The Changing Face of Microsoft

Stocks are a lot like children: Your expectations for them can determine how you treat them. That's why long-suffering Microsoft shareholders may need to alter their view of their difficult child, now a young adult. If you expect Microsoft to return to the glory days of the 1980s or 1990s, you'll be disappointed. But if you see Microsoft (symbol MSFT) as an attractively priced steady grower, it looks far more appealing. "Its prospects for growth are good when compared with other mature blue chips," says Kevin Landis, head of the Firsthand funds.

Shares of the software colossus have lost half their value over the past eight years. They peaked at $60 in late 1999, collapsed in 2000 and fetched just $30 in mid October. All along, the Redmond, Wash., company has delivered steady earnings gains, although growth has slowed considerably since it went public in 1986.

Microsoft consists of five major divisions: Windows operating systems; Office applications; server software; entertainment systems, such as Xbox; and online services. The last category includes Web advertising and search services, in which the company ranks a distant third behind Google and Yahoo. Microsoft loses money on both its online and entertainment divisions.

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The rest of the company is a different story. Because Windows and Office are near-monopolies (more than 90% of new personal computers come with Windows installed), Microsoft collects a toll on most PC sales. Gartner Group estimates that 258 million PCs will be sold worldwide in 2007, and that figure is still expanding by about 10% annually. "Microsoft has an annuity stream," says analyst Keith Maher, of BB&T Asset Management. For the fiscal year that ended June 30, the Windows and Office divisions generated a combined $22.4 billion in operating profits (earnings before taxes and interest), representing a 72% profit margin. The fast-growing server division produced a respectable 35% margin.

Now is a sweet time in the product cycle for all three money-making divisions. Microsoft launched its new Windows Vista operating system and Office 2007 earlier this year. Early next year it's scheduled to release Windows Server 2008. Many businesses will probably upgrade to all three simultaneously. The weak dollar also helps Microsoft, which booked 39% of sales abroad last year.

Under the leadership of chief executive Steve Ballmer and chairman Bill Gates, Microsoft will remain immensely profitable and continue to reward investors with growing dividends and extravagant share buybacks ($47 billion over the past two years). Each month, Microsoft, which is debt-free and holds $23 billion in cash, generates more than $1 billion of free cash flow.

The stock trades at about 16 times estimated profits for calendar year 2008, compared with 15 for the overall market. But Microsoft has much higher profitability, more-consistent cash flows and better franchises than the typical U.S. firm. Despite its girth, it should be able to achieve annual earnings gains of more than 10% over the next few years. It may no longer be a wunderkind, but Microsoft can still generate solid returns. Look for the stock to reach $35 (or maybe a tad higher) over the next year.