Saturday, July 10, 2004

M$: Has Microsoft peaked?

IT Manager's Journal | IT Investor's Journal: Has Microsoft peaked?

Title IT Investor's Journal: Has Microsoft peaked?
Date 2004.07.06 9:46
Author editingwhiz

Microsoft Corp.'s business ambitions have never wavered. Microsoft was founded in 1978, went public in 1987, and has since grown to become the world's largest technology company and one of the world's largest publicly traded companies. It has as an enormous cash balance of around $55 billion on its balance sheet and 93 percent share of the consumer software market. Investors typically regard MSFT stock as a no-risk investment with a stock price that will keep going up. However, that is not the case.

Yes, Microsoft has a ton of cash on the balance sheet. But it's not balance sheet cash or market share that propels a stock price upward. It's growth. And growth leveled off at Microsoft about 18 months ago, when the company went ex-growth and ex-cash.

In October/November 2002, MSFT stock was trading in the high $20s, and the S&P 500 Index was trading at around 990. Three months later, MSFT stock was quite heavily punished in January 2003 after the company reported earnings and missed revenue expectations. Starting in April after the Iraq war, the S&P 500 rallied around 40 percent through the end of 2003 from about 800 to around 1150. However MSFT stock did not participate in this upside and remained in a trading range between $24 to $28. Currently, MSFT stock is roughly at the same levels as it was in October 2002, and yet the broader market is still up around 30 percent since that time.

Melanie Hollands
What this means is that an investor holding MSFT stock from October 2002 would have roughly broken even on his or her capital; but had he invested in the S&P 500 instead of MSFT stock, he would have gained around 30 percent on their capital.

This result contradicts the prevailing conventional wisdom about MSFT stock continuing to be a growth stock.

I have long-term concerns about Microsoft and its growth outlook. If I were to balance out 1) the potential for the areas were Microsoft can grow; 2) handicap the stock for the company's (relative) inability to sell; 3) add in the amount of potential loss of existing business to Linux (a high probability there); and 4) handicap it for the risk of being declared a monopoly, then there seems to be little chance of much growth at Microsoft for the next couple of years. On this basis and over the long term, I believe that MSFT stock trading at 9 times sales is a stock that is priced too high for this low-growth scenario.

Ideally, I'd consider a stock price of somewhere around five to six times sales ($17 to $19) to be a more appropriate reflection of its growth outlook. However, I don't believe the stock will fall that low, since an "air pocket" of higher expectations should keep a floor under the stock at around $24 or so.

Huge business base, but limited growth opportunities

Currently the world's No. 1 software company, Microsoft provides a variety of products and services, including its Windows operating systems, the Office software suite including the programs we all know and use every day – Microsoft Word, Excel, and Outlook. In the enterprise market, Microsoft caters to small- and medium-size businesses as well as large corporations. It sells a variety of software applications such as ERP (enterprise resource planning) and CRM (customer relationship management), and has also expanded into markets such as video game consoles, interactive television, and Internet access. Microsoft's core markets (operating systems and office applications) have matured and, as a result, growth opportunities there have leveled off. Consequently, Microsoft is targeting services for growth by looking to transform its software applications into Web-based services for enterprises and consumers.

Long term, the basic problem with Microsoft is that IT budgets are not going to grow very fast over the next several years, and they already own large chunks of the market. There is limited ability to increase revenues from the Office business, because the company risks ticking people off and driving more people off license. Growth in new PCs, and therefore operating system sales, is likely to be constrained to three to four upgrades for laptops and four-to-six-year cycles for desktops. Creation of new markets for other sorts of operating systems will probably be constrained by the reluctance of many potential partners to get "into bed" with Microsoft.

On its recent analyst call, management showed numbers that claim managed business solutions (MBS) is growing faster than that, but I think the comparison they are using is not "apples to apples." In last year's fiscal fourth quarter, management added the Microsoft-branded software sold through the Microsoft partner channel (as opposed to Great Plains, Navision, Solomon, etc. brands) into the segment revenues when they reorganized with Ayala running MBS sales. The numbers in the quarter are shown net of inter-company transactions, and therefore are "apples-to-apples." So that part of the business will appear to slow down certainly by the first fiscal quarter of 2005 and perhaps as soon as in the fourth fiscal quarter of 2004. Since it's so small, no one will care. But yet another area in which Microsoft's growth is slowing.

However, Microsoft does have some areas where it can grow. Databases and analytical services are two, as well as in the small business end-user segment. Interest rates are heading north at some point, so that will help increase the return on the company's $55 billion cash hoard. Eventually I'd expect to see analysts bumping numbers up to reflect that. Otherwise, MBS continues to grow about 15 to 20 percent year-over-year, and the company should be able to sustain that for the next several quarters.

However, there is no way in my mind that Microsoft's existing ERP/CRM software for business will be ready to be competitive with SAP/Oracle/PeopleSoft anytime in the next decade or so. It's not clear that this is even an attractive option. There is the possibility of getting billions more dollars out of mid-size companies (500 to 5,000 employees), because this market has been under-penetrated. Unfortunately, there don't seem to be enough people in the Redmond group that really understand how to make this happen.

Why all the fuss about Microsoft's size?

The European Union's ruling against Microsoft -- a fine of €497 million (around USD $625 million) for antitrust violations -- was a joke. Even if Microsoft has to end up unbundling the audio and video from this version of Windows -- which is not a technical problem whatsoever -- the company will find a reason to put it all back together again the way it was planned in Longhorn (the next version of Windows, due out in 2008). Microsoft could also reassemble it in some other product. Alternatively, the company still could reach a compromise with the EU or, more likely, fight the EU decision over the next five years or so.

The hope appears to be that the EU ruling would prevent re-bundling the audio and video in Longhorn or some other package. But I don't think it sticks. Microsoft's point is that integration makes the user experience better. The company may have to let in competitors on their API code. Microsoft argues that its audio and video programs will still work the best with the Microsoft product. Plus, if the company charges the same price for bundled Windows as it would charge for the unbundled components of Windows (and I don't see why it wouldn't), then it's all the same to its bottom line. Now other companies can make an interface between Microsoft and these other programs to "simulate" an integrated user experience. But it seems these programs don't run as fast or as well. Anyway, that's the claim made by the Microsoft camp.

I don't see a major impact on the MSFT stock price as a result of the EU ruling, but I do think that the stock progressively and gradually will continue to weaken over the long-term. The stock starts to look expensive in the high $20s. MSFT has been in the process of forming a substantial bottom pattern, and I see support for the stock in the $26.5 to $27 range. That said, I don't yet see a catalyst to move the stock price down again just yet.

Looking out, say, in 12 months' time, I believe MSFT will be trading at lower levels than it is currently, even if the market is marginally higher. It's a rough period for a share price when a company's stock goes from being a growth stock (as MSFT has been in the past) to a value stock (as MSFT is heading now) and the share ownership constituency shifts from growth- to income-oriented.

I consider the EU ruling against Microsoft to be a low-odds negative, but at the margin maybe a negative for MSFT stock over the long-term. The stock has enjoyed a short-term "relief rally" following the official announcement from the EU and getting past the uncertainty. I believe longer-term weakening in the stock price would be due to reasons other than the ruling.

Some of elements I expect will be primary drivers of MSFT's stock price over the next 12 to 18 months include:

* Monopoly products have gone ex-growth for a year or more,
* Slowing operating cash flow growth,
* Threat of competitors,
* Substitute technologies -- specifically Linux

Melanie Hollands may hold a personal or professional position in the stocks she discusses. This article does not constitute a recommendation to buy or sell any security and is intended as "food for thought" only. For 14 years she has covered the technology and telecommunications sectors, from positions held in business strategy (McKinsey & Co., Bain & Co.), corporate finance (Salomon Smith Barney) and fundamental equity research (Merrill Lynch). She follows PC/server/storage hardware, enterprise and application software, wireless hardware/software/middleware, data networking and telecom equipment, optics, semiconductors, semi capital equipment, and various niche technologies (RFID, WiMax, VOIP and others). Hollands is president of Koala Capital (located in Aspen, Colo., and New York City), which focuses on trading/investing in technology stocks. She is also a senior advisory board member for a start-up financial services venture, the Semiconductor Futures Exchange Inc., and an advisory board member for a start-up Linux-HPC venture, Tadpole Ventures, LLC. She has been a guest lecturer and adjunct professor at Columbia Business School, where she earned her MBA, and also holds joint bachelor's degrees in Architecture and Structural Engineering. Ms. Hollands is unable to provide personalized investment advice.

For reference: Use this handy link to stock terminology.

Financial resources and subscription Web sites:

Bill Fleckenstein (www.fleckensteincapital.com) is President of Fleckenstein Capital, a Seattle-based hedge fund. Bill is a successful money-maker, has great insights, and calls it like he sees it -- there's never any doubt where Bill stands on anything market-related. He also writes a column "The Contrarian Chronicles" on MSNBC.

Richard Russell: www.dowtheoryletters.com.

Market History, www.markethistory.com, is a subscription site that provides quantitative analysis based on market history and past trading patterns. It identifies key factors driving the current market and analyses how the market has reacted in the past under the same sets of circumstances.

1. "Microsoft Corp.'s" - http://www.microsoft.com/
2. "MSFT" - http://finance.yahoo.com/q?s=MSFT
3. "ruling against Microsoft" - http://management.itmanagersjournal.com/article.pl?sid=04/03/23/0715245&tid=84
4. "Semiconductor Futures Exchange Inc." - http://www.semifutures.com/
5. "handy link to stock terminology." - http://management.itmanagersjournal.com/article.pl?sid=04/04/23/0819223&tid=103
6. "www.fleckensteincapital.com" - http://www.fleckensteincapital.com/
7. "www.dowtheoryletters.com" - http://www.dowtheoryletters.com/
8. "www.markethistory.com" - http://markethistory.com/


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