Microsoft Feels Like Lead

Shares of the software giant are headed nowhere fast.
By Bill Snyder ,

If you're holding your shares of

Microsoft

(MSFT) - Get Report

until you can book a 10% capital gain, we have a bit of bad news.

You may be waiting a very long time.

Despite a spate of happenings at Microsoft -- including its much heralded $3 dividend and the hiring of Ray Ozzie and the acquisition of his company -- the giant tech stock has refused to edge upward.

Making matters worse, Microsoft's inertia doesn't seem to be a short-term malady. The company's top-line growth has slowed while buyers wait for the next generation of Windows and

a raft of related products. And even when the new software hits the market in late 2006 and 2007, it is not at all certain that it will give sales the kind of boost needed to get the stock moving.

"There's no real reason to sell Microsoft now, but there's no compelling reason to buy," says Pat Adams, chief investment office of Choice Funds, which holds the stock.

Talk about faint praise. But considering how poorly Microsoft's stock has performed, it's probably fair. In two years, Microsoft's shares have appreciated by just 8%, while the

Nasdaq Composite

gained 47%. This despite the company's decision to pour at least $30 billion

into a special dividend last year.

If dividends didn't boost the share price for more than a few months, what could move the needle? Strong sales of PCs, nearly all of which run Windows and Office, would certainly help. But that won't happen in the short term. Growth in the worldwide market for PCs is expected to slow to 9% in 2005, down from last year's faster clip of 11.6%, according to Gartner, a technology research company.

Although the PC slowdown is not dramatic, there's a sobering bit of news in the Gartner report: The most recent upgrade cycle by businesses -- when corporations buy new hardware -- "peaked in 2004 and will decelerate sharply over 2005," says Gartner analyst George Shiffler.

Paste
Microsoft looks stuck

Source: BigCharts.com

The news is especially painfully, because there was a general assumption in the market that the upgrade cycle, the first since 2000, was still in its prime.

Intel

(INTC) - Get Report

took center stage last week, issuing new sales targets that represent a bit of an improvement over earlier expectations. But the

chipmaker's new forecast wasn't strong enough to convince some institutional investors that the tepid PC estimates are too conservative. "I don't see growth in the PC market of more than 10%," Bill Gorman, a vice president of PNC Advisors, said after Intel's midquarter update.

A number of analysts also say that Intel's forecast may be weaker than it appeared, since the current quarter has 14 weeks, one more than usual.

Microsoft founder Bill Gates often jokes that his company's biggest competition is Microsoft. He's right of course. Despite some inroads by Linux, Windows and Office are still in a league of their own.

The trouble is, it is taking more and more of an effort to push consumers and businesses into upgrading their hardware and software. Simply put, many people are happy enough with what they have, despite well-publicized security flaws and other problems with the company's software.

Consider Microsoft Office, the company's gigantic compilation of applications for the desktop, and Windows itself, Microsoft's flagship product. The Microsoft corporate divisions that sell them -- "Client," which handles Windows, and "Information Worker," which sells Office, accounted for 55% of the company's $10.8 billion in revenue in the December quarter. (Client revenue equaled $3.2 billion; Information Worker revenue was $2.8 billion.)

But after spectacular sales growth in early fiscal 2003, and two straight quarters of double-digit, year-over-year sales growth in 2004, Information Worker's sales slowed dramatically, and by the second quarter of fiscal 2005, they were down 3% from a year earlier.

The reason for the slowdown isn't difficult to discern. Microsoft dramatically changed the terms of its licensing agreements in 2002, prompting many businesses to switch to annuity-style agreements, which are recognized ratably over two years, instead of up front. In addition, the release of Microsoft Office 2003 gave sales the kind of bounce you'd expect when a major upgrade is released.

But the licensing shift is over. And with the next version of Office not likely to ship until Longhorn -- the successor to Windows XP -- comes to market in late 2006, there is no compelling reason for customers to upgrade.

"Microsoft is on to the upgrade game," says Nate Root, an analyst with Forrester Research. "They have to show buyers they've done more than move some buttons around on the toolbar."

This month's acquisition of Groove Networks, which makes software that allows workers to share documents and collaborate in meetings over the Internet, gives Microsoft sexy technology that can be added to Office and other Information Worker products. "We believe that Groove's products and technologies could be highly complementary to Microsoft's product offerings," says Goldman Sachs analyst Rick Sherlund.

Sherlund notes that Groove offers important security features, and says that Groove founder Ray Ozzie, who will become Microsoft's chief technical officer, is a visionary who may be able to influence his new employer's strategy and direction. Goldman Sachs has an investment-banking relationship with Microsoft.

Root is also enthusiastic about Groove's technology but warns that it will take some time for it to be integrated into next-generation products. "Remember, these programs have millions of lines of code. It will be a stretch to integrate it into Longhorn or Office 12," he says.

Similarly, the version of Longhorn scheduled for release next year is likely to be a significant improvement over Windows XP, but it will lack some of the snazziest features originally promised by Microsoft. "It will have nice-to-have features, but not must-haves," says Martin Reynolds, a vice president and research fellow at Gartner. Moreover, it will take businesses several years to get comfortable with the new operating system. The shift to XP, which has been on the market for almost four years, is not yet complete, he added.

Despite sentiment that Microsoft's stock is stuck, there are analysts making a bull case. Longhorn-related products should generate license sales of $50 billion over four or five years, says Jamie Friedman, who follows the company for Fulcrum Global Partners, an independent securities firm. Add in another $8 billion in deferred revenue and other items, the new operating system could generate $70 billion, estimates Friedman, who has a buy on the stock and a $30 price target. Fulcrum does not have an investment-banking relationship with Microsoft.

Even if Friedman is bullish, the risks are probably not that great. "With the multiple shrinking, some of the risk has been taken out. There's less downside than in the market as a whole," says Choice Funds' Adams. And the stock has a history of revving up in anticipation of an upgrade cycle.

Fair enough, and if you're looking for a defensive play, Microsoft is likely a good one. But there are a lot of stocks out there that are going to grow significantly faster over the next 12 months or so.

Loading ...