lynch analyst Chris Shilakes in a recent report. (Shilakes rates the stock long-term buy, and his firm hasn't done recent underwriting for the company.) Microsoft will launch several enterprise products in the upcoming quarters including the BizTalk server. Analysts and investors will look for a revenue update on the recently released SQL Server 2000 database, and other server products in the second-quarter earnings call.

Beyond calendar 2001, Microsoft sees its future resting with its ambitious .Net initiative, an attempt to adapt existing software products like Windows and Office for the Web. This initiative also includes developing Internet services over a range of computing devices. The company won't say when .Net will start contributing significantly to revenue. And many investors don't quite understand the project yet.

".Net is the same as Bluetooth [wireless communication technology]: It's not going anywhere, it hasn't been demonstrated and people don't really get what it is," says Matthews at RAM Partners.

Perhaps Morgan Stanley Dean Witter's Mary Meeker put it best in her Dec. 15 report: "The glory days are behind the company, at least for the next year or so." Her firm hasn't done recent underwriting for Microsoft.

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