Dueling Fools

Dueling Fools

Microsoft 2000
Bull Argument

By Matt Richey (TMF Verve)
November 17, 1999

The highest compliment that can be paid to the Redmond software giant is its most obvious characteristic -- at $500 billion, Microsoft is the most valuable commercial enterprise on the planet. That's bigger than the market value of Ford, General Motors, DaimlerChrysler, AT&T, and Disney -- combined. And since companies are valued on the expectation of future results, the collective voice of investors is saying that Microsoft has more future profit opportunity than any other company in existence. That's an amazing compliment, but also a daunting task for Bill Gates & Co. to achieve. In my mind, the most pressing question for an investor to ask is, "Will Microsoft do better or worse than the market expects?"

Quite frankly, Microsoft faces tremendous challenges. Most prominent of late, the government trustbusters are hell-bound to curb the company's fiercely competitive practices. Beyond that distraction, Microsoft's bread-and-butter PC software business is threatened by slowing growth in worldwide PC shipments. Further, the Office suite of productivity applications faces potential saturation. Elsewhere, delays in the release of Windows 2000 is allowing the open source community to make great strides with the industrial-strength Linux operating system (OS).

At the low-end of the market, new non-Windows Internet appliances are a major threat. Part of the rationale behind America Online's $800 million investment in Gateway is to develop cheap Internet machines that do nothing but launch AOL software, thus altogether bypassing Microsoft's computing toll gate, Windows. Microsoft is also losing ground in the rapidly growing handheld device market, where its clunky Windows CE-based units are getting crushed by the much simpler Palm devices.

Fact is, in virtually all product categories, Microsoft is anything but a shoe-in success. But before I fully state the bear's case, let me turn to my reasons for optimism.

Even with all of its challenges, Microsoft's financial results tell of the incredibly strong underlying demand for its software products. Over the past 12 months, revenues have grown by 30% and net income has grown by 50%. That kind of growth is simply phenomenal for a company with more than $20 billion in annual revenues. In response to the latest quarter's results, CFO Greg Maffei enthused, "You have to feel good and optimistic about the periods ahead."

Growth is being driven by strong corporate demand for the Office 2000 productivity suite, the SQL Server database software, and the Exchange Server enterprise messaging software. By the latter half of calendar year 2000, Windows 2000 revenues should really begin to kick in. The newest version of Windows has been exhaustively beta-tested to ensure a much more robust and reliable version of the sometimes-buggy OS. Massive adoption of Windows 2000 will be nothing less than a windfall of growth over the next three years.

Wall Street is already pretty convinced that Microsoft has great profits in store for the next year or so, but really the bull case on Microsoft stems on the company's opportunity in the next decade and beyond. Looking out farther into the future, CFO Maffei offered the following words in a speech in early October:

"If you look at what Microsoft believes, we're really moving into a new era, a third era of the Internet in which programmability is going to massively enhance the usefulness to the average consumer and the average business. It's going to take across the multiplicity of devices and a multiplicity of connectivity methods. Whether it be DSL and cable for broadband narrow band dial up or wireless. To manage all of that multiplicity of connectivity and devices and to do that programmability, great software will be more important and more critical than ever. You're going to strain the ability of software companies to manage that opportunity, but it's going to be an enormous revenue upside potential."

As Foolish investors, we should look for businesses with a track record of using resources efficiently to create shareholder value. Microsoft is just such a company. Take a look at the following core economics of the lightweight software business:

                    (in billions)
Cash & Equity Investments   $33.8 
Total Assets                 39.7 
Non-cash Assets               5.9 
OK, so we're talking about a company that has nearly $40 billion in total assets, but the vast majority of that sum is made up of liquid cash and equity investments. Essentially, Microsoft -- the most highly valued commercial enterprise on Earth at more than $500 billion -- runs its business on a base of operating assets worth less than $6 billion. That's $6 billion worth of land, buildings, networked computers, and loans to customers. That's it. From that relatively meager base, Microsoft generates the following results:
                    (in billions)
12-month Revenue           $ 20.9 
12-month Net Income           8.3
12-month Free Cash Flow       8.8
How many other companies do you know of that generate more in profits every year than their entire base of invested capital? That's wealth creation at its finest. Notice also that Microsoft generates free cash flow in excess of its reported net income.
That means that in a single year, Microsoft has created nearly $9 billion that it could hypothetically issue as a gigantic dividend to shareholders. Fortunately, Microsoft instead chooses to use this cash as an offensive weapon to expand its business. During 1999, the company has made strategic investments in AT&T and Nextel, among others. In September, Microsoft made its 36th strategic investment of calendar 1999 alone. At $15 million, this is a small investment in Akamai Technologies to enhance the delivery of Microsoft's streaming media software.

All in all, Microsoft is using its tremendous financial resources to plant the seeds for new ventures that could eventually grow into huge businesses. We can't see which seeds will turn out to be fruitful, but with nearly $34 billion to spread around, Microsoft is bound to find some fertile ground. As the information age increasingly demands more and better software to manage information, Microsoft will be front and center in meeting this demand. It's not a stretch to imagine that Microsoft's next decade may be more prosperous than the last.

Next: The Bear Argument