Is

Microsoft

(MSFT) - Get Report

, which is approaching an historically low valuation, actually that cheap?

Not really, says Citigroup analyst Brent Thill, who published a thoughtful 15-page note on the software giant late this week.

Thill, who defected from Prudential earlier this year and took his software team with him, says that even at 17 times earnings Microsoft is getting extra credit for its hefty 39% operating margins -- although they're about to sink. He expects margins to fall 230 basis points to 39.5% in fiscal 2006 from 41.8% in fiscal 2005 -- and an additional 50 basis points to 39% in 2007.

And he figures it will take three or four years to return to margins of 42%, let alone the 50% operating margin the company enjoyed in 1999.

Citigroup has an investment-banking relationship with Microsoft.

By way of contrast,

Oracle

(ORCL) - Get Report

, which is expected to deliver an operating margin of nearly 41% this year, is trading at just 15.5 times earnings.

Microsoft, of course, surprised Wall Street last month with plans to spend an extra $2 billion or so on R&D in fiscal 2007. But Thill wonders if Microsoft will get enough bang for the megabucks it plans to spend. "Innovation at Microsoft is not 'frictionless' but rather inefficient, indicting that increased spend on emerging areas could prove unproductive in the near term, even with an R&D budget of $7 billion."

To put the that huge number in perspective, remember that it represents more than 60% of Oracle's total revenue, and more money than

Apple

(AAPL) - Get Report

,

Adobe

(ADBE) - Get Report

,

Autodesk

(ADSK) - Get Report

,

Intuit

(INTU) - Get Report

,

Google

(GOOG) - Get Report

, Oracle and

Yahoo!

(YHOO)

combined spend on R&D. It also represents about 14% of revenue, while Apple, which has innovated rings around Microsoft for years, spends roughly 3% or 4% of revenue on R&D.

"Microsoft needs to grease the skids and increase the return from its development dollars, as we haven't seen these results over the past five years. Vista is long overdue, and the industry is questioning how compelling the upgrade will be," writes Thill.

That last remark flies in the face of the bull argument that Vista will spark a major software and hardware upgrade cycle. But its worth remembering that Microsoft long ago removed the most compelling features of Vista (in particular a new file system) in the interests of getting the mammoth operating system out the door before the end of the decade.

No Respect

If you were the CFO of a company that was growing revenue at better-than-expected 16% to 21% a quarter, you'd probably feel pretty good. But Craig Bruya, chief financial officer of Microsoft's Business Solutions unit, doesn't get much respect beyond the bounds of his company's Redmond, Wash., campus.

That's because his division, which is closing in on $900 million a year in revenue, is dwarfed by the rest of the company.

MBS, as its called internally, will never catch up with the Windows or Office divisions. But Microsoft is beefing up the business unit's resources and working hard to convert what was once a hodgepodge of software acquired via M&A into a unified product set. Indeed, even some veteran industry analysts have been surprised at the generally positive reception the company's Dynamics line of business software has been getting from customers.

"I'm running across them more and more," says Sheryl Kingstone, a software analyst with the Yankee Group. One big reason: People want to stay on the familiar Microsoft platform. Kingstone, who follows customer relationship management software, says that Microsoft's CRM application integrates well with the company's popular Outlook and SharePoint applications, and that makes users quite comfortable, she says.

Dynamics is still a long way from being ready to challenge industrial-strength applications from Oracle and

SAP

(SAP) - Get Report

-- but it doesn't have to fight that battle. There's plenty of revenue to be had from smaller business in the mid-market.

In fiscal 2002, MBS posted just $355 million in revenue. By 2005, that number had more than doubled to $803 million, and the company's guidance calls for growth of 10% to 11% in 2006. In the first three quarters of the year, MBS revenue grew 16%, 17, and 21% year over year, in each case 5 percentage points or more above guidance.

Profitability, though, is another story. The unit turned a small profit in the second quarter, and then posted a loss in the third quarter and will be "close to a profit" in the fourth quarter, says Bruya.

"We invested heavily in R&D a few years ago to develop the Dynamics line, but at this point R&D doesn't have to grow so fast. You will see us moving toward profitability," he said. When might that be? "We have said we expect sustained profitability in the next fiscal year, and I see a little upside from that," Bruya said in an interview.

One area that will get more attention is the distribution channel, says Bruya. MBS sells through a network of resellers, and expanding it means more money for training and marketing. Microsoft has had some difficulty working with the channel, but analyst Sharon Mertz of Gartner says "distribution partners tell me that their relations with Microsoft have gotten much better in the last 18 months."