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Volume 1, Number 22 -- July 28, 2004

Does Dividend Spell the End of Innovation for Microsoft?

by Alex Woodie

Microsoft's decision last week to dispose of its cash hoard by paying shareholders $75 billion over the next four years signals the end of an era for the world's largest software company. The question for potential investors and customers, though, is what will the future bring? Does Microsoft's letting go of the dough mean an inevitable maturing of a company that was the poster child of wealth and strategy in the PC era, or is it a simple admission that the company is out of IT ideas and shareholders are better off investing the money themselves?

Under the plan, approved by Microsoft's board of directors, the company would dole out most of its cash in three ways. First, it would issue a one-time dividend of $3 per share this fall, amounting to $32 billion. Second, it would double its dividend by moving from its current annual dividend of $0.16 per share to a quarterly dividend of $0.08 per share, which would increase the dividend to $3.5 billion per year. Finally, Microsoft plans to buy back up to $30 billion of its stock over the next four years. All told, these three moves would put $75 billion back in the hands of its shareholders through 2008. It is the single largest cash disbursement in history, and is so big that it could provide a noticeable boost in the nation's economy this fall.

Since the Federal government started its investigation into Microsoft's monopolistic tendencies a decade ago, the Redmond, Washington, company has been accumulating cash to fortify its business against not just a rainy day but a legal tsunami. Shareholders have long pestered Microsoft about it plans for the swelling hoard, and company chairman and chief software architect Bill Gates has always said in annual shareholder meetings that the company wanted to keep the money as an insurance policy against possible actions that could disrupt the company. It wasn't until January 2003 that, under pressure from shareholders, Microsoft's board approved its first dividend, in fact.

Microsoft executives pointed to the recent settlements of long-running legal disputes (which we have reported on for many years) as a key driver in the decision to distribute its cash pile. The settlement with the Department of Justice is largely on track, as are settlements with most of the class-action lawsuits brought by individual states. The $1.95 billion it paid to Sun Microsystems in April not only put an end to its legal troubles concerning Java but also served to silence one of Microsoft's most vocal critics. Settlements with AOL-Time Warner and have also made Microsoft feel more secure about its future, although it is facing new troubles in Japan and the antitrust lawsuit with the European Union is still proceeding, however slowly.

Microsoft is clearly feeling good about spending less time in court. "We have resolved the large majority of our legal issues, which the company has always said was a prerequisite to addressing our cash management plans," said Brad Smith, Microsoft's general counsel, in last week's announcement.


On the glass-is-half-full side of things is financial weekly Barron's, whose cover story on Microsoft this week portrayed the company as a well-positioned growth stock, with the potential to accelerate revenue growth and grow profits over the next couple of years.

Barron's portrayal of Microsoft's growth potential was backed by the software company's fiscal year 2004 results, announced last week. From July 1, 2003, to June 30, 2004, Microsoft grew revenues by 14 percent, to nearly $37 billion, and it brought in $8.2 billion in net income; both are company records. The growth argument was further bolstered by results in the fourth quarter, in which the company reduced operating expenses by 6 percent, en route to an 81 percent increase in net income, to $2.7 billion.

But can Microsoft, which has by far the largest research and development budget among technology companies, become a growth stock by cutting expenses and giving its cash back to shareholders? CEO Steve Ballmer, who has expressed concern about the company's stagnant stock price, recently called on the company to reduce expenses by $1 billion per year. Ballmer is concerned that Microsoft's stock price hasn't changed much since the late 1990s, and the huge dividend and buyback, coupled with a drop in expenses, is central to Microsoft's plan to boost its share price.

But how much good will the huge dividend do for Microsoft's long-term standing? While it will surely help shareholders in the short term, some analysts say it won't help the company's long-term position, and will actually hurt earnings because Microsoft won't earn as much interest on $24 billion as it would on more than $60 billion.


Cutting expenses is one way to get back on the fast track, but Ballmer realizes the company needs to grow revenue, too. Although Microsoft has been transitioning from its dependency on PC sales for years, nearly all of its revenue--on the order of $6.5 billion per quarter--still comes from selling Windows operating systems, the Office productivity suite, and the Windows Server System. In fact, the Office and Client operating system divisions each had about four times the profit as the Tools and Technology division, where Windows Server System and development tool sales are booked.

As a PC company, Microsoft will continue to enjoy the fruits of its monopoly on the desktop, albeit in declining numbers. The company forecast PC growth for fiscal 2005 in the range of 7 to 9 percent, and Ballmer recently said that, in several years, the number of PCs around the world will grow from 600 million to about 1 billion, most of which will inevitably run Windows.

The other four business units of Microsoft--Microsoft Business Solutions, MSN, Home and Entertainment, and Embedded Systems--have all historically been money losers for Microsoft. The MSN Internet division turned a profit for the first time in fiscal 2004. With the delay of Project Green, which sought to unite all of the solutions from Microsoft Business Solutions on a single code base, Microsoft Business Solutions will likely make incremental, but not earth shattering, improvements in functionality and market share.


With the next major release of Windows, codenamed "Longhorn," not due until 2007, corporate customers will have to make do with the current crop of Windows components for the next two years. Although it should bring a noticeable increase in security, next month's release of Windows XP Service Pack 2 will be more about praying that your applications don't break, and reinstalling new releases built to work with XP SP2, than about reaping the benefits of glorious new capabilities. Universities and other academic institutions may have a use for the Windows Server High Performance Computing (HPC) edition Microsoft is building, and there will also be hundreds or thousands of buyers of its Virtual Server 2005 product when it ships later this year. But there is nothing earth-shattering until Longhorn and its new file system.

Investors looking for a spark of growth from Microsoft in the near term are better off looking to its other divisions, namely MSN and Home and Entertainment, where Microsoft is plowing much of its heralded $6 billion R&D budget these days. Microsoft is positioning MSN to take on Google and Yahoo with new search technologies. Microsoft won't kill the Xbox gaming console, even though it continues to lose hundreds of millions of dollars per year. To ensure its market position, Microsoft recently lowered the price of Xbox, and it's now the number-two gamer's platform, right after Sony, and is poised to kill off the number three player, Nintendo.

Instead of giving all its capital away, would Microsoft have been better off making a strategic investment in its own business? With $60 billion in the bank, it could have afforded to buy SAP, the undisputed leader in corporate ERP systems. Earlier this year we heard the tantalizing revelation that the two held merger talks in late 2003, but that Microsoft decided against pursuing a merger because of the complexities it would entail. What the companies didn't say was that such a merger would also draw attention from antitrust officials, and having just won the long, drawn-out battle against the Department of Justice, why would it want to enter into another one?

Or perhaps Microsoft could have invested more into its data center products. Fiscal 2004 saw 20 percent growth in core Windows Server System components, including Windows Server 2003, Exchange, and SQL Server, and 20 percent overall growth in its Server and Tools division. These are strong numbers in a market that is just emerging from a protracted three-year slump.

By 2008, Windows will drive 60 percent of server shipments, according to market researcher IDC. Microsoft could probably accelerate the growth of its server market share and better compete against freeware and open source systems--predominantly driven by Linux but also including BSD Unix and others--by enacting steep price cuts on Windows Server System, such as it did for its Xbox game console. But, then again, Microsoft is already going to own most of the server market by 2008, so why bother?

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Editor: Alex Woodie
Managing Editor: Shannon Pastore
Contributing Editors: Dan Burger, Joe Hertvik, Kevin Vandever,
Shannon O'Donnell, Timothy Prickett Morgan, Victor Rozek, Hesh Wiener,
Publisher and Advertising Director: Jenny Thomas
Advertising Sales Representative: Kim Reed
Contact the Editors: To contact anyone on the IT Jungle Team
Go to our contacts page and send us a message.


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