Microsoft Shares The Wealth The software giant finally decides to turn over some of its cash to investors. Does the prospect of a $32 billion dividend make the stock a buy?
By Adam Lashinsky Reporter Associate Wilfried Eckl-Dorna

(FORTUNE Magazine) – Microsoft is handing out money again, and this time shareholders have reason to celebrate. That's because the payout is headed for their bank accounts rather than to the many companies and governments that have taken the software giant to court in recent years. Tempting as that cash may be, however, it's not the best reason to own the stock. (Don't even think of trying to game the one-time $3-per-share dividend the company declared in late July, to be paid in December. More on that below.) Instead, Microsoft (MSFT, $28) is worth a look today despite its cash distributions, not because of them. In short, if there's hope for the stock--and there is--it's because Microsoft is signaling that it's ready to get back to business after a long stretch of turmoil, growing pains, and litigation.

The company has been hoarding its cash for years; when pressed, Chairman Bill Gates and CEO Steve Ballmer would say they needed the reserves as a cushion against legal judgments and to plow into new ventures. But a funny thing happened to Microsoft, the investor. Even after pouring billions into cable investments, basic research, and mass-market product launches like MSN and Xbox, the company has little financial return to show for its efforts. At the same time, thanks to its monstrously profitable Windows operating system and Office applications businesses, the company's cash kept growing. At the end of its recent fiscal year Microsoft had $60 billion in cash and short-term investments. Consider that only 38 companies traded on U.S. stock exchanges have market capitalizations bigger than $60 billion; and of course, no company has anything like that much cash.

Microsoft took a baby step toward letting go last year by declaring an 8-cents-per-share annual dividend, which it subsequently doubled. Then, in late July, it rectified the imbalance with one grand, three-pronged gesture: It declared a special dividend of $32 billion to be paid to shareholders of record as of mid-November; doubled the annual dividend again, to 32 cents; and announced a $30 billion stock buyback. In all the company claims it'll plow $75 billion into shareholders' pockets--all the while reducing shares outstanding, which will boost earnings per share.

Does that mean you should buy some shares before Nov. 17, the record date for Microsoft's special dividend? Definitely not, if you're just after some quick cash. Markets are exceedingly efficient at pricing in special events, and buying just before the payout date won't do you any good because the stock will almost certainly decline by $3 immediately afterward. The fact that the market largely yawned at the dividend declaration shows that investment pros don't see this as an opportunity. "I don't think an individual investor should try to arbitrage this dividend," says Tony Ursillo, a tech stock analyst with fund complex Loomis Sayles in Boston, a Microsoft shareholder. "That's a lot of work that you have to get right."

Nor should you buy Microsoft in the hope that it can return to its glory days. Growth has been lacking at the software giant since the bubble burst four years ago; its recent sales and earnings growth charts might be mistaken for those of a washing-machine maker. The problem is that Microsoft has gotten so big--projected 2005 sales: almost $39 billion--that it needs enormous gains to make an impact. And its shares aren't cheap. Subtracting out the value of the near-term cash payments, the stock trades for about 23 times estimated coming-year earnings. The S&P 500 index, by comparison, is worth about 17 times forecasted 2005 earnings.

Even so, there's a clear case for buying the stock. Not only is Microsoft far more profitable than the typical big company--operating margins run 25%--it still has a dominant position in a far-from-moribund industry. "You've got a company that over a long period of time is going to grow earnings by 12% a year, or double the S&P," says Bernstein analyst Charles DiBona.

Where will that growth come from? Microsoft has a spate of new products on the way, notably next year's Yukon server software, followed in 2006 or 2007 by Longhorn, the long-awaited overhaul of Windows. Longhorn in particular represents the company's next big opportunity because Microsoft could use it to increase its revenues from customers who take out continuing subscriptions for software and services. "It could be a huge home run," says Rob Gensler, who owns Microsoft in his T. Rowe Price Global Technology fund.

The ultimate reason for confidence in Microsoft is that unlike many other companies--especially in the tech sector--it isn't likely to come unhinged anytime soon, especially with so much of its bad news behind it. Says Dane Lewis, portfolio manager with Crosslink Capital, a San Francisco firm with a small position in Microsoft: "They've gotten the litigation out of the way, and I think you'll see them be far more aggressive now, especially on acquisitions." For one thing, Lewis expects Microsoft to buy companies that specialize in security software.

Some are calling Microsoft the new widows-and-orphans stock, but that's not quite right. AT&T (which just announced plans to give up on its consumer business) was once the ultimate example of such a safety stock. But to fit that description in bygone days, a stock needed a market-beating dividend and a protected monopoly. Even after sweetening its regular payout, Microsoft yields only 1.3% (subtracting the value of the special dividend), compared with an average of 1.7% for the S&P 500. As for its monopoly, it faces formidable threats, namely the open-source software movement. It might be more useful to compare Microsoft with venerable blue chips like General Electric and Altria: well-managed businesses that dominate their industries and throw off tons of cash. By upping its dividend--more increases are expected--it's also bringing in a new type of investor, the kind who wants reasonable growth prospects combined with some income.

Is Microsoft a sure thing? Of course not. Otherwise it would have shot up on the dividend news. Instead it rose briefly, then fell back after a mildly disappointing earnings report--further proof that plenty of Microsoft skeptics remain. "You always want to buy stocks during periods of transition and uncertainty," says T. Rowe's Gensler. "If you believe they can pull it off, this will be a great long-term stock."

Reporter Associate Wilfried Eckl-Dorna