First it was a $10 billion dividend. Now it's a possible $40 billion stock repurchase.

So goes the evolution of theories from Goldman Sachs analyst Rick Sherlund on how

Microsoft

(MSFT) - Get Report

will spend its mind-boggling cash hoard, which the company plans to address at its July 29 analyst day.

Sherlund, believed to have the ear of Microsoft executives more than any other sell-side analyst, floated the $40 billion buyback possibility in a note this week entitled: "What if Microsoft Buys Back a Lot of Stock?"

Previously, the veteran software analyst suggested the company could issue a special

one-time dividend of $10 billion to $20 billion. But his thinking has shifted in the ensuing months.

"We believe management is motivated to improve their share price," Sherlund explained in his report, noting that repurchasing shares would help the stock more than a special dividend.

To be sure, Redmond, Wash.-based Microsoft shares could use some help. While up 9.1% in the past year, they badly trail a 21.1% jump in the

Nasdaq Composite

. Since the end of 2002, Mister Softee shares are up only 4.1% vs. a 47.5% jump in the Nasdaq.

"We hesitate to set expectations too aggressively, but believe bigger is now more likely than smaller and repurchase may be more substantial than any special cash distribution," Sherlund added, noting even Microsoft executives may not yet know what they will do. (Sherlund has an outperform rating on Microsoft and his firm has done banking with the company.)

But in a world where expectations are everything, there is a risk that Sherlund is raising the bar too high for the software giant, setting the stage for a classic "sell the news" reaction to whatever the company actually announces.

Furthermore, Sherlund -- who has had an outperform rating on Microsoft since November 2002 and has been recommending the stock since at least April 2001 -- has spurred speculation that he is serving as Microsoft's mouthpiece, floating various "trial balloons" for paring down its cash.

The "special dividend" scenario was "roundly booed by longer-term Microsoft holders, which makes it even more likely he's being used as a conduit by

the company to try out various strategies," commented one buy-side analyst, who requested anonymity.

But in an email exchange Tuesday, Sherlund said his latest theory did not come as a result of a conversation with Microsoft, and at least one investor indicated he doesn't view Sherlund as a conduit to Redmond.

"I just think Rick is laying out some scenarios," said Gus Zinn, an analyst with Waddell & Reed, which holds Microsoft shares. "I don't think he has a clue what's going to happen."

Day of Cash Reckoning

With a stratospheric $56.4 billion in cash plus $15.2 billion in strategic investments, Microsoft has drawn the ire of investors who say the company should share the wealth rather than register paltry single-digit returns on that stash.

Sherlund figured a $40 billion share repurchase would add a dime to earnings per share, raising his calendar 2005 estimate to $1.52 a share. Accompanied by the buyback speculation, that helped Microsoft shares rise 51 cents, or 1.9%, to $27.41 Tuesday.

Still, any buyback-induced EPS boost would come at a time of slower revenue growth for the world's largest software maker. Microsoft already has

cautioned investors that it will suffer tough comparisons in fiscal 2005 as some customers who took advantage of a one-time sales offer are expected to decline to renew their software subscriptions. The result is what Sherlund called a "drag on investment sentiment" for much of this year.

In addition to Microsoft buying back shares, Sherlund has been expecting management to boost its dividend from its current 0.6% yield to 1% later this year. He notes, however, that Microsoft can afford to pay a yield as high as 4% given that it's generating about $12 billion a year in free cash flow.

Or maybe it'll decide to do something in between. "Perhaps they could step the regular dividend up more aggressively to 2% and still have sufficient cash flow for $6 billion per year in share repurchase," Sherlund wrote.

Indeed, Transamerica Investment Management fund manager Chris Bonavico believes investors are already expecting a 2% yield.

But "a $40 billion redistribution is not in the expectations, and I think it would be viewed very positively," said Bonavico, whose firm holds Microsoft shares.

Such a bold move from fiscally conservative Microsoft would "send out a huge message of confidence that their business is going to survive competitive threats and continue to generate plenty of free cash flow going forward," he added, noting that a significant group of investors believes Linux open-source software and piracy outside America are going to stunt Microsoft's growth.

So goes the irony confronting Microsoft, which some say sits on enough cash to buy out the entire Linux market, even as others say Linux has it under siege.