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Microsoft's Snapshot Is a Portrait of Strength

REDMOND, Wash. -- Microsoft (MSFT - Get Report) CEO Steve Ballmer has become a horticulturalist.

Nearly as convincing as he is always passionate, Ballmer spoke at great length Thursday about the three agricultural pillars of the software giant's vision: seedlings, saplings and full-grown trees. The verdant analogy should hearten any shareowner -- if not share-renter -- of Microsoft's stock. If Microsoft delivered one clear message at its annual propaganda/educational seminar for Wall Street analysts and financial reporters, it is that this redwood forest of technology companies will prosper for a long time.

Too optimistic? Nope. In an awesome and surprisingly straightforward presentation on its immediate past and medium-term future, Microsoft demonstrated again and again Thursday just how professional and well-positioned it is compared with nearly every other company in the information-technology arena.

The seedlings in Ballmer's garden include a not-ready-for-prime-time Tablet PC and a collection of unreleased Internet services, the ballyhooed .NET initiative now grouped under the code name Hailstorm. Prominent saplings include Microsoft's MSN and other consumer offerings, which are now a $2 billion business, and Xbox, the gaming console and software collection Microsoft will introduce in November. The healthy trees, of course, are Microsoft's slow-growth desktop platform and software applications, which accounted for 70% of Microsoft's $25.3 billion in fiscal 2001 revenue.

Name another company that has the strength to hold its own in the current environment -- Microsoft's revenue grew 10% for the year ended June 30 and it's forecasting revenue growth of between 14% and 17% for the year ahead -- while confidently planning to invest $5.3 billion in R&D.

Of perhaps greatest interest was just how little frivolity Microsoft displayed Thursday. Gone were the entertaining but silly videos painting a picture of the company's hazy future. Gone were both the defensive whining of last year and the faux pessimism of years past. This company is all business, all the time. Perhaps the only light moment of the 10-hour session was the revelation that the Shrek character in the new Xbox video game counts flatulence among his weapons for thwarting his enemies. Give the customer what he wants, to be sure.

And so even if some of the swagger is gone, the pride is back. Chairman and Chief Software Architect Bill Gates, demonstrating that he hasn't lightened up one iota since stepping down as CEO, noted that it's finally possible for Microsoft to hire the very best employees again, now that the distracted gazillionaires and gold-dust-seeking dot-commers are gone.

Before the dot-come craze there was Microsoft. After its demise there is Microsoft.

Still, there were lessons learned. Chief Financial Officer John Connors, noting the painful $3.9 billion impairment charge for bad investments that caused fiscal 2001 to be the first year Microsoft didn't top the previous year's profits, said Microsoft will become more disciplined about its investing. Stakes in outside companies must be championed by a senior executive who can convincingly demonstrate the opportunity for an adequate return on capital for the investment. Despite the impairment, "Microsoft will stand by investees," Connors said, "except for the ones that are bankrupt." Ouch. That was a thinly veiled swipe at his predecessor, 360 Networks CEO Greg Maffei.

Other blemishes lurk. The unproven Xbox will be a major drag on Microsoft going forward. Thomas Weisel Partners analyst David Readerman reckons that the company will lose between $100 and $150 on each box it ships. That's a lot of money even to Microsoft, which hopes to sell between 4.5 million and 6 million units by June 30.

CFO Connors describes the same situation from a different perspective. Cost of revenue will spike this year to between 19% and 20%, compared with a range of 13.1% to 14.3% for the past three years. That means Microsoft's margins will be pinched. Also, even Microsoft's prudence bodes ill for the legions of tech-industry job seekers. President Rick Belluzzo said the company will hire about 4,000 people this year, about 50% fewer than last year.

But that's almost all the bad news. Despite the investment write-downs, Microsoft ended its fiscal year with $31.6 billion in cash and another $14.1 billion in equity investments. Morgan Stanley analyst Mary Meeker predicts Microsoft's diminishing margins will stop diminishing in December, even as the company's revenue growth begins to accelerate. With the Xbox launch and the coming release in October of Windows XP, the latest operating system upgrade, fiscal 2002 will be one of the most active in product terms in years. And the nagging antitrust suit appears to be dwindling in importance.

Microsoft's share price at around $66 is almost exactly where it was at last year's analyst meeting. Its market value, at about $375 billion, is almost unchanged. The difference, according to a chart CFO Connors displayed Thursday, is that now Microsoft is the country's second-most valuable public company, after General Electric, compared to its fourth-place standing a year ago. Gone completely from the top 10 are Cisco Systems, Nokia, Oracle and Nortel Networks.

Unable to predict with any accuracy PC shipment growth in 2002 and unwilling to suggest that Windows XP will account for a giant surge in revenue (like the fabled Windows 95), Microsoft provided investors with almost no new reasons to buy its stock. "The company said nothing that will move the needle," said Don Young, an analyst with UBS Warburg. But no matter, Young notes that Microsoft already is getting 40% of its revenue from "subscriptions," mostly so-called seat licenses from big corporations. He predicts total subscription-style revenue -- including sales of services like MSN to consumers -- will account for 90% of revenue within a few years.

That's the ultimate in predictability and durability. Like a tall tree, with its seedlings and saplings surrounding it.

In keeping with TSC's editorial policy, Adam Lashinsky doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. Lashinsky writes a column for Fortune called the Wired Investor, frequently guest hosts the TechTV cable television news show Silicon Spin, and is a regular commentator on public radio's Marketplace program. He welcomes your feedback and invites you to send it to Adam Lashinsky.

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