June 8, 2005
Company Watch: Microsoft Corporation
By Brady Willett

Bill Gates and Paul Allen co-founded Microsoft in 1975, and - after the success of MS-DOS (1981) and Windows (1983) - took the company public in 1985.  A decade later Microsoft orchestrated one of the most anticipated and successful product launches ever (Windows 95).  The rest as they say is history.



Operating History

From 1985 to 2000 Microsoft’s financial performance never froze up.  Rather, and thanks in part to the company’s ability to parlay its operating system (OS) monopoly into other opportunities, Microsoft enjoyed an unparalleled 16-year growth spurt.  This impressive financial record gave investors the confidence leading into 2000 to bid shares up to more than 60 times earnings.  Unfortunately investor’s were overly 'confident'.


Despite antitrust investigation uncertainties bubbling since 1990, the first real sign of trouble for Microsoft did not arrive until after the Y2K upgrade period ended, or when the IT spending boom turned to bust. And although Microsoft never actually reported a quarterly loss, after registering massive investment losses and slowing revenue growth in fiscal 2001, the company's days of 40+% net margins and 50+% annual growth were no more.




With the IT slowdown becoming more entrenched in 2001 and 2002, the big question on the minds of investors was whether or not Microsoft would age gracefully. Paying no attention to MSFT's stock price movements, this question has been answered with a resounding YES.  To be sure, Microsoft minimized challenges and grew the business on a net equity basis during the US recession/bear market.  Moreover, Microsoft maximized opportunities by shifting its focus from marketing to product development, and in early 2003 the company started paying a dividend.  In short, Microsoft made the transition from growing tech king to mammoth cash cow look easy (again, assuming you ignore stock price).




New Plans. Same Old Story

“The Company operates in one business segment - the development, manufacture, marketing, licensing, and support of a wide range of software products”
Microsoft 10K, 1994.

It is tempting to try and decipher Microsoft’s competitive position in each of its 7 operating divisions.  After all, if X-Box can grow and consistently produce profits this could be great news for the company longer-term, and MSN growth trends are certainly a hot topic today with Google trying to bully Microsoft and Yahoo around.

But alas, with more than 60% of Microsoft’s revenues still coming from Windows and Office, all of the profits coming from the top three business segments, and with the company increasingly focused on next years new Windows Longhorn launch, speculating about unprofitable and significantly smaller company divisions is unproductive. Quite frankly, forget about MSN battling Google and PlayforSure lining up to circumvent IPod’s reign - Longhorn is what is required to keep Microsoft a relevant and thriving.



It may also be the case that Longhorn is what is required to jump start the company’s lost battles versus newcomer Google.  And while little has been said surrounding how much Microsoft branding can, and will be done with Longhorn, both Yahoo and Google warn in their latest 10Ks that Microsoft will integrate web search tools into the new OS. Whether this will be enough to slow Google remains to be seen.

There are some reasons to believe that Windows dominance will wane, including the competitive long-term threat from Linux and/or Mac OS, and an antitrust settlement (US) that hinders the company’s monopoly powers. Nevertheless, given Microsoft’s current control of OS the company stands to profit when, and if, one forecast rings true:

“It took more than 20 years to grow the worldwide base of PC users to 600+ million. By 2010, we expect this base to grow to 1 billion...” Microsoft 10K, 2004.

Valuation Overview

To highlight how insane the 1990s stock market mania was, MSFT's PEG ratio stayed below 1.17 for more than a decade, and then - in less than 1-year - more than doubled (average on an annual basis).


Mania-mullings aside, it is difficult to paint Microsoft in a strict overvalued and undervalued light. Rather, the challenge for the investor is to decide whether or not Microsoft's dominance in software awards it’s stock price high valuations.

24-times earnings may not seem that high when observing Microsoft’s history, but lets not forget that historically Microsoft’s EPS growth has been influenced by factors other than core business growth.  Indeed, in the 1990s - when 50+% EPS gains were not uncommon - Microsoft was a small company that generated stellar returns from investments, did not expensing options, and benefited from its now renown strong arm tactics. Today Microsoft is $275 billion company that is struggling to produce strong/consistent investment returns, the company is expensing share based compensation, and its business practices are under the regulatory microscope.  Does Microsoft today warrant similar valuations to the Microsoft of the early 1990s?



Another challenge for the investor comes when analyzing what impact, if any, the company's $32 billion special dividend payout in 2004 should have on share price.  Does the company deserve to trade at a lower dividend yield than say the S&P 500 because of the possibility of another large dividend payout down the road?  Can Microsoft continue to increase its dividend so long as global PC sales continue to increase?



Whatever your speculation, what the special dividend did - when averaging out the stock price gyrations before and after the record date - is send MSFT shares higher on a P/B basis. 


Conclusions & Investment Opinion

If you back out higher margin Windows and Office related sales, the sum of the remaining Microsoft parts is equal to nothing out of the ordinary. However, and despite being what many believe is an inferior product, Windows is not going away anytime soon.  Rather, with a new OS launch planned for next year and Linux seemingly unable to live up to its hype, it is wishful thinking to believe that Microsoft will stop producing billions in free cash anytime soon.

A $1 investment in Microsoft gives you 4 cents in earnings, 1.25 cents in dividends, 17 cents in equity, and 2.2 cents in annual R&D. These numbers are not impressive on their own, but when combined and compared to other software companies they stack up well. Specifically, that MSFT has the highest yields and, arguably, the greatest competitive advantage out of any software producer makes the company attractive.  On the downside, MSFT is rich on a price/equity basis, and you only get 2.21 cents for every dollar invested in Research and Development (although it is worth pointing out that on a dollar basis MSFT spends more on R&D than any other software company, and the number 2 software company by sales - IBM - spent more than $2 billion less than Microsoft on R&D in fiscal 2004.) 



The hope for the value investor eying a long-term entry position in Microsoft is that the company's isolated challenges and failures lead investors to overlook the company’s likely long-term success.  This success is based upon the old customers caught in the PC/software replacement cycle, and the new customers/frontiers Microsoft is trying to attract with its massive R&D investments. Should Microsoft test its lower trading range ($20) during the next PC spending pause (which is not anticipated by Gartner until 2006), the investor would have to seriously consider the risks and rewards of purchasing what would then be a company yielding 1.6%, trading at 19 times earnings, and controlling an estimated 90% of the OS market. However, as of right now MSFT is a little rich.


BWillett@fallstreet.com







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