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Microsoft Huffs Through Tough Year

We got less than expected from Microsoft this quarter: Flat sales, sinking operating income, and rising receivables. There's not much to like. Investors should check in next quarter to see if sales from new products accelerate and Softy takes better care of its balance sheet.

By Zeke Ashton (TMF Centaur)
July 21, 2000

Hey, Fools!

We've hit the heart of earnings season, which means we'll be checking in on our Rule Maker companies to make sure all is well. Today, I'll cover Microsoft's (Nasdaq: MSFT) fiscal fourth quarter, and next week I'll hit Coca-Cola (NYSE: KO).

First, I'll say a few things about why we do this each quarter.

We run all of our companies through a quarterly check because it keeps us focused on the companies, not the stocks. Rule Makers are built to last, and through partnering with great businesses over the long-term, we expect to accumulate wealth. With the volatility associated with earnings reports, our quarterly Rule Maker checkup keeps us calm and focused on the criteria we believe are most important for long-term investing.

It would be easy to give in to panic and sell on short-term bad news, or rush into a hasty purchase on short-term good news. It would have been easy to sell Intel (Nasdaq: INTC) several times over the life of this portfolio. It would have been easy to sell Yahoo! (Nasdaq: YHOO) last week. It would have been easy to sell every one of our companies at some point over the past two years if we didn't keep our focus on long-term prospects. Instead, we've never sold any of our Rule Makers, and I doubt anything will crop us this quarter to change that. It would take more than a rough quarter to make us part with them, but without the discipline that comes from leaning on a consistent framework, we might not have the confidence to hold firm.

Also, the quarterly checks are there as an example of how to check your own portfolio. While we run checkups quarterly, we could just as well do so semiannually or even annually. Owning Rule Maker companies provides freedom from having to constantly watch the news for signs of trouble. We do ours quarterly because spending a couple of hours every three months to review the earnings and 10-Q's is something we like to do. We don't do it to be online cheerleaders for the companies; on the other hand, for the most part we invest in companies we really like, and gain satisfaction from seeing them do well.

Enough preamble, on to Microsoft. Because its fiscal year also ended on June 30, we have the opportunity to look at both the quarterly report and the entire year's results.

Microsoft's sales for the fourth quarter were $5.8 billion, up less than 1% from a year ago. This is the lowest sales growth figure Microsoft has reported for the last eight quarters, and I can't remember a quarter where Softy hasn't posted at least double-digit sales growth. It's not something we expected.

While sales were flat, operating profits were down 13.1% to $2.524 billion from $2.9 billion in the fourth quarter of last year. The operating profit margin fell from over 50% last year to 43.5% in the fourth quarter. Normally Microsoft can be counted on to grow operating income faster than sales. Looking at last year's quarter, for example, Microsoft grew sales 38% year-over-year, and operating income increased 55.8%.

More than $1.1 billion of investment income offset weak operating profits. It's more than double the nonoperating income reported a year ago. While investment income is always nice, it doesn't reflect the company's core earnings power and can't be relied on every quarter. Only with help from investment income did Microsoft increase net income 9.4% to $2.4 billion. Net margins, again with help from investments, increased to 41.5% from 38.2% in Q4 last year. Earnings increased 10% to $0.44 cents per diluted share.

On the balance sheet, Microsoft added another $2.5 billion in cash during the quarter, and, of course, there's no debt. Its cash-to-debt ratio is now $23.7 billion to zero. Overall, however, the balance sheet showed marked deterioration, mostly due to the accounts receivables increasing 47% from Q4 last year. We don't like to see accounts receivables and inventories rising faster than sales. The huge increase in those bad current assets caused Softy's Foolish Flow Ratio to jump by more than a third, to 0.49. That's the highest Flow for Microsoft since we began tracking the figure, and I bet it's the highest Flow in the last decade for Softy.

While Microsoft didn't include cash flow data on the report, I know that free cash flow will be negatively affected by the rising Flow Ratio. With a company as large as Microsoft, each point that the Flow rises can cost millions in free cash flow. We'll have to wait for the 10-Q to see exactly how the quarter shaped up, but I'd expect Microsoft to turn in free cash flow around $3 billion.

Microsoft's quarter was pretty poor relative to historical standards. Let's look at the full year to see if we can benefit from looking at the bigger picture.

For the full year, sales increased 16.3% to almost $23 billion. Gross margin, despite the poor fourth quarter, increased more than a full percentage point to 86.9% from 85.7%. Operating margin declined to 47.6% from 50.3%, and operating income increased 10.2% to almost $11 billion. Investment income topped $3.18 billion, up 76% from last year. That bonus pumped net income up 21% to $9.42 billion, up from $7.78 billion. The investments also helped push net profit margins to 41% from 39.4%.

There are a couple of obvious concerns. The first is sales growth. Microsoft boosted sales 16.3% this year, the lowest full-year growth rate in company history. Of course, slowing growth is to be expected at some point, and the company has been defying gravity for years. We do need to keep in mind that Microsoft is at the early stage of a new product cycle, and I expect that sales of Windows 2000, SQL Server 2000, and the new Windows Me product will kick in during the second part of 2000.

The second concern is the Flow Ratio. Further deterioration in this ratio means less free cash flow, and it could also imply that Microsoft's management is taking their eye off the ball a bit in the midst of the legal battle. We'll check on the company next quarter and look for the Flow Ratio to return to historical levels.

On the topic of Microsoft's legal woes, you might be wondering what effect a breakup would have on the Rule Maker Portfolio. In the event of a breakup, I think we should assess the pieces separately as Rule Maker investments. If both companies meet our Rule Maker criteria, we should keep them. If only one qualifies, then we should sell the one that doesn't cut the mustard. That's just my opinion, and I'm open to suggestions. If you've got something to say about Microsoft's earnings or possible breakup, let's hear your views on the Rule Maker Strategy discussion board.

Have a great weekend!

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