Microsoft's (MSFT) - Get Microsoft Corporation (MSFT) Report future earnings may be threatened by more than evaporating PC demand as the value of its investments in other companies shrinks with the Nasdaq Composite Index.

In the software giant's first quarter, which ended Sept. 30, about 3 cents of its profit of 46 cents a share came from $600 million in gains on equity investments. Two of that 3 cents of the gain were from the sale of stakes in

TransPoint

and

Titus Communications

.

But with the Nasdaq off more than 39% in 2000, Microsoft, like any tech investor, has most likely seen the value of some of its holdings fall. Many companies like

Intel

(INTC) - Get Intel Corporation (INTC) Report

and

Gateway

(GTW)

are

facing this problem, as well.

Both Kinds

Microsoft has invested in publicly traded companies and privately held companies. With the publicly traded companies, it's possible to see whether Microsoft's investments have declined in value. And for Microsoft, investments in publicly traded companies are easier to exit since there's a market available.

But it's tougher to gauge how Microsoft is doing with privately held companies since their values on an ongoing basis are unclear, and there's no public market for the stocks. Still, the company may eventually realize smaller gains on its private investments than it originally hoped, since valuations of many of these companies are based on publicly traded outfits. The weak market also makes it less likely that these companies will be able to go public, which would make it easier for Microsoft to cash out.

"The knife is slicing away at it

Microsoft's investment portfolio now. Earnings growth in the near term is becoming less and less," says Christian Koch, of

Trusco Capital Management Fund

, which manages $50 billion. "The jury is still out whether the return on those acquisitions will be worth it to shareholders." (Trusco holds 6 million Microsoft shares.)

Of course, the market could turn -- as it did Wednesday thanks to the

Fed

. But if it remains soft, companies with these investments will continue to have a tough time turning them into easy money, which for months was how it worked. Microsoft and Intel, for instance, were able to get analysts to include the gains in their earnings-per-share estimates. Analysts usually exclude gains, because they're not considered part of the day-to-day business.

Climbing

According to filings with the

Securities and Exchange Commission

, Mr. Softee's equity portfolio at June 30 was worth about $12 billion, up from $9.6 billion a year earlier. In the first quarter ended Sept. 30, it was roughly $14 billion. The company's portfolio swelled in part due to new investments the company made last year. According to Microsoft's 10-K, one-third of its "equity and investments" is in debt securities. All private investments are booked at cost.

So far, Microsoft's management is showing no sign of nail biting over its shrinking investment portfolio. In a Dec. 14 conference call, Chief Financial Officer John Connors said that the company hasn't changed its guidance from the $800 million in investment gains, interest and other income it expects for the second quarter, which ended Dec. 30. So far, Microsoft hasn't written down any bad investments or suggested that it may do so. The company declined to comment for this story.

For fiscal 2001, Chris Shilakes, an analyst at

Merrill Lynch

, still estimates the company will have $3.6 billion in interest income, or 42 cents on total earnings of $1.82 a share.

How It Started

Microsoft began investing heavily in tech and media companies in the early 1990s, when dealmaker Greg Maffei worked as company treasurer and later as CFO. Microsoft invested in growing tech companies like

TCI Technology Ventures

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and

DreamWorks SKG

.

"Unlike, Intel, for example, which invested in everything dot-com, Microsoft made truly strategic investments to further its business," says Fed Hickey, publisher of

High Tech Strategist

. And to make itself look "less predatory in the face of so many legal challenges, the company recently invested in competitors like

Corel

(CORL)

the maker of

Word Perfect

software," says Hickey, who has no position in Microsoft.

Tim Gaumer, a fund manager at

TransAmerica

, agrees that Microsoft has used its portfolio as more of a strategic vehicle than as a speculation vehicle. "That's why they've avoided some of the blowups that other companies are experiencing," says Gaumer, whose fund owns Microsoft stock.

It's not clear what Microsoft may have gained or lost on its investments because the company doesn't release what it originally spent on many of them. Microsoft doesn't include in its bottom line unrealized gains or losses, which reflect the fluctuations in market value of the securities it holds. But the company's balance sheet will show at each quarter's end how much the value of its investments has changed.

The Bad

But Microsoft is likely suffering indigestion over a big investment it made in

AT&T

(T) - Get AT&T Inc. Report

. The softwaremaker bought $5 billion worth of AT&T stock May 6, 1999, for $50 a share. The investment was to "demonstrate Microsoft's continuing commitment to accelerating the deployment of broadband Internet connectivity, communications services and wireless opportunities," according to Microsoft. At that time, AT&T shares were worth $63 each. Now they're worth barely $18. Other deflated investments include

CMGI

(CMGI)

,

Qwest

(Q)

and

Apple

undefined

.

But because Microsoft bought in before the IPO in some cases, it may still be ahead despite a precipitous stock drop. But if its investments have fizzled more than the company wants to tolerate, Microsoft could either sell some of its stock, sell more stock than expected or hold on to the stocks in hopes of a long-term rebound.

Some analysts believe that its financial team is prepared for stock market fluctuations "These are savvy investors. Microsoft has to be hedging their riskier investments," says Patrick Dunkerley, analyst at

Securities Corp. of Iowa

, which hasn't done underwriting for Microsoft. Hedging is a strategy to offset investment risk.

"How effectively they are hedging is the key here," says Dunkerley, who rates the stock hold. "Microsoft doesn't change its strategy based on what the market is doing week to week."