Microsoft-Where Do You Want To Go Today.

I am not normally in the habit of discussing investments on this site but I felt the need to review Microsoft (MSFT) not only because it is a well known company but also because I have held it for a very long time for client accounts. Unfortunately MSFT delivered an lousy earnings report this week while at the same time indicating that their spending would increase substantially over the next year. Wall Street lopped 11% off of the company or over $50 billion dollars in market capitalization.

What do I think? What is there to do here?

Owning MSFT over the past 2-3 years has never been about hoping that the company would ever get back to its high growth days. It is simply too big for that now. But the thesis was that after they paid out their one time 10% dividend that you were being paid to wait for a new generation of products namely XBox for gaming and Vista-the new operating system for computers. Early this year the introduction date for Vista was pushed back to the end of this year. The announcement made on Thursday puts 2007 seemingly out of reach as well.

Goldman Sachs published a piece on Thursday which I will summarize:

"The revenue story at MSFT looks good, with a strong new product cycle upcoming in calendar 2007, some upside developing in the growth rate of deferred revenues, and evidence of some early progress on the piracy front. The spending outlook, however, is quite surprising, with management disclosing plans to accelerate spending by roughly $2 billion more than expected in fiscal (June) 2007. This effectively takes the wind out of the sails of investor sentiment at a time when investors were beginning to warm up to the prospects for accelerating earnings momentum expected from the Vista and Office 2007 product launches in January. We should still see about 20% EPS growth in calendar 2007, but the investment spending will be disruptive to EPS growth for the balance of calendar 2006 and leaves investors unresolved on what the benefits might be of this radical acceleration in spending.
MSFT has not yet disclosed much about its plans to build out what we believe is an online platform of hosted services to address the online advertising market (similar to Yahoo! and Google) and its efforts to build an ecosystem of third party developers with Atlas and other developer tools and support services. We believe much of this incremental spending is intended to fund this initiative, although the strategy has not yet been disclosed. There are pieces of the puzzle that we have talked about that shed light on the unfolding strategy to address the online advertising market, which we review below.
Results for the third (March) fiscal quarter were a bit below expectations, with revenues coming in at the low end of expectations at 13% growth and EPS of $0.31 (excluding litigation charge of $0.02) falling a bit below our $0.33 estimate. Mostly, it appears that there has already been an acceleration in sales and marketing spending that is likely to accelerate in the June quarter and throughout fiscal 2007. This is the quarterly conference call when management typically offers guidance for the following fiscal year, but this guidance was very far from expectations, leaving investors quite surprised. Normally, there is some directional commentary on the January conference call to prepare investors for what plans may be, perhaps this has been a late decision to step on the accelerator and ramp-up investment spending. There were a number of areas of investment noted including Xbox, support for greater sales headcount in the small business market, product launch costs etc, but the areas that we believe are most strategic and likely to receive the majority of this incremental spending will be in the online market. It may have been difficult to address this specifically on the call given that the strategy has not yet been fully disclosed, but management did respond that they expected to devote substantial time to this at the upcoming July 27th analyst meeting. We are revising our estimates for fiscal 2007 and fiscal 2008 downwards to reflect the announced increases in spending by the company. FY2007 is being revised downwards by $0.15 to $1.42 and FY2008 is being revised downward by $0.14 to $1.64.
From an investor sentiment perspective, this is clearly a discouraging development, taking away from the anticipated excitement over the strong upcoming new product cycles in calendar 2007. The value that this investment might generate can probably be better understood at the July analyst meeting when the online initiative is more fully articulated. In any event, the potential for near term gratification from the upcoming new products will need to be traded off for lowered earnings expectations and the uncertain value to be created by this sizable investment in positioning the company in the online advertising market."*

MSFT seems to be caught in no man's land. To slow growing to be a growth stock. Not cheap enough yet to be a value play. Its earnings and prospects probably amount to limited downside at this juncture. Yet there is also no catalyst for much upside unless some new information is forth coming from the company. It seems to be unable to execute as technology shifts away from the PC and becomes more net centric. It is likely dead money and dead money is the worst kind of money on Wall Street.

Thus I have made the reluctant decision to start to move away from this name. That means that in smaller accounts I will ultimately be selling my position and for larger and more longer term oriented accounts I will either lessen their exposure to the name or employ strategies that will hopefully making owning this name less painful. That said nobody has ever made a dime panicking out of a stock and friday's action certainly qualified as such. There may be some spillover in this regard early next week and there is possibly another dollar or so downside in the name. However, I believe that there will be a time and place to start lightening up on this name and that is what I will look to do going forward. Ultimately it will be a source of funds for clients while taking into account their various portfolio profiles.

Possibly at some point in the future this will be an attractive security once again. Perhaps some new information will be forthcoming from the company that lets us change our minds regarding its prospects. Today is not that day. Time to move reluctantly on.

*Sherlund, Rick. Goldman Sachs Investment Research. April 28, 2006.

Long MSFT in various client account. The above posting states what my opinion is regarding MSFT and what I plan for it regarding my own clients. It should not be construed as a blanket investment opinion or any form of an investment recommendation. Please note that my opinion could change with further disclosures from the company which may or may not be commented on in this blog. Please do your own investment research or talk with your own investment advisor before you follow anybody elses investment thoughts.