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Microsoft Faces Rocky Road in Short Term

Microsoft has some rough ground to cover in the December quarter, but things look much brighter in the longer term, according to Goldman Sachs & Co. analyst Rick Sherlund.

"Investors will pretty much just have to look past this fiscal year and look out to fiscal 2003 to get excited about the stock," Sherlund said in research released Wednesday.

Sherlund noted that Microsoft is susceptible to the whims of PC demand, and said the immediate outlook on that front remains poor, with sluggish corporate demand and low consumer confidence "reflecting the recessionary economy."

GS has estimated earnings per share of $1.86 for Microsoft for fiscal (June) 2002, but said the above factors may indicate further downside to that estimate.

"Perhaps helping to offset some of this may be more aggressive cost cutting, and in the September quarter we believe there was some benefit from upgrades to current license agreements in order to qualify for the new Software Assurance program," Sherlund said. "It is more the December quarter that is at issue."

He noted that it is unclear what effect the events of Sept. 11 will have on consumer sentiment, and that in turn clouds the outlook on how Microsoft will benefit from the Oct. 25 launch of Windows XP. Prior to Sept. 11, GS had been estimating revenue of $7.25 billion for the company's fiscal second quarter 2002 (December), up 23 percent sequentially from the $5.875 billion revenue estimate for the quarter just ended. Excluding the $300 million revenue estimate expected to come with the introduction of Microsoft's Xbox game console, that is still up 18 percent sequentially.

"If we were to assume that business, even with the benefit of Windows XP, were up 13.5 percent sequentially as we experienced last year (excluding Xbox), this would imply we might need to take another $250 million out of December quarter estimates (about 3 cents per share before any mitigating cost reductions)," Sherlund said. "The 10 cents per share gain from Expedia in our estimates might be only about 7 cents given current prices. It is unclear whether there will be further losses to be absorbed in the investment portfolio again in the September or December quarters as well. Offsets in addition to possible more aggressive cost reductions could be a more favorable mix of the higher-end operating system, as we have observed over the past two quarters."

But while the immediate outlook is for lower than expected revenues, Sherlund said the company is likely to benefit from a rebound in corporate demand in fiscal 2003. Many corporations last upgraded their desktops to cope with Y2K, most of them several years in advance of the event. The corporate upgrade cycle tends to turn every three to four years, and Sherlund expects corporate demand for upgrades will crest in fiscal 2003, and that the consumer market will also be primed for new products as the economy strengthens.

"This is not that far away, so we believe we need to get through the September quarter results and any further estimate revisions, then perhaps investors will begin to focus on the second half of calendar 2002 for accelerating growth (and very easy year over year revenue and earnings comparisons)," Sherlund said.

On the anti-trust front, Sherlund said investors are less likely to focus on those issues now that a break-up of the company appears to be off the table.

"We are hopeful that a settlement could be brokered by the upcoming court required mediator," he said. "The previous mediator (Richard Posner) was complimentary of MSFT and the DOJ in their good faith negotiations, but the hard-line states he did not mention, implying that they were insistent on a break up remedy. Now that the break up appears to be off the table and the tying case is not being pursued, maybe there is less of a gap to bridge."

He suggested that a settlement in the U.S. could also carry over to the European Union's anti-trust watch-dog, the European Commission (EC). The EC has brought a case against Microsoft over its bundling of the Windows Media Player with the Windows operating system.