Microsoft: Spending Spree

Investors have waited a long time for Microsoft to turn a corner. The stock hasn't gone anywhere since 1999 -- well, actually it peaked at $60 late that year and has been trading in a fairly narrow band in the $20s since 2003. In March, the Redmond, Washington, software colossus disappointed investors mildly when it said it would delay the release of its updated Office software and Vista, the new Windows operating system, until next year.

But investors really got angry on April 28, after Microsoft announced it would spend about $2 billion more than originally anticipated in the June 2007 fiscal year to boost marketing and development of new products. Massive selling drove the shares (symbol MSFT) down 11%, to $24, reducing Microsoft's market value by $32 billion. Chairman Bill Gates lost more than $3 billion on paper.

The company also missed analyst expectations for its March quarter. Microsoft reported that profits rose 16% in the quarter ended March 31, to $3 billion, or 29 cents a share. Sales in the quarter were up 13%, to $10.9 billion, but were less than what analysts expected. "It appears investors can't win," says Friedman Billings Ramsey analyst David Hilal. "When growth was slowing, margins were improving. Investors begged for some meaningful growth. Now we have it, but it's at the expense of profits." Hilal retains his "outperform" rating on the stock, with a price target of $32.

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Microsoft's splurge is aimed at creating Web services that will compete with offerings from Google and Yahoo. Other initiatives include heavily promoting the XBox 360 and crafting new security and communications software. The spending spree "removes any possibility of meaningful earnings acceleration or upside for the foreseeable future," says Lehman Brothers analyst Israel Hernandez, who cut his target price for Microsoft shares from $32 to $25.

The extra expenses for new products is a bump on the long-term path of growth, says Merrill Lynch analyst Kash Rangan. "The time is right for Microsoft to make this bold strategy bet -- two years from now may be too late," he says. Hilal thinks the money spent is a trade-off for long-term gains. "The business is accelerating on the heels of a strong product cycle and double-digit growth should be sustainable for the next few years," he says.

Friday's sell-off puts the stock in valuation territory it has rarely seen before. It sells at 18 times the $1.32 per share that analysts expect the company to earn for the fiscal year ending June 30, according to Thomson First Call, and about 17 times the high end of the range that Microsoft forecasts it will earn in the June 2007 year. While that is cheap by historical standards, it's probably not cheap enough to whet the appetites of true bargain hunters. And uncertainties surrounding Microsoft's earnings prospects make it unlikely that the stock will interest growth investors. For the foreseeable future, the stock is probably dead money.

--Thomas M. Anderson