Microsoft looks to remake itself

NEW YORK (CNNMoney.com) -- In an era where the Web is king, Microsoft is no longer regarded as a growth stock. But if the company's bets on new businesses pan out, it could become one again.

Microsoft (Charts, Fortune 500) has had to play catch-up in many areas - video games, MP3 players and online advertising - with varying degrees of success.

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The company's new "Halo 3" game and Xbox console are increasingly important for Microsoft. The entertainment and devices division makes up 12 percent of Microsoft's revenue and is the company's fastest growing, with revenues increasing 28 percent in fiscal 2007, compared to overall sales growth of 15 percent.

But the Zune MP3 player, which is also part of the entertainment and devices division, failed to capture the attention of the iPod generation.

Microsoft has also seen faced legal setbacks in Europe. The recent court ruling upholding the European Union's order to offer a version of its Windows operating system without its Windows Media Player software is a major blow to the company since it bundles features with Windows.

Of course, Microsoft is still a corporate giant - with annual revenues of more than $50 billion and cash on hand of more than $20 billion. Its core businesses are doing well, thanks to the release of Vista, its latest operating system, and a new version of the Office suite of tools.

But even in these established businesses, Microsoft faces challenges. Office, in particular, faces increased competition from Google and IBM.

Although Microsoft has the cash to muscle its way into competitive new growth areas, it remains to be seen whether it really can become a growth stock again.

Microsoft has looked mainly toward online advertising and gaming to invigorate its sales and earnings growth.

Microsoft is a distant third in the lucrative business of online search. According to the most recent rankings from Web tracking firm comScore, Microsoft's market share in search was just 11.3 percent in August compared to 56.5 percent for Google (Charts, Fortune 500) and 23.3 percent for Yahoo (Charts, Fortune 500).

Earlier this year, Microsoft was in talks to buy DoubleClick, a top digital marketing company, but was outmaneuvered by Google, which agreed to purchase the company for $3.1 billion in April.

Not to be outdone, Microsoft then paid $6 billion to buy another top digital marketer, Seattle-based aQuantive, in May. It was the largest acquisition in the company's history.

Former aQuantive CEO Brian McAndrews has been tapped to run the engineering section of Microsoft's online advertising business, a move that Wall Street hailed.

"The aQuantive acquisition gives [Microsoft] a team of people who really understands the business," said Sid Parakh, an analyst with McAdams Wright Ragen.

Microsoft also announced Thursday that it had launched an improved version of its Live Search in order to better take on Google. The redesigned search engine includes a significant increase in the number of Web pages indexed and an expansion of Live Search's "rich answers" section, which provides responses to specific questions.

On the gaming side, the company has brought in new talent from outside of Microsoft to invigorate the division, which faces a tough battle from Nintendo and Sony. Microsoft hired former Electronic Arts executive Don Mattrick in February as an adviser to its video game group and appointed him head of it in July.

This week it launched "Halo 3," which amassed pre-orders of 1 million copies. Goldman Sachs analyst Sarah Friar wrote in a research report that strong demand for the game could contribute $50 million or more to the company's sales in the first quarter of fiscal 2008, which ends in September.

Microsoft has invested heavily in the division, anticipating long-term gaming trends as far as 10 years out. But the investments have not panned out for Microsoft's bottom line yet. The entertainment and devices division, despite its impressive sales growth, posted an operating loss of $1.9 billion in fiscal 2007.

Although growth has been slower for core products, such as Microsoft Windows and Office 2007, this year saw substantial revenue gains in both divisions because of their recent releases. Sales in the Windows division climbed 14 percent to the fiscal year ending June 30, while sales of Office were up 13 percent.

"The PC market has done tremendously well this year, so you're seeing that flow through Microsoft's numbers," said Morningstar analyst Toan Tran. "Vista is tracking toward expectations and Office 2007 is doing better than I thought it would."

The planned 2008 release of Windows Server should speed adoption of Vista, Tran believes, because executives like to upgrade individual computers and servers at the same time.

In addition, Microsoft is cracking down more aggressively on global piracy, which could spur the sale of more Windows and Office licenses. The company also plans to offer more premium editions of its software for clients who need features, another possible revenue boost.

But several big-name companies have developed free software that could threaten Microsoft's stranglehold on the office software market.

Google Docs, the free Web-based offering from the search giant, has basic word processing and spreadsheet functions and allows easy sharing of documents. IBM (Charts, Fortune 500) is relaunching spreadsheet software Lotus Symphony as a free download, using the new Open Document Format standard, a favorite of governments.

"These new software packages are definitely more of a long-term threat - something that could happen five to seven years from now," said Tran. "Currently the online suites don't have the level of features that someone working in a business environment would need."

If Microsoft wants its stock to head significantly higher, analysts said the company is going to have to get a stronger foothold in markets, such as advertising and gaming.

Fortunately for investors, Microsoft pays a dividend that yields 1.5 percent, a healthy yield for a tech company. And Wall Street has a positive opinion of the company, with 29 of 38 analysts surveyed by Thomson One giving it at least a "buy" rating.

The stock also looks reasonably valued, trading at a forward price-to-earnings ratio of 17.1, a discount to software rivals Oracle (Charts, Fortune 500) and SAP (Charts), which trade at 17.3 and 25.4 times next year's earnings estimates respectively.

Microsoft is more expensive than IBM, which trades at 15.8 times earnings estimates. But the slower-growth IBM is more than just a software company since it also has big hardware and services divisions.

Goldman Sachs' Friar has a 12-month price target of $37 on the company, which implies about 25 percent upside to its current price.

And Microsoft is starting to show some signs of healthier growth again. According to Thomson One, analysts expect earnings to increase 16 percent to $1.73 per share in fiscal 2008, which ends next June, and that sales will increase 12 percent to $57.3 billion.

"Microsoft faces a number of challenges, but we think the stock is a below-average-risk investment given the firm's dominant position in its major markets," wrote Tran.

It's no secret that the company is not going to return to its peak growth levels, but it still may have prosperous days ahead of it.

Goldman's Friar does not own shares of Microsoft, but Goldman Sachs has done investment banking business with the company. The other analysts quoted in this story do not own shares of Microsoft and their companies have not done investment banking with the firm.