Microsoft's Bold Voyage Begins

Like the embarrassing try at moving the USS Intrepid from its Hudson River dock, previous attempts at launching the new Vista software got stuck in the mud.

ON THURSDAY, MICROSOFT SMASH­ ed champagne bottles on the bows of its two biggest product upgrades ever, with a Times Square press con­ ference celebrating the release of new versions of its monopoly soft­ ware products: the Windows operat­ ing system for PCs and the suite of productivity applications known as Microsoft Office.

Like the embarrassing try at moving the massive USS Intrepid aircraft carrier from its long-time Hudson River clock last month, previous attempts at launching the ne,v Vista version of Windows got stuck in the mud. But now operators will be standing by to take orders from Microsoft's corporate customers. At the press con­ ference, Microsoft offered up several Vista test users, including a medical researcher who essentially said that he didn't care what the product cost because it would help him conquer cancer.

Shares of Microsoft (ticker: MSFT) have risen 35% since June, to 29 on Friday, as investors in the Red­ mond, Wash.-based company anticipated the waves of upgrade revenue likely to come from Vista and Office 2007. Those waves have to be quite tall to lift a company that reported annualized sales of around $45 billion in each of its last few quarters, with cash flow bettering a $15-billion-a-year rate. Now that the shares are valued at about 20 times this year's expected cash flow, some investors remain skeptical that Microsoft can pick up enough speed to skim higher,

But the launch will probably succeed. The compa­ ny's sales campaign to drive software upgrades will be awesome-from the glimpses visible last week. And with operating profit margins already exceeding 60% on Microsoft's Windows and Office products, the upside - profit leverage will be 131'ge if the company persuades enough customers to purchase the premium-priced versions of Vista and Office 2007. The company has conservatively planned on only about 50% of purchasers buying the fancy "Professional Plus" or "Ultimate" versions of the upgrades.

Microsoft is also launching products into new busi­ness markets for the company. These new server­ based products for voice communications and collabo­ rative work could offer tough competition for rivals like Cisco Systems (CSCO). Last of all, Microsoft looks like it could finally start turning a profit on products like the Xbox 360, the videogame platform that could displace Sony's overpriced PlayStation as market leader.

Microsoft already has more- than three bucks a sh31'e in cash. It plans to use up to $40 billion in cash flow to buy back stock. The combination of share buybacks and a rise in cash flow from all these new products could get Microsoft's per-sh31'e cash flow growing at better. than 15%. That could incite Wall Street to push Microsoft stock into the mid-30s.

In an impressive piece of accounting research, Freidman Billings Ramsey hard­ ware analyst Clay Sumner asserted in a report Friday that Dell (DELL) has. been manipulating its earnings by under-accru­ ing for warranty costs. Sumner says his research finds that under-accruals have led EPS.to be overstated by two to eight cents a share in five of the past 12 quarters.

Writes Sumner: "First, it appears that Dell regularly uses warranty accruals to materially manage margins and earnings, rendering the reported results less useful for gauging actual margin trends. Second, as of the last quarter for which a lO-Q is available, the cost of actual claims as a per­ centage of product sales was rising steadily-up 30% [year-aver-year] in [fiscal 2006], reducing cash gross margins by 60 [basis points]-and costs may be heading higher. Third, Dell's warranty disclosure is unusual, possibly unique, making it difficult to identify Dell's warranty accruals using only Dell's SEC filings. For this reason, we believe this information is not in the cons en­ sus, and that restatements of earnings may be coming if this turns out to be one of the issues currently under SEC investigation."

Sumner notes that while Dell's war­ ranty claim rate has been relatively stable, the accrual rate tends to vary widely, "a strong indicator of earnings management." Sumner notes that Dell, like many compa­ nies, "tend to underaccrue when times are tough and over-accrue when business gets better," but that the overall trend since 200:3's third quarter has been toward under­ accrual, and "thus overstatement of gross margins." He says Dell's warranty costs were recently running at 46% of its war­ ranty reserve, up from from 28% in 2003's third quarter, and well above the 26% re­ ported by Hewlett-Packard (HPQ) and the 13% reported by EMC (EMC).

Sumner says that Dell's reserve should be higher than HP's, since 85% of Dell's PC customers are corporate buyers, who tend to get three-year warranties, while HP's customer base is 80% consumers, who gen­ erally get one-year warranties. He thinks EMC is more comparable than HP in this case; he notes that EMC is essentialy re­ served for about 23 months of warranty expenses, versus 6.5 month for Dell.

Warranty reserves aren't simply a wise form of insurance against future claims; they are mandated by FASB accounting guidelines.

Sumner also contends that Dell has a confusing approach to disclosing its war­ ranty costs, lumping together both stan­ dard warranties-the kind that come with every PC at no extra charge-and ex­ tended warranties, for which customers pay extra. The two kinds of warranties are accounted for differently: Costs for stan­ dard warranties are expensed up front, while for extended warranties they are spread our ratably over time, like a service contract. "If one doesn't know how large Dell's extended warranty business is, it looks like Dell has a huge reserve for stan­ dard warranties, and hugely conservative standard warranty accruals, while pre­ cisely the opposite is true," he maintains.

Sumner concludes that earnings restate­ ments could be coming if this turns out to an issue in the current SEC investigation of Dell's accounting. As for Dell shares, he doesn't recommend them.

- Eric .T. Savitz