Microsoft Bulls Wait to Exhale

Strong cash flow and a roster of new fall products may not be enough to ignite the Street.
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Microsoft

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investors, the waiting game goes on. And on, and on, and on...

As the tech bellwether prepares to report earnings Thursday, some Microsoft bulls acknowledge that it's going to take more than a seasonally strong fourth quarter to revive the stock. Even an impressive lineup of products -- starting this fall and culminating at the end of next year with a new version of Windows -- isn't enough to get some investors excited.

"That's a long time to be waiting for a catalyst for a major part of their business," Duane Roberts, a portfolio manager with Dallas-based value shop Dana Investments, says of the timeline for the next Windows operating system, code-named Longhorn. (Roberts' firm sold its Microsoft shares after the company paid out a

record-setting dividend last year.) "The window for Longhorn is still too far out for my comfort," he says.

But don't tell that to the sell side. Analysts continue to be bullish on the stock, with their median 12-month price target sitting at a lofty $32 -- a level that has eluded Microsoft shares since early 2002. For years now, they've been touting the company's undeniably strong cash flow -- $14.6 billion in 2004 -- and low valuation, to no avail.

Most recently, for instance, Goldman Sachs software analyst Rick Sherlund noted Monday that Microsoft stock is trading at roughly 19 times his calendar-year-2005 earnings estimate of $1.34 a share and 17 times his calendar-year-2006 earnings estimate of $1.48 -- a significant discount to a group of software names followed by the firm, which averages 30 times 2005 earnings and 26 times 2006 earnings.

"We are expecting the flow of new product over the next 18 months to accelerate growth and drive higher valuation, pulling Microsoft stock out of its well-entrenched trading range," wrote Sherlund, who has an outperform rating on the company. His firm has done investment banking with Microsoft

Another analyst who likes the company, Jonathan Rudy of Standard & Poor's, concedes this about his $33 price target: "It's been frustrating because the company really has been executing the last couple of years and there hasn't been much reward to

the stock."

And there's unlikely to be much reward Thursday, when Microsoft is widely expected to meet fourth-quarter estimates. Analysts polled by Thomson First Call expect earnings to sit at 28 cents, including about 3 cents a share in stock-based compensation -- the high end of Microsoft's range of 27 cents to 28 cents -- on revenue of $10.16 billion, just about the midpoint of the company's range of $10.1 billion to $10.2 billion.

Excluding charges, analysts are calling for earnings of 31 cents a share. (There also could be a legal charge of $775 million, or 5 cents a share, related to a

legal settlement with

IBM

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, Sherlund noted.)

Garban Institutional Equities analyst Richard Williams, the one analyst with a sell rating on Microsoft and a price target of $22, says the problem with the company is that its growth is actually slowing down, and his analysis shows that Microsoft stock is actually expensive.

Williams compares the increase in sales for the four-quarter period ending in March with the previous four-quarter period ending in December and then to the previous four-quarter period ending in September. He concludes that sales growth declined to 1.2% from 2.4%.

The analyst also argues that Microsoft's dividend yield of about 1.25% is very low compared with other dividend-paying companies showing similar growth, noting that the

S&P 500

on average has a dividend yield of roughly 2%. Williams has no position in Microsoft.

But this approach is looking backward instead of forward, counters Mark Lebovitz, a portfolio manager with the

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Munder Internet Fund and

(MTFAX)

Munder Future Technology Fund, which hold Microsoft shares. "I think we should see some accelerating growth in the next year," Lebovitz says of Microsoft's sales.

Analysts on average are forecasting that sales growth will increase from 8% in fiscal 2005 to 10% in fiscal 2006 and fiscal 2007.

The next 18 months will be crucial as Microsoft unveils a slew of new products. This fall, Microsoft will launch new developer tools; a new version of its SQL server database, which is expected to turn up the heat on rivals IBM and

Oracle

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; and the Xbox 360, the second generation of Microsoft's video-game console.

Then, by the end of next year, come the next versions of Office and Windows -- Microsoft's two cash cows.

"You've got the beginnings of a juggernaut of new products coming out for this company" later this year, says Rich Parower, portfolio manager of

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the Seligman Global Technology Fund, which holds Microsoft shares.

One sign of how important customers view these new products will come Thursday from Microsoft's unearned revenue line. Unearned revenue tracks sales to customers on a subscription basis, in which they pay for the right to receive future upgrades during the life of their contract.

Three months ago, Microsoft executives became more optimistic about unearned revenue. They said they expect to end fiscal year 2005 with a couple hundred million more dollars than their previous target of $8.6 billion, representing a sequential increase of $859 million, or nearly 11%.

Sherlund said unearned, or deferred revenue, could even rise as much as $1 billion because subscription renewals for business customers are typically heavy at the end of the company's fiscal year.

However, Parower says it still could take a year after the launch of Microsoft's new database product later this year to reinvigorate growth enough to catch Wall Street's eye.

And that would mean the waiting game for Microsoft's stock carries on until at least next fall.