Buy, Sell or Hold: Despite Challenges, Innovation Will Provide Long-Term Boost to Software Leader Microsoft Corp. (Nasdaq: MSFT)

Thanks to some shrewd maneuvering with its first major software contract in the early 1980s, Microsoft Corp. (Nasdaq: MSFT) built itself into a tech giant and software powerhouse. But the global financial crisis and increasing competition are eroding that longstanding dominance.

There's no doubt the company has made successful strategic decisions for decades.

Founder and Chairman William H. Gates III established Microsoft in 1975 and made it the worldwide leader in software products and services, including operating systems for servers, personal computers and intelligent devices, server applications, business solutions applications, software development tools and video games. It offers product support and consulting services on its impressive array of products, including its widely used Windows operating systems and Microsoft Office software suite.

Let's Make a Deal

To expand beyond software, Microsoft got aggressive with its acquisition strategy a few years ago and pursued companies that allowed it to diversify its reach.

Microsoft kicked off 2008 by acquiring Fast Search and Transfer ASA, one of the global leaders in business-intelligence software. The goal: Develop a search engine designed for the biggest corporations in the world. Microsoft went on to buy Danger Inc., the maker of Sidekick smartphones, to help improve its consumer-focused mobile-applications businesses.

Then it made its first big step into offline media by purchasing Navic Networks, a leader in technologies that present targeted, interactive ads for digital cable.

Last year, Microsoft saw the promise in cloud computing and snagged data-center-management-software firm Opalis Software Inc.

While diving into other computing product areas, Microsoft has kept focus on its software niche and continues to improve and release updated versions of its core products.

In June, Microsoft released in 35,000 retail stores and online its Office Suite 2010, Visio 2010, and Project 2010. And it continues to add updates to features of Excel, Word, and Powerpoint. It remains a favorite with customers by offering online assistance and information, as well as free online versions of the applications.

Currently Microsoft boasts roughly 90 million business customers and approximately 400 million Windows Live users, and those numbers will keep climbing. With more than a billion PCs worldwide running on Office, analysts estimate that Microsoft's Office Web Apps have the potential of reaching half a billion users.

Singed by the Downturn

But even this computing powerhouse couldn't escape effects of the harsh economic downturn. Microsoft's business was adversely affected in fiscal year 2009, as customers and businesses reduced spending.

In that fiscal year, which ended June 30, 2009, entertainment devices pulled in sales of $7.75 billion, down 6% from the previous year. Even though revenue was down marginally, the operating profits were down 66% to $169 million from 2008 operating earnings of $497 million.

The company blamed the declines on price reductions of its Xbox360 system during the past year. Even though Microsoft made less per system, it shipped 29% more systems than in 2008, moving 11.2 million in 2009 compared to 8.7 million in 2008. But Microsoft's Business and Windows Divisions posted much stronger numbers, delivering operating profits of $12.1 billion and $10.86 billion, respectively, in 2009.

Microsoft has also reached a couple areas of product concern. The company's portable music device, Zune is selling 1/50th of what Apple Inc's (Nasdaq: AAPL) iPod sells, and Microsoft's Windows Mobile is losing out to both Apple's iPhone platform as well as Google Inc.'s (Nasdaq: GOOG) Android platform. It seems clear that Microsoft is having difficulty convincing consumers that its products carry the same "cool factor" as Apple and Google - and that is holding back potential revenue.

But 2010 has shown improvements from 2009's financial tumble. On July 22, Microsoft announced a record fourth quarter revenue of $16.04 billion, which was a 22% increase from the same quarter last year. The company also realized net income of $4.52 billion, operating income of $5.93 billion, and earnings per share of 51 cents, which all represent net increases of 48%, 49%, and 50%, respectively. In particular, Windows 7 saw its thirteenth straight month of market-share growth to more than 175 million licenses worldwide.

On top of strengthening financials, Microsoft believes it can continue to weather this economic storm and beat its tech rivals with its strong pipeline of products.

A Look to the Future

Microsoft is ready to boost profits from the increasingly popular gaming world. In June, the company unveiled its new "sleek, silent, and sexy" Kinect game technology, a full-body, motion-sensing, controller-free Xbox360 upgrade that it hopes will compete with the wildly popular Nintendo Wii. Kinect recognizes players' movements and voices, allowing gamers to use their Xbox 360s without a handheld controller. The new device will ship in the United States on Nov. 4 and Kinect-friendly games will be released from many major publishers.

The news so far for this product is largely positive. In console sales, Microsoft ranks second to Nintendo and is just ahead of Sony Corp.'s (NYSE ADR: SNE) PlayStation. Kinect will be a turning point for Xbox, positioning it for an even stronger competitive future.

This fall, Microsoft will also release its next generation of mobile OS multi-touch technology, the Windows Phone 7 series. For the first time, Microsoft will unite Xbox Live games and Zune music and video in a mobile phone. The company is promising the new platform is a fresh approach to phone software, maximizing the phone's capabilities for consumers and offering the most user-friendly experience.

Despite its promising product outlook, Microsoft's stock has been slipping for more than four months.

Since closing at $31.08 on April 22, Microsoft shares have skidded 22%, considerably underperforming the Standard & Poor's 500 Index, which has dropped by only 9% during the same time frame.

Technically, the stock is currently looking bearish.

If we look back at Microsoft's earnings and performance over the last two years, we see a pretty obvious trend. When the global economy slows down, Microsoft earnings and share performance suffers. This is a critical point right now as we stare into the eyes of yet another economic slowdown - especially in the West, from where Microsoft derives so much of its revenue.

While the technicals are bearish, Microsoft is a financially sound investment for the longer-term investor (with enough patience to wait while the global economy works through its current hiccup). But today's market conditions haven't favored longer-term buy-and-hold investors.

Therefore, I'm suggesting that Microsoft is a "Hold" at current prices.

On the other hand, the company looks compelling to me at $21.00 or less. If you really want to own Microsoft and its host of products and services, put in a low-ball, Good ‘Til Cancelled (GTC) bid to buy Microsoft shares at less than $21.00.

If you then get the fill you are looking for, be sure to use a 25% trailing stop to protect your capital to the downside - as well as to lock in potential upside gains.

Action to Take: Hold Microsoft Corp. (Nasdaq: MSFT) at current price. Buy MSFT under $21.00 "GTC" with a 25% trailing stop (**).

(**) - Special Note of Disclosure: Sid Riggs holds no interest in Microsoft Corp.

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About the Author

Sid is the investment community's best-kept secret. Since 2009, he's served at Money Map Press as Director of Research, analyzing thousands of securities and profit opportunities for subscribers. He's an expert in identifying "alpha" potential in a wide variety of industries, but especially the small-cap sector, where he's discovered a pattern of profits that's almost foolproof.

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